banking industry

The distinctive function of banks is the transformation of short-term deposits into longer-term, less liquid and riskier loans (Fama, 1980; 1985; Diamond and Rajan, 2001; Gorton and Winton, 2003). By raising funds from depositors and providing credit, banks avoid the duplication of monitoring, which reduces the overall cost of transferring funds from capital suppliers to its users (Leland and Pyle, 1977; Diamond, 1984). At the same time, however, the greater liquidity of liabilities than of assets, which are typically longer-term and riskier, makes bank balance sheets vulnerable. Not only may banks fail if they are unable to obtain repayment of their loans, but depositors might even decide to withdraw their assets simply anticipating that others will do so. Such a ‘bank run’ can drive an otherwise sound bank to insolvency (Diamond and Dybvig, 1983). The need to protect depositors and so guarantee a stable monetary transaction system explains why the banking industry is so heavily regulated. It is harder for a depositor to protect his interests than for an average investor, because judging the financial condition of a bank is difficult and costly, even for specialists. For this reason, the typical instruments adopted by bank regulators include restrictions on the amount of risk that a bank can take, and compulsory deposit insurance schemes that prevent runs.