The History Of Banking Essay, Research Paper

A common definition of a bank is a financial intermediary that accepts, transfers, and, most important, creates deposits. This includes such depository institutions as central banks, commercial banks, savings and loan associations, and mutual savings banks.

Banks are most frequently organized in corporate form and are owned either by private individuals, governments, or a combination of private and government interests. Although noncorporate banks-that is, single proprietorships and partnerships-are found in other countries, since 1863 all federally chartered banks in the United States must be corporations. Only a few states permit formation of noncorporate banks. All countries subject their banks, however owned, to government regulation and supervision, normally implemented by central banking authorities.

Early Banking

Many banking functions such as safeguarding funds, lending, guaranteeing loans, and exchanging money can be traced to the early days of recorded history. In medieval times, the Knights Templars, a military and religious order, not only stored valuables and granted loans but also arranged for the transfer of funds from one country to another. The great banking families of the Renaissance, such as the Medicis in Florence (Italy), were involved in lending money and financing international trade. The first modern banks were established in the 17th century, notably the Riksbank in Sweden (1656) and the Bank of England (1694).

Seventeenth-century English goldsmiths provided the model for contemporary banking. Gold stored with these artisans for safekeeping was expected to be returned to the owners on demand. The goldsmiths soon discovered that the amount of gold actually removed by owners was only a fraction of the total stored. Thus, they could temporarily lend out some of this gold to others, obtaining a promissory note for principal and interest. In time, paper certificates redeemable in gold coin were circulated instead of gold. Consequently, the total value of these banknotes in circulation exceeded the value of the gold that was exchangeable for the notes.

Two characteristics of this fractional-reserve banking remain the basis for present-day operations. First, the banking system’s monetary liabilities exceed its reserves. This feature was responsible in part for Western industrialization, and it still remains important for economic expansion. The excessive creation of money, however, may lead to inflation. Second, liabilities of the banks (deposits and borrowed money) are more liquid-that is, more readily convertible to cash-than are the assets (loans and investments) included on the banks’ balance sheets. This characteristic enables consumers, businesses, and governments to finance activities that otherwise would be deferred or cancelled; however, it underlies banking’s recurrent liquidity crises. When too many depositors request payment, the banking system is unable to respond because it lacks sufficient liquidity. The lack of liquidity means that banks must either abandon their promises to pay depositors or pay depositors until the bank runs out of money and fails. The advent of deposit insurance in the United States in 1935 did much to alleviate the fear of deposit losses due to bank failure and has been primarily responsible for the virtual absence of runs on U.S. banks.

Commercial Banking in the U.S.

Commercial banks are the most significant of the financial intermediaries, accounting for some 60 percent of the nation’s deposits and loans. The first bank to be chartered by the new federal government was the Bank of the United States, established in Philadelphia in 1791. By 1805 it had eight branches and served as the government’s banker as well as the recipient of private and business deposits. The bank was authorized to issue as legal tender banknotes exchangeable for gold. Although the bank succeeded in establishing a sound national currency, its charter was not renewed in 1811 for political and economic reasons. The history of the second Bank of the United States (1816-36) repeated that of its predecessor. It served ably as the government’s banker, achieved a sound national currency, and failed for political reasons when President Andrew Jackson vetoed charter renewal.

In the next three decades the number of banks grew rapidly in response to the flourishing economy and to the system of “free banking”-that is, the granting of a bank charter to any group that fulfilled stated statutory conditions. Government fiscal operations were handled initially by private bankers and later (after 1846) by the Independent Treasury System, a network of government collecting and disbursing offices. The Independent Treasury, however, could not cope with the financial demands of the American Civil War. Moreover, the multiplicity of state banks, each issuing its own banknotes, had resulted in a highly inefficient currency mechanism. The National Bank Act (1864) established the office of the comptroller of the currency to charter national banks that could issue national banknotes (this authority was not revoked until 1932). A uniform currency was achieved only after a tax on nonnational banknotes (1865) made their issuance unprofitable for the state-chartered banks. State banks survived by expanding their deposit-transfer function, continuing to this day a unique dual banking system, whereby a bank may obtain either a national or a state charter.

The stability hoped for by the framers of the National Bank Act was not achieved; banking crises occurred in 1873, 1883, 1893, and 1907, with bank runs and systemic bank failures. The Federal Reserve Act (1913) created a centralized reserve system that would act as a lender of last resort to forestall bank crises and would permit a more elastic currency to meet the needs of the economy. Reserve authorities, however, could not prevent massive bank failures during the 1920s and early 1930s. See Federal Reserve System.

The Banking Acts of 1933 and 1935 introduced major reforms into the system and its regulatory mechanism. Deposit banking was separated from investment banking; the monetary controls of the Federal Reserve were expanded, and its powers were centralized in its Board of Governors; and the Federal Deposit Insurance Corporation (the FDIC, which now insures each depositor up to $100,000 per bank) was created. The banking system has continued to thrive, secure from widespread panics, and has expanded its services by developing alternative sources of funding and reaching out to new borrowers.

Commercial Banking Today

Loans account for over half of the total bank assets in the U.S. commercial banking system. Interest from these loans is a major source of bank income. Short-term loans to the most creditworthy borrowers usually are priced at the prime (interest) rate. Early in this century, such short-term financing to commercial enterprises was virtually the only type of loan commercial bankers would undertake. Today, bankers lend to businesses, consumers, and governments (both domestic and foreign), with maturities ranging from one day to several decades. In the late 1980s about 90 percent of the banking system’s loans financed commercial and industrial enterprises, real-estate transactions, and consumer loans. The remaining loans were allocated to other financial intermediaries, to security dealers and brokers, and to foreign governments and official institutions. As a rule, the longer the maturity or the less creditworthy the borrower, the greater is the interest rate.

The second largest category of bank assets is investments, held by banks for both liquidity and income purposes. These investments include U.S. government and government guaranteed securities, the bonds of states and municipalities, and private securities. Banks also hold cash assets, mostly for liquidity purposes, but also because the banking authorities mandate that a certain fraction of deposits be held in cash-asset form.

Of the banking system’s liabilities, about three-fourths are in the form of deposits, primarily from individuals and companies, but also from domestic and foreign government agencies. Since 1960, deposit composition has undergone a major shift, from a heavy concentration in demand deposits; by 1987, time and savings deposits exceeded demand deposits by more than a 3:1 ratio. Rising interest rates combined with changing banking practices go far to explain this reversal. Interest rates on assets comparable to time deposits in 1960 averaged 3.5 percent; in 1987 they averaged 7 percent. Bankers supplemented asset-management practices with management of liabilities; today, bankers are willing to acquire liabilities if the funds can be profitably lent out. Thus, beginning in the 1960s, new financial instruments such as large-denomination certificates of deposit were made available to depositors. As banks actively sought deposits in the United States and in Europe, the Eurodollar market was created, a market that was estimated to approach $1 trillion in the early 1980s. Nondeposit liabilities such as borrowings on the federal funds market, involving deposits with the Federal Reserve, were also pursued.

The largest banks account for the bulk of banking activity. In the late 1980s fewer than 5 percent of the commercial banks in the United States were responsible for more than 40 percent of all deposits, and 85 percent of the banks held less than one-fifth of total deposits. Competition for corporate and individual deposits is keen among the banking giants, whose growth is limited by the Bank Merger Act (1960) as well as by antitrust laws. The U.S. banking system differs radically in this respect from such countries as Canada, Great Britain, and Germany, where a handful of organizations dominate banking. In the past geographical constraints on expansion prevented banks from moving beyond their state or even beyond their county. Thus many small bankers were protected from competition. More recently most states as well as the federal government have loosened the regulation of banks, especially in the area of mergers and acquisitions. Many banks have grown by taking over other banks both within and outside their home states. In 1980 there were over 14,000 commercial banks in the United States; in the mid-1990s there were less than 11,000. Computer links among banks and the use of automated teller machines have broken down the geographical barriers to the growth of nationwide banking.

Overall government controls on banking were significantly loosened by the Depository Institutions Deregulation and Monetary Control Act (1980). Among its provisions are abolition of state usury limits on certain types of loans, gradual elimination of interest-rate ceilings on savings and time deposits, and extension of permission of all depository institutions to offer interest-paying checking accounts. The Garn-St. Germain Financial Institutions Act (1982), among its many other important provisions, permits interstate acquisition of failing banks.

While government regulation of commercial banking since the mid-1930s has led to a low failure rate and preserved a substantial amount of competition in some markets, local monopolies have also been implicitly encouraged. Moreover, stringent regulations have caused some bankers to devote considerable resources to circumventing government controls. The present rethinking of the role of government regulation in the economy in general may lead toward even further liberalization of controls over the banking system.

Thrift Institutions

Savings and loan associations (SLAs) and savings banks are similar but separate financial institutions. Both were patterned after cooperative movements in Scotland and England and, although they share the same roots, their different but related goals caused them to develop in different ways.

Historically, commercial banks ignored the nonbusiness sectors of the economy. This led to the evolution of a variety of thrift institutions designed specifically to serve the neglected consumer market. SLAs, which first appeared in the 1830s, were originally founded as “building societies” to provide their members with funds to buy or build a home. Today SLAs continue to concentrate on funding homes.

SLAs accept deposits from the public and use these funds to make various types of investments, mostly in residential real estate mortgages, and particularly in home mortgage loans. SLAs are the largest holders of mortgage debt in the U.S. The bulk of their liabilities are in the form of savings deposits. In the late 1980s the failures of many SLAs caused the government to overhaul the industry. SLAs are regulated by the Office of Thrift Supervision, an agency of the Treasury Department. Deposits in member institutions up to $100,000 are insured by the FDIC through its Savings Association Insurance Fund.

Savings banks were established to encourage thrift among working people and to provide a safe place for them to save. They pooled depositors’ savings for investment and generally were restricted by charter to investing in government bonds. Their holdings in mortgage lending have grown from their early years, and by 1987, some 55 percent of their funds were invested in mortgage loans. A large part of their portfolios is held in stocks and bonds.

Mutual savings banks (MSBs) are found primarily on the eastern seaboard. Deposits in most MSBs are insured by the FDIC, including some MSBs that have converted to federal charters. The 1982 Garn-St. Germain Depository Institutions Act blurred many of the distinctions between SLAs and MSBs, permitting savings banks to convert to federal charters, and creating a new type of

banking system.