What ties together the traditional commercial banking activities of deposittaking and lending? We argue that since banks often lend via commitments, their lending and deposit-taking may be two manifestations of one primitive function: the provision of liquidity on demand. There will be synergies between the two activities to the extent that both require banks to hold large balances of liquid assets: If deposit withdrawals and commitment takedowns are imperfectly correlated, the two activities can share the costs of the liquid-asset stockpile. We develop this idea with a simple model, and use a variety of data to test the model empirically. WHAT ARE THE DEFINING CHARACTERISTICS of a bank? Both the legal definition in the United States and the standard answer from economists is that commercial banks are institutions that engage in two distinct types of activities, one on each side of the balance sheet—deposit-taking and lending. More precisely, deposit-taking involves issuing claims that are riskless and demandable, that is, claims that can be redeemed for a fixed value at any time. Lending involves acquiring costly information about opaque borrowers, and extending credit based on this information. A great deal of theoretical and empirical analysis has been devoted to understanding the circumstances under which each of these two activities might require the services of an intermediary, as opposed to being implemented in arm’s-length securities markets. While much has been learned from this work, with few exceptions it has not addressed a fundamental question: why is it important that one institution carry out both functions * Kashyap and Rajan are from the University of Chicago and Stein is from Harvard University. We thank Eric Bettinger, Qi Chen, and Jeremy Nalewaik for excellent research assistance, and Melissa Cunniffe and Ann Richards for help in preparing the manuscript. We are also grateful for helpful comments from Gary Gorton, George Pennacchi, René Stulz, the referee,

This essay surveys the body of research that asks how the efficiency of corporate investment is influenced by problems of asymmetric information and agency. I organize the material around two basic questions. First, does the external capital market channel the right amount of money to each firm? That is, does the market get across-firm allocations right, so that the marginal return to investment in firm i is the same as the marginal return to investment in firm j? Second, do internal capital markets channel the right amount of money to individual projects within firms? That is, does the internal capital budgeting process get withinfirm allocations right, so that the marginal return to investment in firm i’s division A is the same as the marginal return to investment in firm i’s division B? In addition to discussing the theoretical and empirical work that bears most directly on these questions, the essay also briefly sketches some of the implications of this work for broader issues in both macroeconomics and the theory of the firm.

Affiliation with a multi-bank holding company gives a subsidiary bank better access to external funds than otherwise similar stand-alone banks, implying that affilated banks are largely able to shield lending from a monetary contraction while stand-alone banks are forced to slow loan growth and draw down on liquid assets. In state banking markets where where stand-alone banks have more market share, the response of aggregate lending to monetary policy is stronger. On the other hand, there is little difference in the response of state output across the market share of affiliated banks, implying that the aggregate elasticity of output to bank lending is very small, if not zero. I conclude that while small firms might view bank loans as special, bank loans are not special enough for the lending channel to be an important part of how monetary

This paper examines the functioning of internal capital markets within bank holding companies (BHCs) and its implications for the impact of monetary policy on banks. I find that as monetary policy is tightened, if a small bank operates jointly with a large bank (with easy access to noninsured deposits) within a BHC then the small bank’s loan growth becomes less sensitive to its own internally generated funds. In contrast, if a small bank is unaffiliated with a large BHC, its loan growth becomes significantly more dependent on its own cash flow in periods of tight money supply. I also examine the role of internal capital markets in the investment allocation process of financial conglomerates. I find evidence that within small (more constrained) BHCs the funding of loans becomes less sensitive to cash flow for the worse performing affiliates compared to the best affiliates as the Fed tightens. This finding agrees with the inefficient cross-subsidization (or “socialism”) argument of Scharfstein and Stein (2000), but not with Stein’s (1997) prediction of “winner-picking. ” In contrast, internal capital markets may have a disciplinary role in large BHCs, as poorly-performing affiliates are not cushioned from Fed tightenings even though Fed policies do not constrain large banks ’ access to external finance. These results are remarkable given the many obstacles imposed by bank regulators on the ability of BHCs to allocate capital among their affiliates. They also imply that internal capital markets in financial conglomerates work in ways that can offset the impact of monetary policy on bank credit supply.

We extend the recent literature on the link between financial development and economic volatility by focusing on the channels through which financial intermediary development affects economic volatility. Building on Bacchetta and Caminal (2000) our theoretical model predicts that the effect of real sector shocks on growth volatility is dampened by well-developed financial intermediaries, while monetary shocks are magnified, suggesting that, overall, there is no unambiguous effect of financial intermediaries on growth volatility. We test these predictions in a panel data set covering 63 countries over the period 1960-97, using the volatility of terms of trade and inflation to proxy for real and monetary volatility, respectively. We find (i) no robust relation between financial intermediary development and growth volatility, (ii) weak evidence that financial intermediaries dampen the effect of terms of trade volatility, and (iii) evidence that financial intermediaries magnify the impact of inflation volatility in lowand middle-income countries. * The World Bank. We would like to thank Hosook Hwang for outstanding research assistance and George Clarke, Robert Cull, Gregorio Impavido, Ross Levine, Rick Mishkin, and seminar participants at the World Bank and the Conference of the Latin American and Caribbean Economic Association for useful comments and suggestions. This paper's findings, interpretations, and conclusions are entirely those of the authors and do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent. 1.

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In 2010 all ECB publications feature a motif taken from the €500 banknote. NOTE: This Working Paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB. This paper can be downloaded without charge from

In 2011 all ECB publications feature a motif taken from the €100 banknote. NOTE: This Working Paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB. This paper can be downloaded without charge from

This paper investigates whether the stock returns of banks with different risk profiles exhibit different risk factor sensitivities over the business cycle. More specifically, we investigate whether or not high levels of capital adequacy or functional diversification provide banks with a structural hedge against a deterioration in the prevailing credit market conditions. Based on recent imperfect capital market theories, we develop a number of theoretical arguments for the existence of asymmetries in systematic risk across various types of banks. We use a regime-switching model to test the theoretical hypotheses empirically on a sample of European listed banks. We find that bank stock returns are strongly asymmetric; both the sensitivity to shocks and the conditional volatility are higher during business cycle troughs. Better capitalized and functionally diversified banks are perceived by investors as being better protected against a deterioration in credit market conditions compared to their relatively less capitalized and more specialized competitors.