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.

(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 from , by finding buyers for their equity and corporate bonds. "Universal banks" combine all of those activities and often others such as insurance.

Banking innovations - a brief history

Medieval banking

Some medieval banks have been categorised as "deposit banks" because they accepted deposits and made loans, and others as "exchange banks" because they performed neither of those functions, but were principally the means of enabling transactions between traders using different currencies. Deposit banking is believed by historiansMyers, Stewart, and Raghuram Rajan. "The Paradox of Liquidity." Forthcoming, Quarterly Journal of Economics, 1998 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.

Deposit banking in the 15th century

Modern European deposit banking had it its origins in the Italian city of Florence in the fifteenth century. The most successful of the Florentine bankers were the Medicis - a family that acquired respectability after generations of criminal activity. Among their innovations was the acceptance for a fee of "bills, of exchange" (which are the banking counterpart of promissary note or IOU), which enabled traders to defer payment for a purchase, and the offer to change money from one currency into another - also for a fee.

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.