The Emergence of modern banking

Banks are among the most important financial institutions in the economy and are essential businesses in thousands of local towns and cities. They are the principal source of credit (loanable funds) for households (individuals and families) and for most local units of government (school districts, cities, etc.). Nationwide and worldwide, banks grant more installment loans to consumers than any other financial institution and, in most years, they are among the leading buyers of bonds and notes issued by states and local governments to finance public facilities. The deposits held by banks are the principal money medium for global transactions and the principal channel for government economic policy to stabilize the economy.

When did the first banks appear? Linguistics (the science of language) and etymology (the study of the origins of words) suggest an interesting story about banking's origins. Both the Old French word banque and the Italian word banca were used centuries ago to mean a "moneychanger's table." This describes quite well what historians, looking at the civilizations of Greece and Rome more than 2,000 years ago, have observed concerning the first bankers. They were money-changing institutions, situated usually at a table or in a small shop in the commercial district, aiding travelers who came to town by exchanging foreign coins for local money or discounting commercial notes for a fee.

The first bankers were goldsmiths. Several centuries ago, money consisted primarily of gold coins. Wealthy people found the amounts of gold they accumulated quite heavy. An even bigger drawback is that thieves love gold; stolen gold pieces (or modern coins for that matter) are rarely identifiable. Looking around for safe places to store their wealth, people in medieval Europe thought of goldsmiths. Goldsmiths made jewelry, gold statues, and other precious goods. Most also had some excess space in their heavily guarded vaults.

Most goldsmiths were willing to store valuables for a small fee and issued receipts for the gold deposited with them. Buyers found it convenient to exchange these receipts instead of physically getting the gold, and sellers were happy to take the receipts because they knew they could redeem them for gold whenever they wished. This was the beginning of checking accounts – the receipts issued by the goldsmiths were primitive demand deposits.

The first bankers probably used also their own capital to fund their activities, but it wasn't long before the idea of attracting deposits and securing tem­porary loans from wealthy customers became an important source of bank funding. Loans were then made to merchants, shippers, and landowners at rates of interest as low as 6 percent per annum to as high as 48 percent a month for the riskiest ventures! Most of the early banks of any size were Greek in origin. The Romans generally tolerated banking practices, but were hesitant to set up banks of their own.

The banking industry gradually spread outward from the classical civ­ilizations of Greece and Rome into northern and western Europe. Banking encountered religious opposition during the Middle Ages, primarily be­cause loans made to the poor often carried very high interest rates. How­ever, as the Middle Ages drew to a close and the Renaissance began in Europe, the bulk of bank loans and deposits involved relatively wealthy customers, which helped to reduce religious opposition to banking prac­tices.

The development of new overland trade routes and improvements in navigation in the 15th, 16th, and 17th centuries gradually shifted the center of world commerce from the Mediterranean region to northern and western Europe, where banking became a leading industry. During this period were planted the seeds of the industrial revolution, which demanded a well-developed financial system. In particular, the construction and acquisition of steam-driven machinery and mass production methods required a cor­responding expansion in global trade to absorb industrial output, requiring new methods for making payments and credit available. Banks that could deliver on these needs grew rapidly, led by such institutions as the Medici Bank in Italy and the Hochstetter Bank in Germany.

When colonies were established in North and South America, Old World banking practices were transferred to the New World. At first the colonists dealt primarily with established banks in the countries from which they had come. As the 19th century began, however, state governments in the United States began chartering banking companies. Many of these were simply extensions of other commercial enterprises in which banking serv­ices were largely secondary to, for example, sales of food, housing utensils, and farm equipment. The development of large, professionally managed banking firms was centered in a few leading commercial centers, especially in New York. The federal government became a major force in US banking during the Civil War. The Office of the Comptroller of the Currency (OCC) was established in 1864, created by Congress to charter national banks. This divided bank regulatory system, with both the federal government and the states playing key roles in the control and supervision of banking activity, has persisted to the present day and is a truly unique American invention.

 

1. What is the etymology of the word ‘bank”?

2. When and where did the first bank appear?

3. Can you say what idea became an important source of bank funding?

4. What can you say about the banking industry in the Middle Ages? In the time of the Renaissance?

5. Speak on the development of the banking system in the USA.

 

Reading & Speaking

T E X T 2

Read the text. Define the questions discussed in the text. In each paragraph, find the sentences supporting the main idea of the text. What paragraph contains the most important information?

THE ROLE OF BANKS IN THEORY

Banks are financial intermediaries, similar to credit unions, savings and loan associations, and other institutions selling financial serv­ices. The term financial intermediary simply means a business that interacts with two types of individuals or institutions in the economy: (1) deficit-spending individuals or institutions whose current expenditures for consumption and investment exceed their current receipts of income and who, therefore, need to raise funds externally by negotiating loans with and issuing se­curities to other units; and (2) surplus-spending individuals or institutions, whose current receipts of income exceed their current expenditures on goods and services so they have surplus funds to save and invest. Banks perform the indispensable task of intermediating between these two groups, offering convenient financial services to surplus-spending indi­viduals and institutions in order to raise funds and then loaning those funds to deficit-spending individuals and institutions.

There is an ongoing debate in the theory of finance and economics about why banks exist. What essential services do banks provide that other busi­nesses and individuals couldn't provide for themselves?

This may at first appear to be an easy question, but it has proven to be extremely difficult to answer. Why? Because research evidence has accu­mulated over many years showing that our financial system and financial markets are extremely efficient. Funds and information flow readily to both lenders and borrowers, and the prices of loans and securities seem to be determined in highly competitive markets. In a perfectly efficient financial system, in which pertinent information is readily available to all at negligible cost, in which the cost of carrying out financial transactions is negligible, and all loans and securities are available in denominations anyone can afford, why are banks needed at all?

Most current theories explain the existence of banks by pointing to im­perfections in our financial system. For example, all loans and securities are not perfectly divisible into small denominations that everyone can afford. To take one well-known example, U.S. Treasury bills—probably the most popular short-term marketable security in the world—have a minimum denomination of $10,000, which is clearly beyond the reach of most small savers. Banks provide a valuable service in dividing up such instruments into smaller securities, in the form of deposits, that are readily affordable for millions of people. In this instance a less-than-perfect financial system creates a role for banks in serving small savers and depositors.

Another contribution banks make is their willingness to accept risky loans from borrowers, while issuing low-risk securities to their depositors. In effect, banks engage in risky borrowing and lending activity across the financial markets by taking on risky financial claims from borrowers, while simultaneously issuing almost riskless claims to depositors.

Banks also satisfy the strong need of many customers for liquidity. Fi­nancial instruments are liquid if they can be sold quickly in a ready market with little risk of loss to the seller. Many households and businesses, for example, demand large precautionary balances of liquid funds to cover expected future cash needs and to meet emergencies. Banks satisfy this need by offering high liquidity in the deposits they sell.

Still another reason banks have grown and prospered is their superior ability to evaluate information. Pertinent data on financial investments is both limited and costly. Some borrowers and lenders know more than others, and some individuals and institutions possess inside information that al­lows them to choose exceptionally profitable investments while avoiding the poorest ones. Banks have the expertise and experience to evaluate financial instruments and choose those with the most desirable risk-return features.

Moreover, the ability of banks to gather and analyze financial information has given rise to another view of why banks exist in modern society—the delegated monitoring theory. Most borrowers and depositors prefer to keep their financial records confidential, shielded especially from competitors and neighbors. Banks are able to attract borrowing customers, this theory suggests, because they pledge confidentiality. Even a bank's own depos­itors are not privileged to review the financial reports of its borrowing customers. Instead, the depositors hire a bank as delegated monitor to analyze the financial condition of prospective borrowers and to monitor those customers who do receive loans in order to ensure that the depositors will recover their funds. In return for bank monitoring services, depositors pay a fee that is probably less than the cost they would have incurred if they monitored the borrowers themselves.

By making a large volume of loans, banks as delegated monitors can diversify and reduce their risk exposure, resulting in increased deposit safety. Moreover, when a borrowing customer has received the bank's stamp of approval, it is easier and less costly for that customer to raise funds elsewhere. In addition, when a bank uses some of its owners' money as well as deposits to fund a loan, this signals the financial marketplace that the borrower is trustworthy and has a reasonable chance to be suc­cessful and repay its loans.

1.What does the term ‘financial intermediary’ mean?

2.Explain the meaning of the following terms ‘deficit-spending individuals’ and ‘surplus-spending individuals’.

3.What task do banks perform?

4.Why do bank exist?

T E X T 3

Read the text. Divide it into logical parts. Defend your division. Give the title to the text.

Why are most banks so closely regulated? A number of reasons for this heavy burden of government supervision have been offered over the years, some of them centuries old. First, banks are among the leading repositories of the public's savings — especially the savings of individuals and families. Many savers lack the financial expertise and depth of information to correctly evaluate the riskiness of a bank. Therefore, regulatory agencies are charged with the responsibility of gathering all the information needed to assess the fi­nancial condition of banks in order to protect the public against loss. Cameras and guards patrol bank lobbies to reduce the risk of loss due to theft. Periodic bank examinations and audits are aimed at limiting losses from embezzlement, fraud, or mismanagement. Government agencies stand ready to loan funds to banks faced with unexpected short­falls of spendable reserves. While most of the public's savings are placed in relatively short-term highly liquid deposits with ready access, banks also hold large amounts of long-term savings for retirement in pension programs and Individual Retirement Accounts (IRAs). The loss of these funds due to bank failure or bank crime would be catastrophic in many cases. Regulation acts as a safeguard against such losses by providing deposit insurance and by periodically examining bank policies and practices in order to promote sound management of the public's funds, while minimizing the volume of claims made against the government's deposit insurance fund. On the other side of the coin, however, although safeguarding the public's savings may justify having a deposit insurance system (preferably, one in which banks creating greater risk for their depositors and for the deposit insurance fund pay higher insurance fee s), it is not sufficient by itself to justify the entire basket of modern banking regulations. Banks are also closely watched because of their power to create moneyin the form of readily spendable deposits by making loans and invest­ments (extending credit). Moreover, changes in the volume of money creation appear to be closely correlated with economic conditions, es­pecially the creation of jobs and the presence or absence of inflation. However, merely because banks create money which impacts the vitality of the economy, this is not necessarily a valid excuse for regulating banks. As long as central banks can control money supply growth through their policies and operating procedures, the volume of money individual banks create should be of no great concern to the regulatory authorities or to the public. Banks are also regulated because they provide individuals and insti­tutions with loans which support consumption and investment spend­ing. Regulatory authorities argue that the public has a keen interest in an adequate supply of loans flowing from the banking system. Moreover, discrimination in the granting of credit would represent a significant obstacle to personal well-being and an improved standard of living. This is especially important if access to credit is denied because of age, sex, race, national origin, residential neighborhood, or similar factors. Per­haps, however, discrimination in providing services to the public could be significantly reduced or eliminated simply by promoting more com­petition among banks and other providers of financial services, such as by vigorous enforcement of the antitrust laws, rather than through reg­ulation.

 

1.Why are regulatory agencies charged with the responsibility of gathering the information needed to assess the financial condition of banks?

2.What are periodic bank examinations and audits aimed at?

3.What is regulation aimed at?

4.What are other reasons of bank regulation?

1. Do the activities and responsibilities of central banks vary from country to country? Give your examples.

2. What is the BIS?

3. What does the BIS provide?

 

T E X T 4

INTERNATIONAL BANKING

Banks have been heavily involved in selling their services across national borders from the industry’s very beginning. The first banks were located principally in global trading centers around the Mediterranean Sea, including Athens, Cairo, Jerusalem, and Rome, aiding merchants in financing shipments of raw materials and goods for sale and exchanging one nation’s currency and coin for that of another to assist travelers as well as local merchants.

Nowadays international bankers face unprecedented challenges in both raising and allocating funds. E. Gerald Corrigan, president of the Federal Reserve Bank of New York, perhaps has best captured the essence of today's global bank management problems: “Financial markets and institutions are caught up in an unprecedented wave of change and innovation which makes it very difficult to distinguish ends from means, causes from effects, and actions from reactions”.

As the bankers themselves admit, inter­national bank fund-raising increasingly is being affected by three forces:

1. Financial markets are broadening rapidly into worldwide institu­tions, and many of these markets (such as the markets for Eurocurrency deposits, commercial paper, foreign exchange, and government secu­rities) are becoming 24-hour markets linking Europe, North America, the Far East, and the Middle East in a chain of continuous trading. Not far behind are the stock and futures markets, with overseas exchanges ex­panding to accommodate multiple listings of companies and financial instruments (as evidenced, for example, by the recent expansion of the Tokyo Stock Exchange and LIFFE and SIMEX in London and Singapore). Moreover, the developing nations, confronted with huge capital needs and the decline of these traditional funding sources, are seeking to tap the surplus liquidity of industrialized countries and recycle global savings.

2. Old kinds of debt and borrowing methods are being transformed into new kinds of financial instruments and new fund-raising techniques. Among the most notable developments here are securitized loans, cur­rency options and dual-currency bonds, and global mutual funds. In re­cent years, international banks have found it increasingly difficult to bring in low-cost deposits and must reach farther a field for funds, encouraging financial innovation but also bringing international banks into compet­itive conflict over sources of funds with thousands of other financial institutions. At the same time, scores of desirable loan customers have found innovative ways to raise their own funds (such as through direct sales of short-term notes to investors) without the banker's help.

3. The barriers between securities dealers and international banks are falling in many countries, aided by London's "Big Bang" and deregu­lation in leading countries. This erosion of traditional roles is making it harder for the public to see real differences between financial institutions. While banks were the first to internationalize their operations, securities dealers have followed in the 1970s and 1980s, capturing many former customers that traded almost exclusively with international banks.

Many international banks and other financial firms see their future success closely linked to their ability to establish a firm beachhead in all major global markets and to offer a complete line of financial services, centered around securities trading and underwriting, investment plan­ning and saving, credit insurance, and risk management. This is partic­ularly important in fund-raising by international banks because of the necessity in today's intensely competitive environment for each bank to find the cheapest funds sources, whenever they may be found, around the globe.

1. Where were the first banks located?

2. What forces is international bank fund-raising being affected by?

3. What do many international banks see their future success in?

 

T E X T 5