Banking: A Brief Overview

bank image

What is a bank?

All of us know about banks. Most people on earth have a bank account, if not several. Many people’s most stressful moments in their week involve doing their banking. But what, technically, is a bank?

The dictionary defines a bank as follows; a financial establishment that uses money deposited by customers for investment, pays it out when required, makes loans at interest, and exchanges currency. The central point in this definition seems to be the exchange of money, or transfer or wealth.

Importantly, a bank is an institution that is licensed to receive deposits and to make loans. However, in modern times, an institution may only be called a bank if it meets certain requirements set out in legislation. These regulations are designed to protect consumers and the economy as a whole, as banks hold significant amount of a country’s wealth in their hands.

Before we go any further, however, it is important to distinguish between different types of banks.

Commercial Banks are the banks that we run into every day. They are the banks that people will hold bank accounts at and where people will get a home loan or mortgage. Small businesses will often also use a commercial bank for their banking purposes. Some examples are Commonwealth Bank of Australia, Bank of America Corporation and ANZ Bank.

Investment Banks take on purely corporate clients. They provide services such as underwriting, and assistance with merger and acquisition activity. The work of investment banks is far reaching and incredibly important, and summarising all of their activities would require an entire blog post to do. Some examples of investment banks include Goldman Sachs and Morgan Stanley.

The final important type of bank is the Reserve Bank. Also known as a Central Bank, reserve banks are controlled by the government and are responsible for things such as controlling inflation, economic stability and the supply of money. You will often run into discussions about the Reserve Bank on the news or shows like 60 Minutes.

An alternative to banks are credit unions, although this will also have to be covered in another post.

A Brief History of Banks

Money lending activities can be traced as far back as 2000BC in places such as Assyria. However, institutions that resemble the modern bank first began to appear in Italy during the Renaissance. The Medici bank, one of the more famous banks was established by Giovani Medici in 1397. Banca Monte dei Paschi di Siena is the oldest bank still in existence and has operated continuously since 1472.

The Goldsmiths of London would be the first real modern bankers, introducing practices such as fraction reserve banking and the issue of banknotes. (Banknotes as essentially a certificate which, when presented, entitles the bearer to a certain amount of money. Banknotes issued by a reserve bank are legal tender.) People who owned gold or silver would deposit it with the goldsmiths, who would lend it out on the behalf of the depositor using banknotes. The issuance of banknotes by the goldsmiths is incredibly important as they embodied a new kind of money – that is, the debt of the goldsmiths. These banknotes could be traded. As they represented a promise of actual gold or silver from the goldsmiths, people gave the banknotes themselves value. The goldsmiths would hold a fractional reserve of actual gold or silver in order to pay any requests that were made – inventing fractional reserve banking.

The Bank of England was started in the 1690s in order to save the government and raise money for it. This would soon develop into the Reserve Bank that we recognise today, which is a vital part of the civic system.

In the modern world, banks are also moving into the internet space, with many banks arising with no physical branches. These banks only have an online presence, and due to the reduction in costs, are able to offer more competitive interest rates.

How a Bank Works

The need for a bank arises when someone is not able to safely store all their wealth by themselves. A bank can provide this service for the person, usually for a fee. The modern bank, as devised by the goldsmiths of London, then lends that wealth (I will use money in place of wealth from now on for simplicity) out to others, again for a fee. Let’s consider a simple case to see how this works.

Joe is very wealthy and decides he wishes to deposit his money into a bank. He approaches the Bank of the World, who agrees to hold Joe’s money for him. Joe gives them his $1 million. Later, Jane decides that she wants to start a bakery. However, she doesn’t have the money required to build the shop, buy the equipment, or hire staff. She approaches the Bank of the World, who agree to give her $1 million, with the requirement that she pay back the money in 6 months, and that in return for the money, she give them an extra $500,000. The other catch here is that instead of giving Jane the money itself, they will give her a banknote promising that they will pay it on demand. Jane uses this banknote to pay for what she needs to start her bakery and pays the $1.5 million back to the bank in real money. (Let’s assume real money in this case is gold.)

The bank now has $2.5 million in gold. However, there are two claims to this gold out in the world. First is Joe, who has a claim to $1 million, and the other is someone who Jane gave the $1 million banknote to.

This is a simple example, and, the process can happen hundreds of times in reality. Eventually, if everybody made claim to their money at once, the bank would be unable to pay everybody. This is what is known as fractional reserve banking. That is part of what happened during the 2008 Global Financial Crisis.

bank and money

What about those investment banks?

Investment banks are an entirely different beast. At their core, they still accept deposits and make payments but do so for bigger operations and often in riskier environment.

For example, let’s say that Jane wants to take her company public. This means that she wants to sell shares of the ownership of the company to raise money. For this, she would approach an investment bank. She approaches Investment Bank of the World, who agree to help her with this venture. They agree that in return for selling 100,000 shares of Jane’s Bakery on the open market, they will give her $1 million. (That is, they are giving her $10 per share.) Investment Bank of the World then goes to the World Stock Exchange and offers the 100,000 shares of Jane’s Bakery for $15 each. They are only able to sell 90,000 of these, making $1,350,000.

You can imagine that this kind of operation is a lot more risky than a commercial banking operation, as there is the potential for Investment Bank of the World to lose money if they are not able to sell enough shares.

However, it is important to remember that this is not the only activity that an investment bank takes part in.

So what is a Reserve Bank?

A reserve bank is a more modern invention than the Commercial or Investment bank. It arose when a need for more regulation in the banking sector arose. A reserve bank also issues banknotes, however these banknotes are accepted as legal tender in the country or region they are issued. The creation of currency is therefore up to the reserve bank, and therefore the reserve bank controls the rate of inflation. Like investment banks, reserve banks also perform a wide range of roles, which are often closely tied to the government’s activities. Reserve Banks require an entire blog post to do them justice.

RBA

Is my money safe in a bank?

The simple answer here is that there is no simple answer. Since the 2008 Global Financial Crisis, people have felt quite uneasy about the security of their money in banks. However, due to the modern need of banks to function in society, we prefer not to think about this. Due to the practice of fractional reserve banking and other similar practices, it is possible for a bank to fail and for your money to simply disappear. However, regulations have been put in place about the kinds of activities banks can take part in, and how risky they are allowed to be.

The banking system is not perfect by any means. It is highly complex, extremely technical, and is constantly changing and evolving as bankers work to make every cent they can. But there is no simple solution to this problem. In fact, there is no solution at all right now. We simply have to be smart about how we handle our money, and be ahead of the game when things go wrong.

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