stability vs efficiency..!!!

There has often been trade off between stability on one hand and efficiency on the other hand in many physical systems and its true even in the case of financial systems. Lets explore it in the case of banks and the reason why they are bound to fail from time to time . Banks have often been leveraged to the extent of 10:1. Banks require huge capital to enable them to have size which ensures profitability.

It is difficult to fund such high capital requirements only through equity. Moreover,a complete equity funded bank will have its cost of capital too high that it will not be able to compete with other banks which have lower cost of capital on account of leverage . An equity funded bank can easily withstand losses as it has no debt obligations.Thus a bank which is entirely funded by equity will be most stable ,i.e it might never fail but it will be inefficient as it might not be able to compete in the market.

On the other side of the spectrum, we have high leveraged banks which have debt to equity 10:1 . Such banks are highly competitive in the market but are highly unstable as they are quite liable to fail as even a small loss can erode equity base and make it default on its external obligations. Such high leverage also enables them to produce high return for their equity investors. The pressure to produce higher returns often induce Boards to go for higher leverage.

Its for society to decide whether they want a system which is highly stable but may not fulfil their expectations or a system which has an inherent risk built into it but is efficient in serving the people at large.