Banking

Banking makes a major contribution to mature economies but banking crises can do them great damage. Bank regulation is a compromise between the avoidance of banking crises and the preservation of banking efficiency. Following the crash of 2008, proposals for regulatory reform are under consideration, and there are prospects of major changes to the structure of the world's banking industry.

(Banking's role in currency management is dealt with in a separate article on currency controversies)

(For definitions of the terms shown in italics in this article, see the glossary on the Related Articles subpage, and for a child's guide to the mathematics of fractional reserve banking see the Tutorials subpage).

Banking essentials

The task of understanding banking can be hampered by a preoccupation with its long and varied history, or with the complex instruments and additional functions that banks have acquired in the course of the last thirty years. Putting those preoccupations aside, the matter is straightforward.

Banks are financial intermediaries - acting as middlemen between lenders and borrowers. They have that in common with moneylenders - but they are more than that. Most banks accept payments from depositors and lend money to borrowers - most of which are businesses. Loans are shown on their balance sheets as "assets" and deposits are shown as "liabilities". In order to lend more money than they possess (that is to say more than the total of their deposits, the repayments and interest payments from borrowers and the money received from shareholders) they can borrow money from their government's or central bank's "discount window"", or from the money market , in return for short-term notes or longer term bonds (that are then sold to investors). They make profits by charging higher interest rates to their borrowers than they pay to their lenders (the difference is known as "spread").

On the normally sound assumption that depositors will not all want to have their money back at the same time, banks can safely use those arrangements to make loans amounting to many times the total of their deposits - often as much as twenty times as much (a multiple known as "leverage"). However, to guard against the possibility of a surge in depositors' withdrawals, banks have to maintain reserves in the form of cash or assets that can be quickly sold for cash (known as maintaining adequate "liquidity"). A liquidity crisis brought upon a bank because it does not have enough money to meet the demands of its depositors can usually be dealt with by borrowing from other banks (using the "interbank market") or, in an emergency, by borrowing at a "penal" rate of interest from its "central bank" (calling upon the central bank's function of acting as "lender of last resort") - although that is seen as a sign of incompetence and has been known to alarm a bank's depositors and provoke a "run" in which large numbers of depositors demand to have their money back.

There are other complications, but those are the essentials.

The banks that perform the above functions are called "commercial" or "retail" banks. "Wholesale" banks deal with other banks or financial companies, rather than the general public. "Investment banks", also known as "merchant banks", concentrate on raising money for companies by finding buyers for their equity and their corporate bonds. "Universal banks" combine all of those activities, and often others such as insurance.

Banking innovations - a brief history

Medieval banking

A variety of enterprises whose activities can be broadly described as banking were in existence before and during the middle ages. Some, that have been categorised as "deposit banks", accepted deposits and made loans; some, termed "exchange banks" were restricted to providing the means of making transactions between traders using different currencies; and others combined both functions. Deposit banking is believed by historians to have evolved from money changing. Coins were displacing barter as a means of trading but since they were of variable quality, it is thought to have been convenient to use the services of a money-changer. A trader could open an account with a money-changer into which he could deposit and withdraw coinage. Payments to other traders with accounts with the same trader could then be made by having the money-changer debit his account and credit theirs. The money-changer had to keep some coins in reserve for withdrawals and payments to other money-changers but since, with random inflows and outflows, a net outflow amounting to a major proportion of the money deposited was unlikely, the otherwise idle cash was made available for loans. Those loans usually took the form of overdrafts to depositors because they were considered less risky than loans to strangers. The main causes of bank failures were fraud, and defaults on loans made to kings to pay their armies .

Renaissance banking

Few European banks achieved a reputation for probity and stability before the 17th century, mainly because of the absence of established property rights or of the effective discouragement of fraud. There were a few local attempts to create stable and reliable banks. For example, the municipal authorities in Barcelona set up a public bank in the late fourteenth century, which accepted deposits but was not authorised to make loans to the public , but elsewhere banking fraud and financial failure were commonplace. The best-known among the few exception was the Medici bank, which flourished in Florence in the first half of the fifteenth century, surviving long enough to develop some significant innovations. In particular, it brought about the general commercial use of "bills, of exchange" (which are the banking counterpart of promissary notes or IOUs), which enabled traders to defer payment for a purchase . Its practices are thought to have served as the model for modern European banking.

Banking in the 17th and 18th centuries

In the early years of the 17th century, the municipal authorities of Amsterdam, being aware that commercial activity there was being hampered by the uncertainties created by the circulaton of coins of various currencies and differing quality, decided to take action. As a corrective they founded the "Wisselbank" in 1609, , and required it to maintain a high level of stability by maintaining its reserves of coins and precious metals at a level close to 100 per centof its deposits. It operated mainly as a service to merchants who were trading in different currencies and it did not make loans to the public. Its main contribution to banking innovation was a system of transfers by cheques and direct debits that was similar to the system in use in the 21st century. The Wisselbank had some of the characterestics of a modern central bank, and it inaugurated a five-hundred-year period of participation in, and regulation of banks by public authorities. However, the claim to have been the world's first central bank is made by the Swedish Riksbank which was inaugurated 1668 as the successor to John Palmstruch's "Stockholm Banco". It was nominally a private bank, but the King of Sweden appointed its management, and regulated its operations. Unlike the Wisselbank, it issued loans and maintained reserves at only a fraction of its deposits. Its main contribution to banking innovation was the issue the first modern banknotes, which were interest-free bills of exchange, denominated in specific amounts and - in principal - corresponding in total value to money deposited in the bank. It was in due course to be formally recognised as a public bank with a statutory monopoly of the issue of banknotes . The Bank of England was created as a private bank in 1694, mainly in order to raise money for the government of the day (by converting some of its debt to shares in the bank and in 1709 it was granted a partial monopoly in the issue of banknotes . The bank maintained sufficient reserves of gold to redeem its notes on demand (except during the Napoleonic War, when that facility had to be suspended).

Crisis in the 21st century

What happened in 2008 was described by the Deputy Governor of the Bank of England as "possibly the largest financial crisis of its kind in human history ".

Banking regulation

Basel I and Basel II

Responsibility for assessing risk was placed upon the banks and the credit agencies.

Banking failures

The seventeenth and eighteenth centuries

Bank runs first appeared as part of cycles of credit expansion and its subsequent contraction. In the 16th century onwards, English goldsmiths issuing promissory notes suffered severe failures due to bad harvests plummeting parts of the country into famine and unrest. Other examples are the Dutch Tulip manias (1634-1637), the British South Sea Bubble (1717-1719), the French Mississippi Company (1717-1720).

The nineteenth century

the "Post Napoleonic Depression" (1815-1830)

The supply of money and credit

Control of the money supply

Discount rate changes

By reducing its discount rate (the interest rate that the it charges for loans to banks), a central bank can increase the banks' motive to increase their reserves by borrowing, and thus raise their ability to issue loans and create money. Correspondingly, an increase in the central bank's discount rate is a means of reducing the money supply.

Open market operations

The money supply can also be raised by an open market operation in which the central bank offers to buy government securities from them, paying for them by a nominal increase in the reserves that the banks deposit with it (sometimes referred to as "printing money"). The resulting increase in the banks' reserves enable them to increase borrowing and create money.

Reserve and capital requirements

Alternatively, the money supply can be increased more directly by reducing their required reserve ratios, or their required capital adequacy ratios.