Banking system and the credit economy

Banks play a double role in the economy. They realize, with other no-monetary financial intermediaries, the link between the loanable funds of households and the financial needs of entrepreneurs and they create money in order to finance the entrepreneurial innovative projects which can not be satisfied (qualitatively or quantitatively) by the existing loanable funds. This side is not well considered by the standard economics.

 

a) Financing the growth: the standard view

Schumpeter argued that the services provided by financial intermediaries are essential for technological innovation and economic development as a monetary complement of growth process. The recent works on the endogenous growth and on the link between financial intermediaries and the economic development show a renewal of interest for this Schumpeterian intuitive vision and illustrate the close ties between financial conditions and economic development. The financial intermediaries tend to alter the composition of savings in a way that is favourable to capital accumulation because the banks are assumed to permit risk-averse savers to hold bank deposits rather than liquid unproductive assets. Financial intermediaries collect and analyse information and facilitate the migration of funds to the sectors where they have the highest social return. Financial intermediation can promote growth because it allows a higher rate of return to be earned on capital, and growth in turn provides the means to implement costly financial structures. In this perspective, the main role of the financial sector is to improve the efficiency of physical capital accumulation. The best management of risk reduction and the liquidity services of financial intermediaries lead the economy to orient savings to long term financial investment.

Also, the informational frictions that add to the costs of external finance (informational costs) apply mainly to younger firms which are not well collateralized. Hence financial institutions play a crucial role in the microeconomic resources allocation process thereby affecting the economic performance of firms. This is true when we take into account technological innovations because of the fact that technological change means further uncertainty. Therefore, credit rationing may come into the picture and obstruct the evolution of the young firm which cannot undertake the phase of apprenticeship and learning by doing process. In the process of innovation, the rise of monetary needs and the rise of risk may dissuade some firms from engaging in innovative activities. The high costs of R&D imply therefore the presence of imitators. R&D strategies and imitation strategies will follow a learning-by-doing process in order to stabilize the potential market competition between leaders and followers..Leadership and R&D firms have the advantage of a cumulative advance of knowledge but need to be accompanied by financial advantages. It is obvious that the willingness of banks to provide the flow of credit, which is needed for increasing the level of investment, is a necessary condition for the implementation of innovations. But in the models studying the links between finance and growth, banks are only analysed as information producers and liquidity insurers. They ensure the transformation between borrowers and lenders of funds as the other no-monetary financial intermediaries do it. As a methodological implication, we can remark that there is no specific reason, in this schema, for studying the banking system beside the other financial intermediaries.

As far as we know, all recent works analyse the financing problem as a problem of the efficiency of the use of loanable funds. Now, the current theory of financial intermediation creates a paradox. In these models, a well-behaved financial system is sufficient for ensuring a good circulation of loanable funds between innovators and savers. When the problem is solely the efficiency of the use of existing funds, there is no direct need for banks. All no-monetary financial intermediaries can orient savings to investment purposes.

. b) Financing growth: the Schumpeterian view

Usually the finance-development link is typically not the economic mechanism most closely associated with Schumpeter. The standard statement of the Schumpeterian vision is of creative destruction, a process by which innovations replace both old production methods and old goods with better procedures, new commodities and new services.

Yet, an integral part of the Schumpeterian methodology is that those are banks which make innovations possible, and along with them, economic development. In the logical schema Schumpeter attributes the priority to the money creation process. Banks create the credit required for the realization of the potential entrepreneurial dynamics. Credit enlarges the means of payment in order to finance the evolution of the economy. Borrowing is at the core of economic dynamics with the creation of new debts circulating as means of payment the counterpart of which is an expected flow of profits.

Credit money created by banks in order to finance the entrepreneurial future profit expectations underlies the growth process. Contrary to other intermediaries, banks issue large amounts of debt in the form of deposits which circulate in the whole economy as general means of payment, i.e., money. That is the credit view in which the credit is an essential element in the fluctuations of real output. We can emphasize therefore the very productive role of banks which expresses itself in funding projects without prior savings. When economic development arises from the mere circular flows, there is a gap to bridge in the carrying out of new combinations. The banking system provides this bridge. Through credit, entrepreneurs are given access to the social stream of goods before they have acquired the normal claim to it. This function constitutes the keystone of the modern credit structure. The credit structure extends not only beyond the existing money basis, but also beyond the existing commodity basis. Thus, this change of methodology leads to an analysis able to think the market economy in an evolutionary fashion and has not to admit the ad hoc stationary equilibrium hypotheses.

In order to carry out his new combinations, the individual needs credit. The banker makes possible the dynamic. The whole economic process cannot be studied without this relation as banks’ response to the monetary needs of entrepreneurs' projects determines the path of economic development.

When we consider the economy as a monetary one, its working is obviously linked to the existence of some particular agents which can create means of circulation on the basis of a set of social rules (i. e., general and not private) governing the creation (grant of bank credit), the circulation (use of the monetary signs in the whole economy) and the annulment (extinction of debts) of money..These agents are the banks. They are not solely the monetary complement of industrial development. They are active agents and, by rationing credit, they may obstruct entrepreneurial innovation. The nature of rationing depends on the behaviour of the banking sector according to the hypothesis that banks do not have perfect knowledge of the riskiness of the project. When the finance required for the investment expenditures is not granted by banks, entrepreneur cannot undertake his projects. By rationing credit, banks can affect economic development negatively.

In order to improve the results of the Schumpeterian methodology in economic analysis, we have to show that the endogenous economic change depends not only on the innovative behaviour of entrepreneurs but also on the changing strategies of banks. Banks adopt innovative behaviour in order to protect their market share or to improve their strategic positions.

In extending the entrepreneurial dynamic behaviour of the Schumpeterian economic evolution process we remark that the banks’ innovations change the economic conditions as much as the entrepreneurial innovations. They affect the functioning of ‘economic engine’ because they modify the monetary and financial conditions on which the whole economic structure is founded. The evolutionary changes in banks' behaviour are the results of profit-seeking strategies. In order to avoid regulatory constraints or to follow structural changes on the markets, banks create new financial products or new financing processes. Banks innovate in response to authorities’ regulations in a regulatory dynamic context. This exogenous-forced-innovative dynamic process can be qualified as monetary creative destruction in a Schumpeterian vein. However, the innovative behaviour of banks is not solely due to the regulatory dialectic. For banks innovate also in response to changes in market structure.

In this evolutionary process, risk transferring innovations, which are new instruments (or techniques) allowing investors or traders to transfer the price or credit risks in financial positions, appear in order to avoid the individual risks due to the new financial products. The use of bank standby letters of credit enhances the negotiability and market price of debt instruments issued by nonbanks. The bank, in effect, assumes the risk of default on the issuers' debt offering and receives a fee for this service. Its recorded assets, and, hence its required capital, do not increase. The off-balance sheet banking denotes that the activities involve contingent commitments or contracts which generate income to a bank, but are not normally included as assets or liabilities under conventional procedures.

The use of recent financial innovations to increase the amount of commitments but also of risk that banks assume in pursuit of higher returns is imminent in the intensified competition unleashed by new technologies that have enabled development of new innovations. The evolution of the financial markets and the behaviour of the banking system change the financing conditions of real economic activity and affect the path of economic evolution.

The banking system feeds the whole economic structure throughout its

effect on the possibility of undertaking new activities. Interactions between banks and entrepreneurs determine, in part, the market structure (size of firms, their monopoly power on the market, etc.). In the core of the Schumpeterian story, the entrepreneur is acting as an innovator and not as a capitalist, inventor or manager.

He borrows funds from banks, purchases the rights of an invention made by another, sets up a firm in order to exploit this invention and to «realize» a profit after reimbursing the loan. The change is endogenous and given by the profit-seeking innovative strategies if the financing occurs as desired by entrepreneurs.

Then, the credit system affects innovations which reinforce the firm's performance and its growth possibility leading to accumulation. The monetary path of the economic evolution gives a general result, which can be an equilibrium point or a disequilibrium situation depending on whether the real individual behaviours are consistent on the whole or not.