The New Palgrave Dictionary of Economics

2018 Edition
| Editors: Macmillan Publishers Ltd

Banking Industry

  • Dario Focarelli
  • Alberto Franco Pozzolo
Reference work entry


The distinctive function of banks is the transformation of short-term deposits into longer-term, less liquid and riskier loans (Fama 1980, 1985; Diamond and Rajan 2001; Gorton and Winton 2003). By raising funds from depositors and providing credit, banks avoid the duplication of monitoring, which reduces the overall cost of transferring funds from capital suppliers to its users (Leland and Pyle 1977; Diamond 1984). At the same time, however, the greater liquidity of liabilities than of assets, which are typically longer-term and riskier, makes bank balance sheets vulnerable. Not only may banks fail if they are unable to obtain repayment of their loans, but depositors might even decide to withdraw their assets simply anticipating that others will do so. Such a ‘bank run’ can drive an otherwise sound bank to insolvency (Diamond and Dybvig 1983). The need to protect depositors and so guarantee a stable monetary transaction system explains why the banking industry is so heavily regulated. It is harder for a depositor to protect his interests than for an average investor, because judging the financial condition of a bank is difficult and costly, even for specialists. For this reason, the typical instruments adopted by bank regulators include restrictions on the amount of risk that a bank can take, and compulsory deposit insurance schemes that prevent runs.


Adverse selection Assets and liabilities Asymmetric information Bank deregulation Banking crises Banking industry Bankruptcy Barriers to entry Capital controls Credit Excessive risk taking Glass–Stegall Act 1933 (USA) Information costs Information monopolies Liquidity Mergers and acquisitions Moral hazard Relationship lending Technological innovation 

JEL Classifications

This is a preview of subscription content, log in to check access.


  1. Allen, F., and D. Gale. 2003. Competition and financial stability. Journal of Money, Credit, and Banking 36: 433–480.Google Scholar
  2. Basel Committee on Banking Supervision. 2005. International convergence of capital measurement and capital standards: A revised framework. Basel: BIS.Google Scholar
  3. Berger, A., and T. Hannan. 1989. The price–concentration relationship in banking. Review of Economics and Statistics 71: 291–299.CrossRefGoogle Scholar
  4. Berger, A., A. Kashyap, and J. Scalise. 1995. The transformation of the US banking industry: What a long trip it’s been. Brookings Papers on Economic Activity 1995(2): 55–201.CrossRefGoogle Scholar
  5. Berger, A., A. Saunders, J. Scalise, and G. Udell. 1998. The effects of bank mergers and acquisitions on small business lending. Journal of Financial Economics 50: 187–229.CrossRefGoogle Scholar
  6. Boot, A., and A. Thakor. 2000. Can relationship banking survive competition? Journal of Finance 55: 679–713.CrossRefGoogle Scholar
  7. Broecker, T. 1990. Credit-worthiness tests and interbank competition. Econometrica 58: 429–452.CrossRefGoogle Scholar
  8. Dell’Ariccia, G. 2001. Asymmetric information and the structure of the banking industry. European Economic Review 45: 1957–1980.CrossRefGoogle Scholar
  9. Dell’Ariccia, G., E. Friedman, and R. Marquez. 1999. Adverse selection as a barrier to entry in the banking industry. RAND Journal of Economics 30: 515–534.CrossRefGoogle Scholar
  10. Diamond, D. 1984. Financial intermediation and delegated monitoring. Review of Economic Studies 51: 393–414.CrossRefGoogle Scholar
  11. Diamond, D., and P. Dybvig. 1983. Bank runs, deposit insurance, and liquidity. Journal of Political Economy 91: 401–419.CrossRefGoogle Scholar
  12. Diamond, D., and R. Rajan. 2001. Liquidity risk, liquidity creation and financial fragility: A theory of banking. Journal of Political Economy 109: 287–327.CrossRefGoogle Scholar
  13. Fama, E. 1980. Banking in the theory of finance. Journal of Monetary Economics 6: 39–57.CrossRefGoogle Scholar
  14. Fama, E. 1985. What’s different about banks? Journal of Monetary Economics 15: 29–34.CrossRefGoogle Scholar
  15. Focarelli, D., and F. Panetta. 2003. Are mergers beneficial to consumers? Evidence from the market for bank deposits. American Economic Review 93: 1152–1172.CrossRefGoogle Scholar
  16. Focarelli, D., and A. Pozzolo. 2005. Where do banks expand abroad? An empirical analysis. Journal of Business 78: 2435–2464.CrossRefGoogle Scholar
  17. Focarelli, D., F. Panetta, and C. Salleo. 2002. Why do banks merge? Journal of Money, Credit, and Banking 34: 784–803.CrossRefGoogle Scholar
  18. Gorton, G., and A. Winton. 2003. Financial intermediation. In Handbook of the economics of finance, ed. G. Constantinides, M. Harris, and R. Stulz, vol. 1. Amsterdam: North-Holland.Google Scholar
  19. Hellman, T., K. Murdock, and J. Stiglitz. 2000. Liberalization, moral hazard in banking and prudential regulation: Are capital requirements enough? American Economic Review 90: 147–165.CrossRefGoogle Scholar
  20. Keeley, M. 1990. Deposit insurance, risk, and market power in banking. American Economic Review 80: 1183–1200.Google Scholar
  21. Leland, H., and D. Pyle. 1977. Informational asymmetries, financial structure and financial intermediation. Journal of Finance 32: 371–387.CrossRefGoogle Scholar
  22. Petersen, M., and R. Rajan. 1995. The effect of credit market competition on lending relationships. Quarterly Journal of Economics 110: 407–443.CrossRefGoogle Scholar
  23. Petersen, M., and R. Rajan. 2002. Does distance still matter? The information revolution in small business lending. Journal of Finance 57: 2533–2570.CrossRefGoogle Scholar
  24. Rajan, R. 1992. Insiders and outsiders: The choice between relationship and arms length debt. Journal of Finance 47: 1367–1400.CrossRefGoogle Scholar
  25. Shaffer, S. 1998. The winner’s curse in banking. Journal of Financial Intermediation 7: 359–392.CrossRefGoogle Scholar
  26. Sharpe, S. 1990. Asymmetric information, bank lending and implicit contracts: A stylized model of customer relationships. Journal of Finance 45: 1069–1087.Google Scholar

Copyright information

© Macmillan Publishers Ltd. 2018

Authors and Affiliations

  • Dario Focarelli
    • 1
  • Alberto Franco Pozzolo
  1. 1.