Theories of Banking

Introduction

In this post you are going to learn about the various theories of banking. These theories which are propounded by scholars who, bearing in mind the banks unique type of business, sought to provide solutions on how can the unique business survive. These theories include the Real Bills Doctrine, the shiftability theory, the anticipated income theory, and the liability management theory.

The Real Bills Doctrine         
The Real Bills Doctrine or the commercial loan theory states that a commercial bank shoyuld advance only short-term self-liquidating loans to business firms. In other words, this theory holds that banks should lend only on “short-term, self-liquidating commercial papers. This is for the simple reason that a bank has liabilities payable on demand, and it cannot meet these obligations if its assets are tied up for long periods of time. Rather, a bank needs a continual and substantial flow of cash moving through it in order to maintain its own liquidity, and this cash flow can be achieved only if the bank limits its lending activities to short-term maturities. Self-liquidating loans are those which are meant to finance the production, and movement of goods through the successive stages of production, storage, transportation and distribution. When such goods are ultimately sold, the loans are considered to liquidate themselves automatically.

The theory states that when commercial banks make only short-term self-liquidating productive loans, the central bank, in turn should only lend to the banks on the security of such short-term loans. This principle would ensure the proper degree of liquidity of each bank and the proper money supply for the whole economy. This in essence aim at the stabilization of the banking system. The weakness of this theory stems from the failure to realize that the loans are made, given the value of the goods and not the good itself; and also the value of goods itself is subject to variations, given the state of the economy.  

The Shiftability Theory  
The Central thesis of this theory holds that the liquidity of a bank depends on its ability to shift its assets to someone else without any material or capital loss when the need for liquidity arises. This theory asserted that if the commercial banks maintain a substantial amount of assets that can be shifted on to the other banks for cash without material loss in case of necessity, then there is no need to rely on maturities.

According to this view, an asset to be perfectly shiftable must be immediately transferable without capital loss when the need for liquidity arises. This is particularly applicable to short-term markets investments, such as treasury bills and bills of exchange which can be immediately sold whenever it is necessary to raise funds by banks. For example, it is quite acceptable for a bank to hold short-term open market investments in its portfolio of assets, and if a large number of depositors decide to withdraw their money, the bank need only sell these investments, take the money thus required and pay off its depositors.

Therefore, the theory tried to broaden the list of assets demand legitimate for bank ownership, and hence redirected the attention of banks and the banking authorities from loans to investments as a source of bank liquidity that is; the fundamental source of liquidity is the banks secondary resources.  

The flaw of this theory does not lie on the theory itself, but on the bank management practices to which the theory led. One bank could obtain the needed liquidity by shifting its assets but not so possible when all members of the bank behave the same way (Fallacy of composition). Hence, the problem of liquidity of the whole banking system is simply not solvable by commercial banks alone. This is where a central bank that is prepared to act quickly and decisively is an absolute necessity.

The Anticipated Income Theory  
According to this theory, regardless of the nature and character of a borrower’s business, the bank plans the liquidation of the loan from the anticipated income of the borrower. This theory opines that a bank should make long-term and non-business loans since even a “real bill” is repaid out of the future earnings of the borrower; i.e out of anticipated income. At the time of granting a loan, the banks take into consideration not only the security, but the anticipated earnings of the borrower. Thus a loan by the bank gets repaid out of the future income of the borrower in installments, instead of in lump sum at the maturity of the loan.  

The Liability Management Theory
According to this theory, there is no need for banks to grant self-liquidating loans and keep liquid assets because they can borrow reserve money in the money market in case of need. A bank can acquire reserves by creating additional liabilities against itself from different sources.

These sources include the issuing of time certificates of deposits, borrowing from other commercial banks, borrowing from the central bank, raising of capital funds by issuing shares, and by ploughing back of profits. Arguing that a bank can use its liabilities for liquidity purposes, the theory opines that it  can manage its liabilities so that they actually become a source of liquidity by going out to by money when it needs it (for paying its demand deposits and meeting loan requests). That is, liability management suggests that the bank borrow the funds it needs by means of various bank-related money market instruments.