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Essay on Roles of Banking in Economy
The role of banking on the real economy is subtle and complex. What distinguishes financial institutions from other firms is the relatively small share of real assets on their balance sheets. Thus, the direct impact of financial institutions on the real economy is relatively minor. Nonetheless, the indirect impact of financial markets and institutions on economic performance is extraordinarily important. The banking sector mobilizes savings and allocates credit across space and time. It provides not only payment services, but also more importantly products which enable firms and households to cope with economic uncertainties by hedging, pooling, sharing, and pricing risks.
An efficient banking system reduces the cost and risk of producing and trading goods and services and thus makes an important contribution to raising standards of living. Beginning in 2000, American economy started to get the shocks: the dot-com bust, the investment bust, then 9/11, the wars in Afghanistan and Iraq, and the corporate governance scandals. Not surprisingly, these shocks led to serious erosion in confidence and a pullback in spending by the business sector.
Both monetary policy and fiscal policy responded aggressively to these shocks. The Fed slashed short-term interest rates starting in 2001 to their lowest levels in forty years. And the Congress passed tax-cut packages to stimulate spending. But because these macro policies, especially monetary policy, affect the economy with a lag, we still had substantial job losses and clear signs of stress in the corporate sector. For example, bond downgrades and defaults rose sharply in the recession, matching levels reached in the previous recession. And risk spreads on high-risk corporate bonds spiked, exceeding previous peaks.
In the face of these shocks, both large banks and community banks proved to be far more resilient than in the previous recession.........
