1: The Origins and Function of Banking
Core definition: "A bank is an institution that accepts deposits from savers, extends loans to borrowers, and provides a range of other financial services." The bank plays a critical role in the financial system, facilitating the flow of money within an economy and serving all players: households, corporations, nonprofits, and government all deal with banks for their monetary needs.
The core services of banks have not changed for millennia, but the modern economy puts more capital in the hands of more people, and the digital channels educate and empower them, changing the methods (though not the purpose) by which wealth is managed.
It is only in the past few decades that banks have consolidated, and many of the biggest banks have global operations. There are still pockets of the world in which banking is not available, but the evolution of technology (particularly digital and mobile) is quickly brining the capabilities of the bank to those who previously had no access.
The global financial crisis of 2007-2009 (EN: a decade before this book was written) was a wake-up call. The large banks are powerful, but also very fragile as was demonstrated in the recent financial crisis, in which it was demonstrated that the failure large, global organizations has a large and global impact. Large corporations and the economies of several moderate-sized nations failed. A fleet of new laws has been passed to regulate the world financial system, which bring problems and inefficiencies of their own.
The authors concede that this book will be heavily influenced by recent events, but is intended to be a general overview of the banking industry that applies regardless of the economic climate.
A Short History of Banking
The practice of money-lending is ancient. Likely as soon as money was invented, someone wanted to borrow it, and those who had it saw the opportunity by renting out their idle capital for others to use. The author speaks briefly about banking in Europe, in Greece and the Roman Empire (EN : but banking is also seen in China centuries earlier, and in most cultures, so the "history" is decidedly ethno-centric).
For many years, only wealthy individuals had money to lend and managed their own lending. IT was not until the mercantile era that most people handled money, and it was not until the Renaissance that "modern" banking arose - in which the "bank" was an institution that aggregated the capital of many people and organized lending it for a commission.
Banks were often located in centers of commerce where there was a great deal of trade and money changing hands. Mercantile capitals such as Florence, Amsterdam, and later London were the locations of much commerce, borrowing, lending, and financing. The banks that arose in these locations consolidated the services that had previously been fragmented.
The first corporate bank, the Bank of England, was founded in 1694, primarily for the British government to borrow money from its people (and others) to finance its war with France. The BE was not formally declared the official central bank of Britain until the twentieth century, but functioned in that capacity long before.
Corporate banks tended to outlast private banks because they did not depend on the fortune of a single family, nor were they subject to the capriciousness of wealthy individuals managing their own fortune. Being corporate, they aggregated the capital of many and were governed by a democratic process. So they outlasted the lives of their depositors and made decisions that were more conservative and considered the longevity of the organization rather than short-term profit schemes that ruined many private banks.
The original banks also created money in the form of bank-notes, which were essentially documents that authorized the bearer to withdraw certain amounts of capital (specie) from the bank. So long as the bank was solvent, people were happy to trade their notes and letters of credit as if they were actual money. Various disasters and acts of wholesale fraud eventually gave government the excuse to regulate the industry - to oversee banks on behalf of the public and ascertain their notes would be honored. The Banking Code of 1844 provided detailed guidance, much of which is echoed in modern day banking regulations.
An interesting aside: the growth of large banks is not a modern phenomenon. By the 1850s many small banks began being acquired by larger ones, and by 1920 five large banks (Westminster, National Provincial, Barclays, Lloyds, and Midland) accounted for 80% of all deposits in the UK. These same five banks continued to dominate the world economy through the Depression and until the end of WW2, when the economy of Europe was devastated and the global set of commerce was transferred from England to the USA.
There's some mention of the building societies of the 18th century, which were established to create mortgage loans to finance house building (the first major real estate boom when the middle classes, enriched by industrialization, were able to afford to build homes). While many of these have gone corporate, there are still around forty still operating in the UK.
In America, there were multiple attempts to establish a national bank (The Bank of North America, First National Bank of the US, Second National Bank of the US, etc.) that did not take hold until after te great depression, when the Federal Reserve was created. Commercial banks such as the Bank of Massachusetts and the Bank of New York formed, long before corporate banks arose in Europe.
There is a history of swings back and forth between national banking and free banking, in which the majority of banking vacillated between government and private banks, generally when some crisis caused one bank to collapse and depositors to flee to another.
Banking stabilized in the USA when the Federal Reserve and Federal Deposit Insurance Corporation were established during the Great Depression. This created a powerful and stable central bank and a safety net for depositors at private banks that were FDIC insured. This made US banks the most stable in the world, and along with the Breton Woods system (which essentially made the dollar the supporting currency for all other world economies), made the United States the monetary capital of the world, a position that has only recently been challenged, and with limited success, by the European Economic Union.
Basic Bank Financials: Balance Sheet and Income Statement
The best way to understand the operations of a bank are to consider how it functions like any other corporate organization: its assets, liabilities, and the means by which it creates income. Since a bank's inventory is money, it is necessary to disentangle the bank's money from its depositors' funds.
- When money is deposited, the bank gains the asset of cash, balanced by a liability of payables to the depositors (which are due on demand)
- When money is withdrawn, the bank decreases its cash, but also decreases its payables to depositors
- When interest is paid to depositors, the amount of cash stays the same, but the total interest is added to its liabilities (the depositor's funds) and deducted from the bank's own equity.
The same is true of any bond or liability issued by the bank: issuing a bond raises cash and increases payables, paying off a bond decreases cash and decreases payables - though this is generally at the bank's discretion or according to the terms of the bond or note.
- When the bank extends a loan, cash leaves the bank but it gains an account receivable - the liability to depositors is not changed by this transaction
- When payments are made on the loan, cash comes in, the amount receivable is decreased by the amount of principal, and the bank's equity is increased by the amount of interest
Again, the same is true of any investment the bank makes with its depositors funds: it is a trade of cash for a future payment, which does not affect the amount the bank owes to its depositors.
A bank generates profit by charging/collecting more interest on its loans and investments than it pays to its depositors. This is the bank's gross profit, from which operating expenses are deducted to arrive at the net profit of the bank.
Banking Services
Historically, the single-service bank was simply a money warehouse. It stored the valuables of its clients in exchange for a monthly fee. This is still the nature of the service of a bank that offers safe deposit boxes.
Most bank balances are not stored in the vault but loaned or invested. So in this sense, the bank is borrowing money from its depositors to lend to its debtors (or to invest) - but at the same time guaranteeing its depositors can withdraw their funds at any time, regardless of whether the borrower has repaid the loan.
The term "retail banking" is used to refer to the services banks provide to individuals and households for their personal financial matters. A household checking account, savings account, and time deposits are the common deposit products. Mortgages, auto loans, personal loans, and credit cards are the common loan products.
Retail banking often includes services to small businesses like proprietorships and partnerships, which generally have modest needs.
Retail banks may also offer other financial services such as personal accounting, financial advice, investment brokering, insurance, foreign currency exchange, pension management, and so on. These are not technically "bank" products though they may be offered by the bank.
Wholesale banking includes banks that serve other banks, often acting as middlemen between banks who have more funds on deposit than their borrowers want to loan and banks who have the opposite problem. There are various vehicles by which these exchanges are facilitated, but it fundamentally comes down to matching idle money with the demand to borrow it.
Corporate banking, involves larger scale operations to serve the needs of large organizations such as corporate entities. These are still basically borrowing and lending operations, but tend to be for large amounts of money, and there are various formalized kinds of deposits and loans that a bank provides or coordinates for their larger customers.
Investment banking is not really "banking" but more in the nature of "brokering." When a company approaches an investment bank to borrow money, the bank does not loan from its depositors' capital (and investment banks generally do not have depositors), but instead raises the money by creating a security (an issue of stocks or bonds) that is sold on the financial market to investors. Investment banks often facilitate exchange of securities that were created by other banks.
Types of Banking Organizations
In the present day, most banks are commercial banks. They are corporations that are owned by shareholders. There are very few banks that serve the public that are proprietors or partnerships.
Mutual banks are owned by their depositors. They are essentially identical to commercial banks, except that funds on deposit substitute for shares of ownership when it comes to governance and profit sharing.
Private banks are banks that do not serve the general public, but only a few clients - one very wealthy individual or family, or a number of wealthy households that have established a bank to serve their own needs. These banks function as a personal treasury, managing the money of their clients.
State banks are common in smaller nations, in which the government provides banking services through a "bank" that is actually a government office. The state bank may have more or less independence based on the letter of the law.
Central banks are the state banks of larger countries that management the assets of the government, and who issue official currency of a given nation. They often act as wholesale banks for various banking entities within the nation, managing the national money supply.
The author then provides some statistics on the largest banks in various parts of the world. Many of the banks in the top-ten list manage one trillion or more dollars in assets.
The Shadow Banking System
The sinister-sounding "shadow" banking system includes many private and largely unregulated firms that provide financial services. Most of these institutions are entirely mundane and nonthreatening:
- Hedge Funds - Are investment companies whose charter gives management broad latitude in how they may manage the funds contributed by shareholders.
- Exchange-Traded Funds (ETF) - Are similar to mutual funds, but their shares are traded on the open market rather than restricted to be bought and sold from the management firm
- Special-Purpose Vehicle (SPV) - Is a corporation that is set up to manage the debt of another company, such that its shareholders are (somewhat) protected from loss if the original company fails
- Asset Management Company - An investment company that serves a few wealthy clients, which profits by charging fees or claiming a share of profits.
- Money Market Fund - A mutual fund company that invests in treasury securities and other ultra short-term debt
- Real Estate Investment Trust (REIT) - A corporation that purchases and manages real estate that is rented to tenants. A REIT may hold apartment complexes, shopping malls, commercial office buildings, and the like.
While these organizations are not part of the formal banking industry, they manage a great deal of wealth, and some banks use shadow banking organizations to manage some of their deposits - hence the fear that the failure of the shadow banking industry could have a serious impact on the formal banking industry. This fear is amplified by the suspicion that there are ore assets in the shadow banking industry (where it cannot be observed or regulated) than there are in the official banking industry.
The Payments System
In a cash economy, there is no need to process payments: the value is transferred from one person to another the moment he hands over a stack of silver coins. But for various reasons (mainly safety and convenience), people came to prefer other methods of payment that had to be processed.
The simplest form of payment was a check - which was a note entitling someone to make a withdrawal from a given bank. To make payment, the payer wrote a note to the recipient giving him permission to withdraw coin from the payer's account, and the recipient would go to the bank to retrieve the coin, then carry the coin to his own bank to deposit (or if payer and payee used the same bank, to simply "journal" ownership of the coins from payer to recipient).
Modern payment systems still use that same arrangement. The payer gives the recipient ownership of his money. There are various ways to make this payment (check, credit card, electronic or verbal authorization, etc,.) and various ways to transfer the money from one bank to another.
The earliest clearing houses simply matched debt between banks. Rather than transferring silver coins, banks could meet and exchange bundles of notes that represented deposits and withdrawals to their account. This could be a direct swap between Bank A and Bank B, or a sophisticated web of exchanges between a dozen or more banks - but the net result was to minimize the amount of coin that would need to be physically transported from one bank to another.
Since the economy has gone global, there are also clearinghouses for international debt that function in the same manner. After the national clearinghouse manages debt between domestic banks, any foreign payments are taken to an international house.
In the present day, this is all done electronically and on an ongoing basis - the net result of which is the virtually instantaneous transfer of money from one hand to another. The recipient of a payment need not wait weeks or months for a check to clear with the payer's bank and the payment to be transferred to his own bank. The automated clearing house (ACH) facilitates virtually instantaneous transfer of funds from one bank to another, anywhere in the world.