Why banks do what they do. How the Monetary System Affects Banking Activity

Banks have a vital role to play in financing investment and trade. In recent years, however, they have encountered increasing difficulty in bringing money where it is needed. This paper argues there is a structural feature of the monetary and financial system that largely determines the conditions and incentives for banking activity, driving them astray from their proper task. This feature is liquidity, i.e. the interchangeability of assets and money. Liquidity is commonly viewed as a positive and desirable characteristic of the financial system, since it is assumed to encourage the funneling of money toward the most promising investments. However, as crises show, liquidity also allows the opposite flow, the liquidation of investments and the accumulation of idle money balances, which eventually obstruct the financing of trade and investments by the banking system. This paper analyses the faults of “banking on liquidity” and advocates a financial reform aimed at reducing, rather than increasing, the liquidity of money and credit.