Banking, transactions carried on by any individual or firm engaged in providing financial services to consumers, businesses, or government enterprises. In the broadest sense, a bank is a financial intermediary that performs one or more of the following functions: safeguards and transfers funds, lends or facilitates lending, guarantees creditworthiness, and exchanges money. These services are provided by such institutions as commercial banks, central banks, savings banks, trust companies, finance companies, life insurers, and investment bankers.
A narrower and more 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 savings bank by allowing traditional SLAs to convert to savings banks. These new savings banks are federally chartered and are insured by the FDIC. Today SLAs, MSBs, and savings banks are all referred to generally as savings institutions.
The Garn-St. Germain Act expanded lending powers for savings institutions in the areas of consumer, commercial, and agricultural lending. These new authorities have allowed savings institutions to become full-service consumer financial centers. Savings institutions now offer a range of consumer loans, including automobile loans, home equity and home improvement loans, educational loans, trust services, and credit card purchases. Limited authority to make business loans was also part of the 1982 bill. Savings institutions also offer depositors checking accounts in the form of NOW accounts and Super NOW accounts, as well as a wide range of savings instruments, including insured money market accounts. As mandated by the Depository Institutions Deregulation and Monetary Control Act, all savings account interest rate ceilings and minimum balance requirements at savings institutions—and at commercial banks—were removed as of March 31, 1986.
On the lending side, the development of the adjustable rate mortgage (ARM), helps savings institutions match their incomes with their expenses. ARMs also function to keep housing affordable by offering borrowers lower initial interest rates on mortgage loans. An ARM loan permits adjustments in the interest rate or payment at specific intervals, based on the movement of an independent index reflecting economic conditions. Even with their expanded powers, the primary focus of savings institutions remains real estate lending, particularly home mortgages. See also Credit Union.
European Banking
Significant structural differences distinguish the U.S. banking system from that of developed nations. The main differences are in ownership, scope and concentration of activities, and the giro system of banking.
Virtually all banking institutions in the U.S., as well as Canada and Great Britain, are privately owned. In France and Italy, however, the government either owns the major commercial banks or the majority of their stock.
European banks engage in some activities prohibited to banks in the U.S., such as the placement and acquisition of common stock. Commercial banks in Europe tend to be more business oriented and limit their lending to shorter-term loans. Long-term loans are handled by bank affiliates. The share of the deposits and loans handled by the major European banks tends to be considerably larger than that handled by their U.S. counterparts. This stems from the absence of restrictions on branching, leading the large European banks to maintain extensive networks of branches in their home countries. The absence of an antitrust tradition also accounts for the greater degree of concentration.
A common system of arranging consumer payments in Europe is the use of giro accounts. In a giro transaction, the payer will order the giro bank to pay specific sums to a number of payees. The payer's account is debited, and the payees' accounts are credited.
Banking in Great Britain
Since the 17th century Great Britain has been known for its prominence in banking. London still remains a major financial center, and virtually all the world's leading commercial banks are represented there.
Aside from the Bank of England, which was incorporated, early English banks were privately owned rather than stock-issuing firms. Bank failures were common; so in the early 19th century, joint-stock banks, with a larger capital base, were encouraged as a means of stabilizing the industry. By 1833 these corporate banks were permitted to accept and transfer deposits in London, although they were prohibited from issuing banknotes, a monopoly prerogative of the Bank of England. Corporate banking flourished after legislation in 1858 approved limited liability for joint-stock companies. The banking system, however, failed to preserve the large number of institutions typical of U.S. banking. At the turn of this century, a wave of bank mergers reduced both the number of private and joint-stock banks.
The present structure of British commercial banking was substantially in place by the 1930s, with the Bank of England, then privately owned, at the apex, and 11 London clearing banks ranked below. Two changes have occurred since then: The Bank of England was nationalized in 1946 by the postwar Labour government; and in 1968 a merger among the largest five clearing banks left the industry in the hands of four (Barclays, Lloyds, Midland, and National Westminster).
The larger clearing banks, with their national branch networks, dominate British banking. They are the key links in the transfer of business payments through the checking system, as well as the primary source of short-term business finance. Moreover, through their ownership and control over subsidiaries, the big British banks influence other financial markets dealing with consumer and housing finance, merchant banking, factoring, and leasing. The dominance of the clearing banks was challenged in recent years by the rise of "parallel markets," encompassing financial activities by smaller banking houses, building societies (similar to SLAs in the United States), and other financial concerns, as well as local government authorities. The major banks responded to this competition by offering new services and competitive terms.
A restructuring in the banking industry took place in the late 1970s. The Banking Act of 1979 formalized Bank of England control over the British banking system, previously supervised on an informal basis. Only institutions approved by the Bank of England as "recognized banks" or "licensed deposit-taking institutions" are permitted to accept deposits from the public. The act also extended Bank of England control over the new financial intermediaries that have flourished since 1960.
London has become the center of the Eurodollar market; participants include financial institutions from all over the world. This market, which began in the late 1950s and grew in some 25 years to an estimated volume of $1 trillion, borrows and lends dollars and other currencies outside the currency's home country (for example, franc accounts held in any country other than France).
Banking in Developing Countries
The type of national economic system that characterizes developing countries plays a crucial role in determining the nature of the banking system. In capitalist countries a system of private enterprise in banking prevails. In a number of socialist countries (for example, Egypt and Sudan) all banks have been nationalized. Other countries have patterned themselves after the liberal socialism of Europe; in Peru and Kenya, for instance, government-owned and privately owned banks coexist. In many countries, the banking system developed under colonialism, with banks owned by institutions in the parent country. In some, such as Zambia and Cameroon, this heritage continued, although modified, after decolonization. In other nations, such as Nigeria and Saudi Arabia, the rise of nationalism led to mandates for majority ownership by the indigenous population.
Banks in developing countries are similar to their counterparts in developed nations. Commercial banks accept and transfer deposits and are active lenders, especially for short-term purposes. Other financial intermediaries, particularly government-owned development banks, arrange long-term loans. Banks are often used to finance government expenditures. The banking system may also play a major role in financing exports.
In the poorer countries, an extensive but primitive nonmonetary sector usually continues to exist. It is the special task of the banking community to encourage the use of money and instill banking habits among the population.
Role of Central Banking
The foremost monetary institution in a market economy is the central bank. These are usually government-owned institutions, but even in countries where they are owned by the nation's banks (such as the United States and Italy), the responsibility of the central bank is to the national interest.
Most central banks perform the following functions: They serve as the government's banker, act as the banker of the banking system, regulate the monetary system for both domestic and international policy goals, and issue the nation's currency. As banker to the government, the central bank collects and disburses government income and receipts, manages the issue and redemption of government debt, advises the government on all matters pertaining to financial activities, and makes loans to the government. As banker to the nation's banks, the central bank holds and transfers banks' deposits, supervises their operations, acts as a lender of last resort, and provides technical and advisory services. Monetary policy for both domestic and foreign purposes is implemented and, in many countries, decided by the national banking authorities, using a variety of direct and indirect controls over the financial institutions. Coins and notes that circulate as the national currency are usually the liability of the central bank.
The ability of the central bank to control the money supply and thus the pace of economic growth is responsible for a major economic-policy debate. Some economists believe that monetary control is extremely effective in the short run and can be used to influence economic activity. Nevertheless, some hold that discretionary monetary policy should not be used because, in the long run, central banks have been unable to control the economy effectively. Another group of economists believes that the short-run impact of monetary control is less powerful, but that the central banking authorities can play a useful role in mitigating the excesses of inflation and depression. A newer school of economists claims that monetary policy cannot affect systematically the pace of national economic activity. All agree that problems related to the supply side of the economy, such as fuel shortages, cannot be resolved by central-bank action.
International Banking
The expansion of trade in recent decades has been paralleled by the growth of multinational banking. Banks have historically financed international trade, but the notable recent development has been the expansion of branches and subsidiaries that are physically located abroad, as well as the increased volume of loans to foreign borrowers. In 1960 only 8 U.S. banks had foreign offices. By 1987, about 150 U.S. banks had about 900 foreign branches.
Similarly, the number of foreign banks with offices in the United States increased almost three-fold during the 1970s and 1980s. Most of these banks are business-oriented banks, but some have also engaged in retail banking. In 1978 the U.S. Congress passed the International Banking Act, which imposed constraints on the activities of foreign banks in the United States, removing some of the advantages they had acquired in relation to U.S. banks. Foreign banks have also penetrated the American market by acquiring ownership of existing banks.
The growth of the Eurodollar market has forced major U.S. banks to operate branches not only in Europe but also in Asia. The world's banking system played a key role in the recycling of petrodollars, arising from the surpluses of the oil-exporting countries and the deficits of the oil-importing nations. This activity, while it smoothed international financial arrangements, is currently proving worrisome as foreign debtors find it more difficult to repay outstanding loans.
See also Finance; Investment Banking; Savings Institutions.
Contributed by:
Jonas Prager