May 21, 2014

Banks can be a lot like poorly designed hotel plumbing, according to a working paper by SFI External Professors Martin Shubik and Eric Smith.

Different kinds of banks -- in particular, government-run central banks versus private, profit-seeking ones -- are a lot like systems for managing water pressure in a hotel. In a poorly designed system, a toilet flush cuts the supply of cold water, leaving someone in a nearby shower standing under a stream of scalding hot water.

Likewise, a poorly designed banking system could transmit shocks between sectors, ultimately cutting into bank patrons' wealth. The question is, what does the ideal bank look like, and how do real-world commercial banks measure up to that ideal?

Shubik and Smith consider two options: an idealized central bank that takes deposits and loans money but makes no profits, and a set of private banks that profit by demanding a higher interest rate on loans than on savings. In conventional, equilibrium-focused economic theory, both systems should work equally well, Shubik says, but real economies aren't in equilibrium; they change day to day, hour to hour, as consumers and investors respond to each other's choices.

To study how private and central banking systems compared in an ever-changing world, Smith and Shubik designed a simple economy with two industries, one of which can invest to increase production. While those investments interrupt supply and therefore prices in one industry, Smith and Shubik found that a central bank can shield one industry from shocks to the other, just as properly-sized reservoirs of water buffer toilet flushers' effects on bathers.

Profit-seeking banks, on the other hand, mix deposits from both industries, loan that money out, and take a little bit for themselves, ultimately transmitting shocks between sectors like a hotel with leaky pipes and small water tanks -- and little incentive to improve them.

Still, Shubik and Smith say, private banks are worth the occasional scalding-hot water. The centralized bank of the Soviet Union, for example, ended up as a "total disaster," Shubik says -- a sprawling bureaucracy that was impossible to manage effectively. Commercial banks can still tamp down economic shocks -- if imperfectly and at a cost in the form of their profits-while being nimbler than any real-world central bank could be.

Read the SFI working paper (March 2014)

All SFI working papers