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).

Banking essentials
Banks are financial intermediaries - acting as middlemen between lenders and borrowers. Most banks accept payments from depositors and lend money to borrowers. In addition to the money they get from depositors they can get short-term loans from their  central bank's "discount window"", or from the money market. They make profits by charging higher interest rates to  their borrowers than they pay to their lenders  - a difference that is known as  their "spread". They normally make loans amounting to many times the total of their deposits - often as much as twenty times as much -  but  maintain reserves in the form of cash or assets that can be quickly sold for cash in order to pay for withdrawals by depositors. Reserves  can usually be augmented, if necessary, by borrowing from other banks or, in an emergency, by borrowing  from their central bank.

The banks that accept deposits from the public 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.

The Diamond-Dybvig model
Banks usually make loans that they cannot withdraw at short notice, and pay for them with deposits that can be withdawn without notice. This is referred to as a situation in which a bank's liabilities are more liquid than its assets. A bank is said to suffer a liquidity crisis if too many depositors attempt to withdraw their money at one time - a situation referred to as a bank run. The Diamond-Dybvig model  explains why banks choose to issue deposits that are more liquid than their assets and to understand why banks are subject to runs. The model has been widely used to understand bank runs and other types of financial crises, as well as ways to prevent such crises.

Incomplete contract theory
An incomplete contract may be necessary when the exact nature of the benefit to be conferred by an agreement will depend upon a contingency that is yet to be realised. Under some circumstancea a contingent contract can be drawn up which specifies the nature of the benefit to be provided under each of the feasible contingent outcomes, but that procedure is prohibitively expensive if the number of possible outcomes is large. Under those circumstances it may be better to agree an incomplete contract that includes an undertaking to renegotiate when the true outcome is known. Incomplete contract theory is concerned with ...

The agency problem
A problem can arise when an agent, who is employed to look after the interests of a principal, uses for his own benefit the authority given to him for that purpose. The agency problem is to decide how much it is worth spending on precautions or incentives to discourage such behaviour.

The creation of money
It can be shown that a fractional-reserve banking system  can actually create money, and that, for example, a bank with a ten per cent reserve ratio  can convert a £1000  deposit into an increase in money of up to £10,000. Tutorials subpage).

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

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 later 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). An attempt was made to set up a French central bank in 1710, but after a successful start, it collapsed in 1720, causing a major economic crisis. . United States banking commenced  in  the 1780s with the chartering of the Bank of North America, and the creation of the First Bank of the United States with a limited role as a central bank..

Banking in the 19th century
In the United States, there followed a protracted series of politically controversial and mainly unsuccessful attempts to regulate its rapidly expanding banking sector. At the state level, banks had to be registered with state legislatures, who set reserve requirements that were, at best, loosely enforced. Few of them survived for more than five years. At the national level, the First Bank of the United States was closed, to be succeeded by the Second Bank of the United States until it too was closed in 1836 without achieving a significant improvement in banking stability. In 1864, the United States Congress passed the National Banking Act with the intention of creating a network of federally-chartered "national banks" with improved regulatory standards, but without setting up another central bank.

In England, the need for intervention became evident in 1866 when the collapse of the Gurney-Overend bank caused a panic in which large numbers of people tried to withdraw deposits from their banks; leading to the collapse of over 200 companies. On that occasion the Bank of England had refused to help, but the influential commentator Walter Bagehot urged that in a future panic it should "advance freely and vigorously to the public out of its reserves" in order to avoid another "run on the banks", a recommendation that is credited with the esablishment of the concept of the central bank as lender of last resort. The 1890 failure of the Barings bank (then the world's largest investment bank) further established the role of the Bank as a guardian of the English banking sector when it organised a rescue by guaranteeing loans to it by other banks, thereby establishing  the concept of "too big to fail". The Bank Charter Act of 1844  had already established it  as the only institution in England with note-issuing powers, and the Bank of England was gradually assuming in full, the role of a modern central bank.

Regulation, deregulation and securitisation in the 20th century
In the United States there had been similar initial inaction in face of the panic of 1893 but following the further panic of 1907 the Congress created the Federal Reserve System and granted it powers to assist banks that faced demands that they would otherwise be unable to meet. The subsequent practice of central banks in the United States and elsewhere has been to assume the role of lender of last resort and provide short-term loans to solvent banks to tide them over  temporary liquidity difficulties, and  also to provide or arrange longer-term loans to avert failures that would be large enough to threaten the stability of the banking system. The next important innovation was prompted by the sequence of bank runs and failures that occurred in the period from 1929 t0 1933. The Banking Act of 1933, established the Federal Deposit Insurance Corporation, with  authority to regulate and supervise state  banks outside the Federal Reserve System and provide them with deposit insurance. The Act also prohibited combinations of commercial and investment banking. and other restrictions were also imposed upon banking activity (see the Addendum subpage). Restrictions upon banking activities - intended to reduce the danger of a recurrence of the financial instability experienced in the early 1930s - were imposed by most other industrialised countries. Until the 1980s, investment banks were not normally permitted to undertake non-financial activities, nor other financial activities such as branch banking, insurance or mortgage lending.

In the 1980s, however, there was extensive deregulation of the banks with the intention of increasing competition and improving efficiency. , which made possible a series of innovations, the  most significant of which was the practice of  securitisation, meaning the conversion of their loans into graded packages of bonds; and  the development of the strategy  known as "originate and distribute", under which  such bonds were sold  to pension funds, insurance companies and other banks.

The benefits of banking
There is a presumption that - by providing an improved conduit between savers and investors - banking makes a significant  contribution to the functioning of an economy. The improvement that it provides is generally  attributed to the  banks' screening of applicants for investment funds, to their mobilisation of savings, to their monitoring of investment projects, and to their allocation of risks in response to the needs of different categories of investors. Despite measurement difficulties, the consensus view among economist is that belief in the economic benefits of banking is well supported by empirical  evidence - even to the extent of suggesting that a well-functioning banking sector may  be a necessary precondition for economic growth. Studies of the Dutch Republic, England, the U.S., France, Germany and Japan suggest that the establishment of a financial system has always preceded the onset of economic growth, and a correlation between financial developments and economic growth over the period 1850-1997 has been established by a cross-section study of 17 countries. It has also been shown that countries with more sophisticated financial systems tend to  engage in more trade, and appear to be better integrated  with other  economies. . Other empirical investigations have shown that the ratio of banking liabilities to GDP is strongly correlated with economic growth .

Inherent risks
Like any other enterprise, a bank can increase its profitability - but also its risk of insolvency -  by increasing its leverage  (as explained on the tutorials subpage). A bank creates leverage when it lends more money than it holds as reserves  (the money provided by its shareholders plus retained profits). With leverage ratios commonly as high as 20, losses of over 5 per cent can be sufficient to create insolvency. For a bank, the principal risks of loss are  credit risk, which is the risk that the value of a bank's loans will fall as a result of defaults on the part of borrowers, and interest rate risk, which is the risk that the value of a fixed-rate loan will fall as a result of a rise in interest rates.

In common with other enterprises that make profits by financing long-term investments by short-term borrowing, banks are also vulnerable to liquidity risks. Deposits in banks that can be withdrawn on demand  are,  in principle, the same as  short-term borrowings, although in normal circumstances it is unlikely that any  substantial proportion of them would be withdrawn simultaneously. Should that happen, however, the bank may find itself unable to raise the money needed to pay its depositors. A run on a bank can happen if depositors lose confidence in its ability to repay all deposits in full, and try to withdraw their funds immediately. Liquidity crises and bank runs are not the same as insolvency, but they can drive a bank into insolvency as a result of losses on the resulting forced-sales of its assets . A loss of confidence in one bank can spread to other banks by a process termed contagion. It may affect only those banks that are considered  to face similar problems, but it  may becomme a panic and affect banks that would otherwise be considered trouble- free - and, under extreme circumstances, it  can lead  infect non-banking organisations and lead to a systemic failure of a country's financial system, or even of the world's  entire financial system.

The effects of recent innovations
The banking innovations that were introduced in the 1980s  allowed risks to be shared more widely, enabling investments to be undertaken that woould not otherwise have been possible, and thus contributing to economic growth. It was not recognised at the time that they also increased the risk of systemic failure, but there were some expressions of concern in the early years of the 21st century. One cause for concern was a growing tendency to finance lending by short-term borrowing on the money market. In normal times, money market loans were automatically renewed (rolled over) as soon as they matured, but any hint of trouble could prompt the withawal of that facility. Another was the realisation that the process of securitisation had transferred decision-making from managers on fixed salaries to investment managers who were being awarded profit-related bonuses that had the effect of rewarding risk-taking, and a suspicion that the market was being further distorted by herding behaviour by managers who feared being outperformed by their rivals . It also seemed possible that investors and regulators might not be getting an accurate picture of where risks were falling because of the opacity of a system in which "off-balance-sheet" investments enabled banks to conceal their true risk-exposures.

Risk management
A further innovation was the widespread development of risk-management models based upon the "Capital Asset Pricing Model". However, such models assume that risks can be represented by the symmetrical bell-shaped normal distribution, and can give inaccurate results if the true distribution has a "fat tail", as a result of which there is a significant additional tail risk, and there is evidence that suggests that securitised assets may be expected to involve significant tail risks. . The risks represented in those models are based upon analyses of past experience and since the events involving such risks are by definition rare, they cannot be expected to be picked up by models based upon a five or six years' run of data.

Central bank supervision
Governments have long been aware of the danger that a loss of confidence following the failure of one bank could lead to the failure of others, and eventually to "systemic failure" of the entire financial system. To limit that danger, they have traditionally required  banks to limit the extent to which their loans exceed the funds provided by their shareholders  by the imposition of minimum "reserve ratios"  and have placed various other restrictions upon their activities. In the 1980s, however, it was widely considered that those regulations were imposing  excessive economic penalties, and there was a general move toward "deregulation". Restrictions that had prevented investment banks from broadening  their activities to include  branch banking, insurance or mortgage lending were dropped, and reserve requirements were relaxed.

International recommendations
In 1974 the governors of the central banks of the Group of Ten leading industrial countries had set up The Basel Committee for Banking Supervision to coordinate precautionary banking regulations, and in 1988, concern about the increased danger of  systemic failure led that committee to publish a set of regulatory recommendations that related a bank's required reserve ratio to the riskiness of its loans. In 1999 further concern about the danger of instability led to the creation of the Financial Stability Forum  to promote information exchange and international co-operation in financial supervision and surveillance. In 2004, the Basel Committee published revised recommendations known as Basel II intended to require banks to take more detailed account of the riskiness of their loans. Responsibility for assessing risk was placed upon the banks and the credit agencies.

Failures and crises
.

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)

Proposals for reform
The crash of 2008 has been  seen as an reminder of that system's  inherent instability and of the inadequacy of its existing methods of management.