Does combining deposit taking and lending involve synergies?

Two of the main activities performed by banks are deposit taking and lending. Arguably those two activities are irreconcilable. As Adam Levitin put it in the abstract of this paper, “Banking is based on two fundamentally irreconcilable functions: safekeeping of deposits and re-lending of deposits. Safekeeping is meant to be a risk-free function, but using deposits to fund loans inevitably poses risk to deposits, thereby undermining the safekeeping function.”

In contrast to that, Anil Kashyap and co-authors in a paper entitled “Bankers as Liquidity Providers…” argue that there are synergies to be gained from combining deposit taking and lending.

Kashyap & Co’s argument runs off the rails in their first paragraph where they say “More precisely, deposit-taking involves  issuing claims that are riskless and demandable, that is, claims that can be redeemed for a fixed value at any time.”

The problem there is that those “claims” are very definitely not riskless. As Levitin put it in the above quote,  “…using deposits to fund loans inevitably poses risk to deposits…”. That is banks thru history have gone bust with monotonous regularity, which means that (absent banks being backed by taxpayers) depositors face a risk. Plus of course bank shareholders face a risk.

On the other hand if banks ARE BACKED by taxpayers so as to dispose of the above risk, then that’s a subsidy of banks, and subsidies do not make economic sense.

At the very least, if Kashyap & Co need to be more precise about their above “riskless” claim.

However Kashyap & Co’s main point (and this is a clever and plausible point I haven’t come across before) is as follows. Where a bank undertakes to let depositors have their money back on demand, banks obviously have to have a stock of money to actually meet those demands. Also, banks having promised sundry borrowers they can withdraw money on demand up to the maximum amount of agreed loans, have to have another stock of cash to actually meet those “demands to withdraw”. So in a sense, depositors and borrowers are both depositors.

Now the larger the number of deposits at a bank, the smaller the stock of cash the bank needs (relative to total deposits) in order to be 99.9% sure of being able to meet demands to withdraw every day. To illustrate, if a bank had just one deposit of $1000, the bank would definitely need to keep $1000 in cash in order to be able to deal with the far from remote possibility that the depositor wants all his or her money back. In contrast, if the bank has ten thousand depositors, than at a very rough guess it would only need to keep a hundredth that amount in the form of ready cash in order to be 99.9% sure of being able to meet demands to withdraw.

Ergo, there are economies of scale or synergies to be had from combining deposit taking and lending.

However, there’s a flaw in that argument commonly known as the “fallacy of composition”. The fallacy of composition is the assumption (which often doesn’t work out) that one can extrapolate from the microeconomic to the macroeconomic. Put another way it’s the assumption that what benefits some microeconomic entity like a household or bank will also benefit the economy as a whole.

In the case of a bank calculating the minimum stock of cash it needs in order to meet withdrawals, obviously anything that reduces that stock is beneficial to the bank. However, viewed from the perspective of the economy as a whole, i.e. the macroeconomic perspective, supplying the economy with more cash costs nothing. To take an extreme example, if everyone wanted to keep an extra £1,000 under their mattress or in some state run savings bank, the state can meet that demand at almost no cost. That is, printing a ton of £50 notes costs almost nothing, compared to the face value of the notes. And as to non-physical money, the central bank can create limitless amounts of money at the click of a computer mouse.

As Milton Friedman put it, “It need cost society essentially nothing in real resources to provide the individual with the current services of an additional dollar in cash balances.”