Lecture 13: Banks

What this lecture covers

This lecture asks what banks actually do, why they are prone to crisis, and how regulators try to keep them safe. Shiller distinguishes traditional deposit-taking banks from investment banks and central banks, then traces the origins of interest and banking from ancient Sumeria through Renaissance Italy and goldsmith bankers in England, before turning to the modern theory of banking and the mechanics of capital regulation under the Basel agreements.

By the end, you should be able to explain why banks are useful (the economic problems they solve), why they are fragile (why runs happen), and how a bank's required capital is calculated under Basel-style risk-weighting, including why those rules can create unintended incentives.

Key ideas

• Spread income and liquidity transformation: banks profit from the difference between the interest they pay depositors and the interest they charge borrowers, and they create liquidity by borrowing short (deposits withdrawable any time) and lending long (multi-year loans).
• The Diamond-Dybvig model: a theoretical framework showing that banking has multiple equilibria; if people trust the system, it functions well, but a shift in expectations alone can trigger a self-fulfilling bank run, which is why deposit insurance matters.
• Adverse selection: ordinary investors cannot easily judge which securities or borrowers are good risks, so banks with local loan officers who know the community fill this information gap.
• Moral hazard: borrowers (and banks themselves) may take on excessive risk when someone else bears the downside, which banks address through continuous monitoring and renewable short-term loans.
• Deposit insurance: government-backed guarantees (like the FDIC, created in 1933) prevent runs by making depositors confident their money is safe, but insurers can themselves fail, as happened with the FSLIC during the 1980s US savings and loan crisis.
• Risk-weighted assets (RWA): the Basel framework assigns risk weights to different asset classes (0% for government bonds, 20% for municipal and agency bonds, 50% for mortgages, 100% for commercial loans) to determine how much capital a bank must hold.
• Basel III capital requirements: a minimum 4.5% common equity to risk-weighted assets, plus a 2.5% capital conservation buffer (effectively 7%), plus an optional 2.5% countercyclical buffer regulators can impose during booms.
• Regulatory blind spots: mis-weighting agency debt like Fannie Mae and Freddie Mac bonds as low-risk encouraged banks to favor those assets over small business loans, a distortion Shiller ties directly to the 2008 crisis.

Walkthrough

Basic principles of banking (2:52)

Shiller defines the scope of the lecture (deposit-taking banks, not investment banks or central banks) and describes the core functions of banking: earning spread income, historically issuing notes (a function now largely limited to a few UK and Hong Kong banks), and creating liquidity by borrowing short and lending long. He notes this liquidity creation is also what makes banks vulnerable to runs.

The beginnings of banking: types of banks (10:46)

The lecture traces interest and banking from Sumeria around 2000 BC (where the same word meant both "interest" and "lamb," linked to livestock rental), through Song Dynasty China, to Renaissance Italy's Banca Monte dei Paschi in Siena (founded 1472, the oldest surviving bank), which also pioneered deposit insurance in the 1600s. Shiller then describes England's goldsmith bankers, whose gold-storage receipts evolved into circulating paper money, and surveys modern US bank types: commercial banks, savings banks, and credit unions, each with different origins and typical loan books.

Theory of banks: liquidity, adverse selection, moral hazard (24:00)

Shiller introduces the Diamond-Dybvig model of banks as liquidity providers with multiple equilibria, explaining how a shift in expectations alone can cause a bank run. He then explains how banks solve adverse selection (local loan officers know borrowers' character and reputation better than the public can) and moral hazard (ongoing monitoring and renewable short-term commercial loans discourage borrowers from taking reckless risks with borrowed money).

Bank runs, deposit insurance and maintaining confidence (33:03)

The lecture covers the creation of the FDIC in 1933, which has never failed, contrasted with the FSLIC, which went bankrupt during the 1980s savings and loan crisis and required a $150 billion government bailout. Shiller adds the 2007 Northern Rock run in the UK, where deposit insurance only partly covered deposits and the run was stopped only when the Bank of England pledged a full bailout, and a parallel case of Germany's IKB Deutsche Industriebank, bailed out preemptively to avoid a run.

Bank regulation: risk-weighted assets and Basel agreements (41:07)

Shiller explains why insured banks must be regulated to prevent moral hazard, then introduces the Basel Committee's series of international, non-binding recommendations: Basel I (after the S&L crisis), Basel II (2004, updated for more complex derivatives, but published just before the 2008 crisis), and Basel III (2010, phased in through 2019). He walks through the risk-weighting categories and works a numerical example: a bank with $400 million in assets split across government bonds, Fannie Mae-type securities, mortgages, and commercial loans, showing how to compute risk-weighted assets ($170 million in the example) from those weights.

Common equity requirements and its critics (53:27)

Working through the numbers further, Shiller shows how a bank's required common equity (7% of risk-weighted assets under Basel III, or 9.5% with the discretionary countercyclical buffer) determines how much more it can lend or invest once it holds surplus capital. He demonstrates that because agency bonds carry only a 20% risk weight versus 100% for commercial loans, a bank with excess capital can expand into far more agency bonds than small business loans for the same capital cost, illustrating a criticism that Basel's weighting scheme discouraged lending to small businesses in favor of instruments like Fannie Mae and Freddie Mac debt that later proved risky.

Recent international bank crises (1:02:49)

The lecture closes with brief case studies of historical banking crises: Mexico's 1994-1995 crisis, following bank privatization without adequate regulation; the 1997 Asian financial crisis, which spread from Thailand and Korea through Russia and Brazil via international lending contagion; and Argentina's 2002 crisis. Shiller ties these together as evidence that banking crises recur throughout history and reiterates that banks solve real economic problems (liquidity, adverse selection, moral hazard) even though their regulation remains complex and imperfect, briefly flagging the unregulated "shadow banking" system as a topic for a future lecture.

Before you watch

• The previous lecture on regulation (bank regulators, the SEC, and the concept of macro-prudential versus micro-prudential rules) provides useful background for the Basel discussion here.
• Basic familiarity with a bank balance sheet (assets, liabilities, equity) helps with the risk-weighted assets calculation.

Check your understanding

1. Why does a bank's core function of borrowing short and lending long create both liquidity and fragility?
2. According to the Diamond-Dybvig model, how can a bank run occur even when a bank is fundamentally sound?
3. Walk through how risk-weighted assets are calculated for a bank holding government bonds, agency bonds, mortgages, and commercial loans, and explain why the choice of weights matters.
4. Why did assigning a low risk weight to Fannie Mae and Freddie Mac securities create an unintended incentive for banks, according to Shiller?
5. What role did deposit insurance play (or fail to play) in the Northern Rock and IKB Deutsche Industriebank episodes?