Principles of Banking

¶ … Banking

Modern banking has its antecedents in ancient Greece, where entrepreneurs undertook many of the basic functions still conducted by modern banks -- taking deposits, lending money and handling currency. Throughout the middle ages, various groups performed banking functions, mainly for royalty, traders and wealth landowners (Historyworld.net, no date). During this time, governance of the banking industry became stricter and the industry became more formalized.

For much of early banking history, the issue of interest was controversial. Christianity forbade the charging of interest and there were many instances where rulers banned bankers or interest-charging. Some banks, such as the Bank of St. George, were nonetheless able to prove successful, financing trade around the Mediterranean. As world trade grew more far-flung, risk levels increased. As a result, the banking profession grew and increased in complexity in response to the new operating environment of world trade, increasingly complicated by long distances, wars, and uncertain supply chains.

The National Bank Act at the end of the Civil War established the modern banking system in the United States, and the system developed in a similar fashion in other developed nations. The banking system was beginning to take shape, with a central bank and with stricter regulations.

The most fundamental function of banks is to act as a financial intermediary between savers and borrowers (SparkNotes, 2009). Banks accept deposits -- a form of safekeeping for money -- and then lend that money back out. The deposit function is seldom a viable business on its own, but it does serve a valuable purpose with respect to the safeguard of money. Physical forms of wealth are inherently insecure -- they can be stolen. Thus, banks provide security for such wealth. The lending function is where bankers can make profit. This function allows for economic expansion. It facilities capital investment, be it in housing or in equipment for a business.

Banks have expanded their role as facilitators of economic growth and capital preservation over the years. Banks now play a critical role in the creation of money. They lend to each other, in addition to the public. The result of this lending is that banks have a higher system-wide capacity for lending. Since more money can be lend, the needs of more borrowers can be met, spurring growth (Ibid).

Banks are just one of many different types of financial intermediaries. Although banks have expanded their roles over time, they have maintained a relatively strict role for themselves. They accept deposits and lend out the money in the form of mortgages, business loans, credit cards and lines of credit. The banks accept deposits in a variety of forms as well.

Banks are just one of many financial intermediaries that comprise the modern financial system. They are the second-largest financial intermediary, after pension funds (Federal Reserve Bank of San Francisco, 2001). Other institutional forms within the system are insurers, mutual funds, finance companies, credit unions and money market funds. Each has a specific role to play. Some of these institutions compete directly with banks in either deposits or lending. The leeway given to banks with respect to doing a wider range of business has helped them establish a strong market share, despite the increased amount of blurring between the different types of financial intermediaries (Marquis, 2001).

Banks maintain a vital role in the economy. They serve the financial needs of individuals through both their lending and deposit-taking functions. Banks provide consumers with safe storage for their money. Banks can do this by selling securities, but more commonly they do this through savings. To ensure that banks are able to fulfill this function, the federal government created the FDIC to insure bank deposits up to $100,000.

Consumers also benefit from the lending function. Bank loans finance a wide variety of consumer activity. These loans are used to make large purchase, such as cars and houses. Banks can provide credit to help a consumer smooth out his or her cash flows. These functions allow consumers to make large purchases they otherwise would not be able to make. The benefit to this is that it improves the standard of living for most consumers to be able to protect their savings and make these purchases.

For business, banks are a valuable resource. While most businesses have some form of current account that they can use to safeguard small amounts of capital, access to credit is a far more important consideration for business. For most businesses, expansion cannot be incremental, but in leaps and bounds. Such expansions are based on expectations of future cash flows, not present cash flows. This means that the business would not be able to expand without financing from the bank.

Banks also provide significant liquidity to the stock markets, in turn allowing for industry to acquire capital. Banks are among the largest institutional investors in the world, owning stocks in their own portfolios, in portfolios of their clients and in portfolios of investment funds. The liquidity that the banks provide makes capital markets more efficient, resulting in easier access to capital for most companies. This again spurs economic growth. It should be noted that banks do not exercise direct ownership in the way that they do in many other countries. They are invested in the markets but do not exert significant control over these companies and do not consider any non-financial firm to be a subsidiary; they are merely investments.

The government therefore also relies on the banks. Because of the credit they provide, banks facilitate economic expansion. In the United States, banks play a less direct role in economic growth than they do in other nations where the government-bank relationship in economic growth is built into the structure of the banking system (i.e. Canada, Japan). However, the government still relies on the banks to fulfill their role in order to keep the economy moving forward. The recent credit crunch is an example of a time when the banks have become unwilling to lend, and this has hindered the government's ability to bring about a restoration of economic growth.