15: The Business of Banking
Banks may extend credit by one of two means: by granting loans of money held in deposit, and by issuing "fiduciary media," which is credit that is not covered by money. They can be traced to different historical roots, and both may be practiced by the same institution with little distinction. However, they must be considered separately in economic theory in order to correctly understand their nature and fuctions.
Aside of "banking activities proper," many banks carry on other activities that are closely related to this basic business. For example, they may exchange money, involve themselves in the purchase and sale of securities, or manage the finances of their customers. These activities are largely unrelated to the economic significance of the core business of negotiating credit.
Banks as Negotiators of Credit
A person who lends his own money is termed a "capitalist," one who lends the money of others a "banker."
In terms of credit that is based on loans backed by money, banks essentially borrow money (funds on deposit are paid a given interest rate by the bank) in order to lend it to others, who pay interest for the use of these funds. The difference between the amount of interest paid and collected constitutes the revenue of the bank, and when overhead costs are deducted, its profit.
In negotiation of credit, banks must seek to achieve a balance, to ensure that the payments it receives on loans it extends is sufficient and timely to cover the demand for repayment of principal by its depositors. And because there is no legal connection between credit and deposit, banks must manage the credit they extend to ensure they can meet the obligation to repay their own debt to depositors. Just as a person is held responsible for paying their debt, regardless of any monies owed to them, so must a bank honor its obligations to pay independently of its ability to collect. And it is from its acceptance of this risk that the bank "earns" its profits.
And this is all that needs be said about the issuing of credit backed by money, as it is of no particular significance to monetary theory.
Banks and Fiduciary Media
A direct exchange requires both parties to fulfill their obligations to one another at the same time. If one party fills its obligation to the other at a later time, it is a credit exchange: the obligation is granted immediately based on the "credit" given to the other party that he will meet his obligation at a later time.
Basic examples of credit transactions are an immediate payment for goods to be delivered in future, or the immediate transfer of goods for payment to be granted in future. Some economists have considered the distinction between the two, but it is essentially inconsequential.
The same principle applies when an exchange of money takes place: a sum of money is granted (loaned) immediately, and a roughly equivalent sum of money is granted (repaid) in future. It is "roughly" equivalent because it is commonly accepted that the party who meets their obligation immediately is entitled to an additional measure in repayment - by virtue of the inconvenience of being deprived of payment for a period of time, the risk that payment will not be made at all, and the risk of inflation decreasing the exchange value of an equal sum in future.
However, money has one peculiar quality that is not true of any consumer good: it has no use other than as a medium of exchange. Hence, a person does not typically seek to gain money for its use, but intends instead to immediately get rid of it. Property loans are a good example: when an individual borrows money to purchase property (such as real estate), he does not seek to hold the money, but instead to spend it immediately on a tangible good (the real estate).
This leads to the phenomenon of the "bank note" as a money substitute: an individual may borrow five pounds of silver from a bank and receive, instead of the metal, a note that can be redeemed for the silver at the bank. If the recipient of the note comes immediately to the bank to exchange it, the bank must tender the metal. However, if the recipient instead uses the note in payment of his own debt, and that recipient uses the note in payment to another, and so on, then the bank note may remain in circulation for an extended period of time without being redeemed.
Loans among banks further complicate the matter: a bank may obtain a loan, in the form of a note, from another bank, hold that note and write notes of its own. When called upon to redeem its notes, it must then redeem the note from the other bank to obtain the metal. This may result in a long chain of notes that are backed by other notes, ultimately back to the actual metal. Even so, every note in circulation is backed by an equal quantity of metal in storage, however remote.
However, a bank can issues notes based on the metal (or money) it expects to receive in future from its own debtors, based on the assumption that the money will be on hand by the time the notes are redeemed. In this practice, the amount of notes received can be equal to the principal and interest of the repayment. Such notes are termed "fiduciary media" - money substitutes backed by an amount of credit rather than cash on deposit.
By writing notes in the amount of interest, a banks creates money substitutes in excess of the supply of money - which itself is currently in use in exchange. This compounding can be done, and historically has been done, to the point at which the amount of money substitutes created by means of fiduciary media is sufficient to influence the exchange value of money itself.
Deposits as the Origin of Circulation Credit
Fiduciary media are "grown on the soil of the deposit system," which is to say that banking began as money storage, then began to lend money from its stores, and finally began to lend on the expected future cash flows.
Deposits fit the definition of credit - the exchange for a present good for a future good - in the sense that the depositor gives money to the bank in exchange for receiving from money from the bank in future. It could be argued the depositor withdraws from his own stock of money, but the bank manages funds in aggregated, and deposits are thus pooled resources.
The fact that a depositor places his funds into a bank in exchange for a future promise of access to those funds is based entirely on his confidence in the bank's constant readiness to tender his funds on demand. In a practical sense, albeit not a legal one, the depositor has loaned money to the bank, on the terms it is to be repaid on demand.
It is this same faith in instant redemption that make bank notes an acceptable medium of exchange, and upon this same faith that banks have been able to issue fiduciary media: the bank manages savings and loans such that it can make immediate payment of any loan and itself absorbs the risk of the timing of its debtors' repayment of funds borrowed.
The author refers to the notion of a banker as being a person who loans other peoples' money as the "English definition" of banking. There is some reference to the age in which English banks were merely money-vault that paid no interest, and often charged a fee to depositors to safeguard their money.
(EN: And from another source, it is noted that bankers began loaning out money without permission - and when suit was brought against them [Foley 1848], it was concluded that so long as the funds were available for withdrawal on demand, the depositor had no valid claim of any damage done. They payment of interest as a "share" of profit made from loans was an accommodation to appease the objections of depositors, but not a requirement of the outcome of the case.)
The notion of "reserve" banking arises from the estimation of the amount of funds that would likely be withdrawn in a given time, and managing the loan of funds from the bank to ensure that there would be sufficient funds on reserve to meet this demand. To better predict the outflow of funds, banks created the notion of the time deposit, in which the depositor would abdicate his right to withdraw for a given amount of time (usually for a higher interest rate) and, in turn, the bank could have a more reliable expectation of the amount of money it would be "safe" to loan for a given amount of time.
By virtue of regulation, there have been times at which there was a distinction between a "savings" bank (on demand withdrawal) and a "deposit" bank (time deposits), though the two are commonly practiced by a single institution. And further, a "loan bank" was often created to handle the business of lending money. (EN: Hence the current-day reference to a bank as a "savings and loan," a throwback to when these were separate institutions.)
Granting of Circulation Credit
The nature of a bank note is often misinterpreted as a credit instrument - that, in effect, a person who holds a note that the bank must redeem for currency or metal is a creditor of the bank. This is erroneous and results in several lines of specious logic about the nature and role of banks.
A bank note is merely a token that can be redeemed, on demand for a certain quantity of money or metal. Where the currency is fully backed by funds on deposit, and as such, the bank has no net increase in assets as a result of having issued notes: each note in circulation is a debit against which funds in the bank are a credit, so it is a zero-balance equation.
A more accurate way to consider bank notes is in their similarity to a ticket one receives at the coat-room of a theater: because you have given the clerk your hat and hold a ticket you must present to claim it does not mean the clerk has borrowed your hat, or owes you any fee for the use of it until it is claimed.
However, a bank note that represents a value is commonly accepted in trade. To return to the coat-room analogy, a patron could check a hat at the coat-room and sell the hat to someone else, giving them instead the ticket to claim it at the theater rather than the hat itself. It is (arguably) a matter of convenience to have a ticket to claim the item rather than the they physical item.
(EN: A few other topics are covered here, but it seems that Von Mises is splitting hairs. My sense is that he is responding to the theories and misconceptions of his day. It may be useful to revisit this in the context of an argument that asserts that a bank "borrows" money from the public, but it seems rather overly fussy about details that do not seem consequential.)
Fiduciary Media and the Nature of Direct Exchange
Because bank issue notes that represent a claim against funds on deposit and notes that represent a claim against funds in the future, and because both are utilized in commercial exchange, it is common to consider the two to be equivalent. However, there are situations in which the differences are significant, which will be identified in following chapters.
In terms of their use in commercial exchange, the difference is of little to no importance. When a merchant prices a quantity of goods at a pound of silver, he seldom concerns himself with whether the buyer pays with physical metal or a note, or a note that can be immediately redeemed versus one that can be redeemed after thirty days, or whether the note is backed by present metal (commodity) or metal that will be available in future (credit).
To the merchant, all of these variations are acceptable under most circumstances, as he believes that whatever form of payment he receives can be used in his own payment to others. That is, he accepts it because everyone else will, too.
"Under most circumstances" implies there are exceptions: if the merchant does not believe the note to be genuine, if the bank issuing the note is questionable, etc. he may not be willing to accept a particular banknote. In terms of exchange, this is little different than refusing the coin of a known counterfeiter.