Banks and Banking
The principal types
of banking in
the modern industrial world are commercial banking and
A commercial banker
is a dealer in money and in substitutes for money, such as checks or
The banks of the
banking business is borrowing from individuals (firms and occasionally
governments)- receiving “deposits” from them. With these resources and
with the bank’s own capital, the banker makes loans or extends credit
invests in securities. The banker makes profit by borrowing at an rate
interest and lending at a higher rate and by charging commissions for
A bank must always
have cash balances on hand in order to pay its depositors upon demand
the amounts credited to them become due. It must also keep a proportion
assets in form that can readily be converted
into cash. Only in this way can confidence in the banking system
maintained. Provided it honours its
promises, a bank can create credit for use by its customers by issuing
additional notes or by making new loans which in their turn become new
deposits. The amount of credit may considerably exceed the sums
available to it
in cash, but the bank is able to do this, only as long as the public
the bank can and will honour its obligations. The claims against the
be transferred by means of checks or other negotiable instruments from
party to another.
These are the
essentials of deposit banking as practiced throughout the world today,
partial exception of socialist-type institutions.
Another type of
banking is carried out by central banks, bankers to governments and
last resort” to commercial banks and other financial institutions. They
often responsible for formulating and implementing monetary and credit
policies, usually in cooperation with the government.
In some cases, the
US Federal Reserve System have been established specifically to lead or
regulate the banking system; the Bank of England have come to perform
functions through a process of evolution.
savings banks, investments banks, trust companies are often called
they don’t perform the banking functions described and are only
intermediaries, cannot create money, they can lend no more than savers
development of banking system
Banking is known
about it prior to the 13th century.
Early “banks” dealt
primarily in coin and bullion, their business being money changing and
supplying of foreign and domestic coin. Another group of banking
was the merchant bankers, who dealt in goods and in bills of exchange,
providing for the remittance of money at distance through one of its
Another form of early
banking activity was the acceptance of deposits based on oral agreement
the parties whereby the customer would be allowed to overdraw his
In the 17th
century, English bankers begun to develop a deposit banking business.
dealt in bullion and foreign exchange, acquiring and sorting coin for
As a means of attracting coin for sorting, they were prepared to pay a
About the same
time, a practice grew up, whereby a customer could arrange for the
part of his credit balance to another party by addressing an order to
banker. This was the origin of modern check. It was only a short step
making a loan in specie or coin, to allowing customers to borrow by
customer could overdraw his account at once or up to a specified limit.
first case, interest was charged on the full amount of the debit, and
second, the customer paid interest only on the amount actually borrowed.
Another way in
which a bank could create claims against itself was by issuing bank
amount depended on the banker’s judgement of the possible demand for
The first bank notes issued in Europe
the Bank of Stockholm in 1661. Nowadays, in most countries the issue of
bank-notes has become a prerogative of the Central Bank.
When the check
proved to be a convenient mean of payment and the public begun to use
the larger part of their monetary transactions, banks begun to grant
drawing of checks much in excess of the amount of cash hold, in this
“creating money”, claims that were generally accepted as means of
money come to be known as “bank money” or “credit”. When a check is
loan is created but usually every loan so made tends to return to the
system as a deposit, and so deposits tend to increase for the system as
to about the same extent as loans.
The check was
defined as a bill of exchange and the early legal recognition of the
negotiability of credit instruments. Bill of exchange was one of the
important factors in the development of banking in England.
the other hand, in continental Europe,
limitations on the negotiability of an order of payment presented the
of deposit banking based on check. Continental countries developed
system, known as giro payments, whereby transfers were effected on the
written instructions to debit the account of the payer and to credit
II The business of banking
business of banking consists of borrowing and lending. As in other
operations must be based on capital, but banks employ comparatively
their own capital in relation to the total volume of their
purpose of capital and reserve accounts is primarily to provide an
cover against losses on loans and instruments. In the United States,
capital accounts also have a legal significance, since the laws limit
proportion of its capital, a bank may lend to a single borrower.
arrangements exit elsewhere.
A bank’s main
liabilities are its capital, including reserves and subordinated debt,
deposits. The latter may be from domestic or foreign sources
firms, private individuals, other banks and even governments). They may be repayable on demand(sight deposits or
current accounts) or repayable only after the lapse of a period of time
term or fixed deposits and saving deposits).
A bank’s assets
Cash in the form of credit balances with other banks,
usually with a central bank
Liquid assets- money at call and short notice,
day-to-day money, short term government paper, commercial bill of
can be converted readily into cash without risk of substantial lost
Instruments of securities- medium term and longer term
government securities including those of local authorities and in some
countries shares in industrial concerns
Loans and advances made to customers of all kinds
The bank’s premises, furniture and fitings
All bank balance
sheets must include an item that relates to contingent liabilities
balanced by an item to the other side of the balance sheet representing
customer’s obligations to indemnity the bank.
The bulk of the
resources employed by a modern bank consists of borrowed money (that
deposits) which is lent out as profitably as is consistent with safety.
Insofar, as an increase in deposits provides a bank with additional
increase in cash supplements its loanable
resources and permits a more than proportionate increase in its
An increase in
deposits may arise in two ways:
When a bank makes a loan, it may transfer the sum to a
current account, thus directly creating a new deposit; or it may
arrange a line
of credit for the borrower upon which he will be permitted to draw
were deposited by third parties, likewise create new deposits
An enlargement of government expenditure financed by
the Central Bank may occasion a growth in deposits, since claims on the
government will be paid into the commercial banks as deposits
one bank in isolation, an increase in
its loans may result in a direct increase in deposits, that is an
the potential liability to pay out cash. It is in this way that an
deposits usually provides the basis for further bank lending.
From time to time,
any individual bank may experience market fluctuations in its deposit
and all the banks in a country may be subject to seasonal variations.
confidence on the part of the depositors is the true basis of
Confidence is steadier if there exists a central bank to act as a
last resort”. Another means of maintaining confidence employed in some
countries is deposit insurance, which protects the small depositor
in the event of a bank failure.
Since the banker
undertakes to provide depositors with cash on demand or upon prior
is necessary to hold a cash reserve and to maintain a “safe” ratio of
deposits. The safe ratio is determined largely through experience. It
established by convention or by statute. If a minimum cash ratio is
law, a proportion of a bank’s assets is in effect frozen and not
meet sudden demands for cash from the banks’ customers. No banker can
ignore this. Unless a bank held cash covering 100% of its demand
could not meet the claims of depositors if they were all to exercise in
and at the same time their rights to demand cash. If that were a common
phenomenon, deposit banking could not longer survive.
A bank may mobilize
its assets in several ways. It may demand repayment of loans,
immediately or at
short notice; it may sell securities or it may borrow from the Central
usong paper representing investments or loans as security.
But banks must
either maintain their cash reserves and other liquid assets at a higher
or have access to a “lender of last resort” such as a central bank,
willing to provide cash against the security of eligible assets because
in loans or selling marketable assets would disrupt the delicate
Long term and medium term
Banks that do a
great deal of long-term lending to industry must ensure their liquidity
maintaining relatively large capital funds and a relatively high
Such banks have
developed special means of reducing their degree of risk. Every
preceded by a thorough technical and financial investigation. The
advance may be an interim credit, later converted into a participation.
A bank may be
obliged to hold such shares for long periods before being able to
them. They often retain an interest in a term as an ordinary investment
as to ensure a degree of continuing control over it.
position of industrial finance in Britain and the
countries is usually handled by specialist institutions, with the
banks providing only part of the necessary capital. In Japan
long-term financial needs of industry are met partly by special
banks and partly by the ordinary commercial banks. In Germany
commercial banks customarily handle long-term finance.
Since World War II
the commercial banks in United States have
developed the term loan,
especially for financing industrial capital requirements, and it was
popularized in the economic depression of the 1930.
Most term loans
have an effective maturity of 5 years, though sum runs for 10 years.
They are the core
of the banking business. It consists in the provision of working
the banks also provide temporary finance for fixed capital development,
a customer until long-term finance can be found elsewhere.
Much of this
short-term lending is done by overdraft. This one permits a depositor
overdraw an account up to an agreed limit. Often, overdrafts are
allowed to run
indefinitely subject to a periodic review. An advance is reduced or
repaid whenever the account is credited
deposits and recreated when new checks
are drawn upon it, interest being paid only on the amount outstanding.
method of short-term method of lending is to debit a loan account with
amount borrowed, crediting the proceeds to a current count; interest is
payable on the whole amount of the loan, which normally is for a fixed
In a number of
countries, including United States,
the United Kingdom,
short-term finance is often made available on the basis of discountable
commercial bills or promissory notes. Some of these papers are usually
rediscountable at the Central Bank, thus becoming virtually a liquid
unlike a bank advance or loan.
Credit may be offered
with or without formal security depending on the reputation and
strength of the borrower. In many countries, a customer may use a
banks, and these institutions usually freely exchange information about
credit risks. In Britain
however most concern tend to use a single banking institution for most
THE PRINCIPLES OF
The principles of
central banking grew up in response to the recurrent British financial
of the 19th century and were later adopted in other
The expansion or
contraction of the money supply to which banks contribute may be
this raising the need for a desinterested outside authority able to
economic and financial developments objectively and to exert some
control over the activities of the banks.
first concern of a central bank is the maintenance of a strongly based
commercial banking structure. It must also cooperate closely with the
source of economic instability is the supply of money. If banks expand
to such an extent that inflationary pressures develops, a period of
caution in the making of loans follows inevitably and sometimes even
crisis and bank failures. Such crises threaten the existence of
the willingness of a central bank to offer support to the commercial
other financial institutions in time of crises was greatly encouraged
gradual disappear and of weaker institutions and a general improvement
also become more experienced in the evaluation of risks and in some
central bank educates commercial banks in the canons of sound finance.
example, in the United
States, the Federal Reserve System
the books of the commercial banks and carries on a range of frankly
most obvious danger to the banks is a sudden and overwhelming run of
resources in convergence of their liability to depositors to pay on
the ordinary course of business, the demand for cash is fairly constant
subject to seasonal fluctuations that can be foreseen.
central bank protects banks from the consequences of a sudden demand
For doing this, the central bank is permitted to buy the assets of
banks or to make advances against them. It has also the power to issue
acceptable to bank depositors.
a central bank plays this role with respect to commercial banks, it is
to exercise a degree of control over the way in which the banks conduct
most central banks now take a continuing day-to-day part in the
the banking system.
evolution of those working relations among banks implies a community of
that in some countries is relatively recent. The concept of a central
responsible for the stability of the banking system supposes mutual
and cooperation. That’s why contact between the central bank and the
banks must be close and continuous.
a central bank formulated its policy, the commercial banks must accept
leadership, otherwise the whole basis of central banking would be
central bank and the national
the number of modern economies is self contained, central banks must
considerable attention to trading and financial relationships with
countries, so there is a permanent demand for foreign and home currency.
there is a surplus of purchases and sometimes a surplus of sales.
disequilibrium don’t matter, but it is rather important that there be a
tendency to balance over a longer period since a country can be a
or to continue building up a command over goods and services that it
period disequilibrium can be met very simply by diminishing or building
balances of foreign exchange. If a country has no balances to diminish,
borrow but normally, at least carries working balances. If the
find unprofitable to hold such balances, the Central Bank is available
equilibrium is more difficult to achieve. It may be approached in 3
ways: price movements, exchange revaluation or exchange controls. For
imports, the monetary authorities can induce a relative rise in home
encouraging an expansion of credit. If additional exports are necessary
authorities can attempt to force down cost at home by operating to
objective may be achieved more directly by revaluing a country’s
If the rate is appreciated, exports become more expensive for
foreigners to buy
and if the rate is depreciated the prices of export goods in the
markets are lower. In both cases, the effect is likely to be temporary,
authorities often prefer relative stability in exchange rates.
often, governments have resorted to exchange controls to allocate
exchange more or less directly in payment for specific imports. The
proved reasonably efficient in achieving balance on external payments
Its chief disadvantage is that it interferes with normal market
thereby encouraging rigidities in the economy, reinforcing vested
restricting the growth of world trade.
method is chosen, the Central Bank or a institution closely associated
supervise the process to ensure that proper responses are made to
monetary influences is an important contributory factor in economic
fluctuations the Central Bank has the responsibility to regulate the
lending by banks and it may even influence in some degree the direction
lending as well as the amount.
greater responsibility of the Central Bank is that of taking measures
prevent or overcome a slump.
the Central Bank to be effective in regulating the volume and
credit so that economic fluctuation may be damped, if not eliminated,
at least be able to regulate commercial bank liquidities.
and a growing number of Western European countries have adopted the
setting growth targets for the money supply and sometimes other
targets as well, usually setting some range of allowable variation.
is incorrect to suppose, however, that the actions of the Central Bank
achieve a high degree of stability; this degree depends on the
provision of an
appropriate fiscal environment.
responsibility of the Central Bank is to ensure that banking services
adequately supplied to all members of the community that need them.
of a country may be “under-banked” and central banks have attempted,
or indirectly, to meet such needs.
different sort of problem arises when the business methods of existing
are in satisfactory. In such circumstances, a system of bank inspection
audit organized by the central banking authorities or of bank
may be the appropriate answer (France’s
developing countries, central banks may encourage the establishment and
of specialist institutions such as savings institutions and
or industrial finance corporations. These serve to improve the
tapping existing liquid resources and to supplement the flow of funds
investment in specific fields.
STRUCTURE OF MODERN BANKING SYSTEMS
banking systems of the world have many similarities, but they also
sometimes in quite material respects. The principal differences are in
details of organization and technique. The differences are gradually
less pronounced because of the tendency in each country to emulate
that have been successful elsewhere.