Why Banking Crises are Inevitable

Posted on 29/10/2010

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It has long been my view that asset-price bubbles and the financial crises that often follow are intrinsic components of the capitalist system that cannot be avoided.  Thanks to Anjan Thakor at Washington University in St Louis, we can now understand why crises are inevitable within the banking system.  In “Are Financial Crises Inevitable?” he finds that in a competitive environment returns on standard banking products are driven-down to the cost of capital, leaving zero economic profits for the banks.  Because of this, banks are forced to innovate with new financial products for which there is no reliable default history, creating the possibility of disagreement between banks on the optimum product pricing and therefore giving rise to the potential for banks to earn economic profits.  Thakor finds that in equilibrium both the level of financial innovation and the probability of a crisis occuring are positive.  He believes the probability of a banking crisis occuring is unaffected by capital requirements, a finding that makes the recent Basel III proposals obsolete.  Finally, he notes that more innovative and competitive banking are more vulnerable to crises, implying that policy measures to reduce innovation and/or competitiveness in the banking sector may reduce the likelihood of future crises.

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