No. 280 - Why Banks Have a Future: An Economic Rationale

by Raghuram G. Rajan
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According to some, the commercial bank is anachronistic and in a state of terminal decline. The evidence, however, is mixed. This paper takes a different approach to analyzing the future of banks: I examine whether there was an economic rationale for their existing in the past and whether this rationale continues to hold. I first outline why both core banking activities of taking deposits payable on demand and originating non-marketable loans are performed by the same financial institution. Both activities essentially require an institution to come up with cash at short notice, that is, to provide liquidity. Scale economies in providing liquidity then explain why both activities are provided by the same entity - a commercial bank. Deregulation and innovation have increased competition, which has forced banks to concentrate on the essentials of liquidity provision. This is why the outward nature of their activities - though not the underlying economic rationale - has changed. However, in the course of performing their traditional activities banks have acquired know-how that enables them to perform a variety of other financial and non-financial activities which deregulation and innovation have opened up to them. The paper concludes with a discussion of why banks may want to limit their entry into some new activities.

Presentation at a Seminar held by the author at the Research Department of the Bank of Italy, 17 June 1996.

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  1. 30 October 1996
    No. 280 - Why Banks Have a Future: An Economic Rationale
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