The Bank as a Production Unit: Illuminating Two Genres of Banking Theory

Any debate on the measurement of the performance of banks needs to be preceded by an understanding of the banking theory of the bank as a production unit. The extant framework used for other financial services cannot be uncritically applied to banking. This paper revisits the following fundamental questions: (i) Primarily, is the bank a production unit or a financial intermediary? (ii) Do banks produce real output? (iii) Do banks create savings and investments? (iv) Are banks special? (v) Is a bank obliged to maximize profit? (vi) What is the bank’s responsibility? (v) Which theoretical framework is appropriate for studying the bank as a production unit? Some of the fundamental answers are as follows: (i) Banking theory lies at the intersection of monetary economics, macroeconomics, production theory, and development economics. (ii) Banks create savings and investment through the agency of deposits and advances. and (iii) Banks are primarily production units rather than financial intermediaries. The chapter conceptually illuminates the presence of two genres of banking theory that are fundamentally different, and hence their methodology cannot be the same. Neo-classical production theory applies to frontier functions that view a bank as a financial intermediary. And Industrial Economics as applied to banking applies to banks as a production unit set in a live context of banking markets. The attempt to merge the two genres or to impose one on the other, or to continue endless debate on which is the right method, is futile. This chapter segregates the two genres and provides a fresh perspective on the concept and theory of the bank as a production unit.