Do We Need Banks in Models

The Bank of England's recent conference on its One Bank Reserach Agenda has prompted a few comments on the issue of the inclusion of banks in macroeconomic models.  Various people have observed that it is rather odd that the models used by central banks seem to completely ignore the role of banking.  So why might it matter whether we explicitly model banks or not?

Before we even think about including banks, we need to have a model with financial assets and liabilities, so at the very least we need some agents that are borrowers and some that are lenders.  Let's assume we have this.

Some people might think we need banks, as they can make loans without first needing to attract funding, when non-banks cannot.  It might seem that without banks in the model, we have no way for financial assets and liabilities to grow, they can only be passed around.   

However, in general this is not the case.  Most models with financial assets allow for the quantity of those assets to expand and contract in response to spending and saving decisions.  Although these are not generally modelled to the level of the individual payments, it is easy to add a payment system in and when you do, it makes no difference.  So, on this point, we can rely on an implicit banking system - we don't need to explicitly model it.

A more likely possible answer is that we need banks because some part of their liabilities constitute money.  Exactly what part depends on how we want to define the term.  

This would be the monetarist position - that banks matter because they influence the growth of the money supply.  Whether this means we needs banks in models would then come down to our view of the quantity theory - the question of whether money supply growth causes growth in nominal GDP.

For banks and money to matter in this way, we must assume people view holdings of money differently to holdings of other assets.  For example, we might assume that people want to hold money only in some proportion to their income, but that they have an infinite appetite for other financial assets.

The problem with this comes down to drawing the line between money and those other financial assets.  Balances which can be used in payment processes might be considered to be special, but these represent only a small part of bank balance sheets and they tend to respond to demand with a highly elastic supply.   Modelling bank behaviour, specifically lending behaviour, won't tell you much about these balances.

On the other hand, modelling bank lending might tell you about the overall size of bank liabilities.  But you then need to explain why these bank liabilities are so different from non-bank liabilities.  How much is it going to affect behaviour if someone has a Treasury repo, say, with a non-bank as opposed to with a bank?

So far none of this seems to me to suggest there is much to be gained by adding banks explicitly into models.  Where I think it does matter is when we come to think about the terms on which loans are made.

In the simplest model with borrowers and lenders, anyone who wants to borrow can borrow as much as they like at the same interest rate.  This is a model that ignores credit risk and for some purposes this is OK.  However, incorporating credit preferences into the model can help provide a lot of insight.  Once we include credit limits and credit spreads, the borrower's spending pattern increasingly depends on the preferences of the lender as well.

We still don't necessarily need banks to include credit preferences.  Savers will have their own preferences and if we believe banks' actions merely reflect the credit preferences of their depositors, then they would indeed be no more than intermediaries, whose existence could be safely ignored.

However, this is not how it works in the real world.  Bank lending decisions are considerably removed from the preferences of depositors and are shaped by other factors, including notably their regulatory structure.  Capital and liquidity regulations play an important role in determining how bank lending develops and these can only properly be captured in a model where banks appear explicitly.  This to me is the real reason why we might need to model banks.

In conclusion, I think that for many purposes, we don't need to include banks in models - we can just treat them as implicit.  We certainly don't need to include them simply because we believe in "endogenous money".  Indeed the whole point about endogenous money is that money is not an important causal factor as the quantity theorists would have it, but merely a by-product.  However, once we want to think about how credit limits and credit spreads might develop in a modern economy (and these are important things to think about), we need to start saying something about banks.