A short history of banking

The earliest-known money-lending activities have been identified in historical civilizations and societies including Assyria, Babylon, ancient Greece, and the Roman Empire. Modern-day banking can be traced back to medieval and early Renaissance Italy, where privately-owned merchant banks were established to finance trade and channel private savings into government borrowing or other forms of public use. Private banks were typically constituted as partnerships, owned and managed by a family or some other group of individuals, and operating without the explicit sanction of government. Amsterdam became a leading financial and banking centre at the height of the Dutch Republic during the 17th century; succeeded by London during the 18th century, partly as a consequence of the growth in demand for banking services fuelled by the Industrial Revolution and the expansion of the British Empire. The first shareholder-owned bank in England was the Bank of England, founded in 1694 primarily to act as a vehicle for government borrowing to finance war with France. Despite its important role in raising public finance, the Bank of England did not assume its modern-day position as the government’s bank until the 20th century.

Acceptance of the principle that banks could be owned by large pools of shareholders was key to the evolution of modern commercial banks. Shareholder-owned banks could grow much larger than private banks by issuing or accumulating shareholder capital. The shareholder bank’s lifetime was indefinite, not contingent on the lives and deaths of individual partners. The Bank of England was originally incorporated with unlimited shareholder liability, meaning that in the event of failure shareholders would not only lose the capital they had invested, but were also liable for their share of any debts the bank had incurred. The same applied to private banks constituted as partnerships. Unlimited liability was seen as essential, because banks had powers to issue banknotes, and might do so recklessly unless their shareholders were ultimately liable when the holders of banknotes demanded redemption.

In England the introduction of shareholder banks was inhibited by the prohibition, until the early 19th century, of the issue of banknotes by banks with more than six partners. During the 18th century, the population of small private banks had increased; but many had insufficient resources to withstand financial shocks. Legislation passed in 1826 granted banknote-issuing powers to private banks with more than six partners headquartered outside a 65-mile radius of London. In 1844 the issue of banknotes was tied to gold reserves, paving the way for the Bank of England eventually to become the sole note-issuing bank. The inscription that appears on all English banknotes ‘I promise to pay the bearer on demand  the sum of ....., signed by the Chief Cashier on behalf of the Governor of the Bank of England, dates historically from the time when the Bank of England accepted a liability to convert any banknote into gold on request. The gold standard was abandoned by Britain at the start of the First World War,  reintroduced  in 1925 but abandoned again, permanently, in 1931.

The year 1844 also saw the establishment of a banking code, comprising detailed regulations on governance, management, and financial reporting. With a framework now in place for the charter and regulation of banks, the case for shareholder banks to be granted limited liability status and brought under the wings of general joint stock company law gained traction. Limited liability status was permitted in legislation passed during the 1850s, eliminating a major constraint on the growth of individual banks. Subsequently a trend towards the consolidation of shareholder and privately-owned banks through merger and acquisition progressed steadily, resulting in the emergence of several large commercial banks with nationwide office networks. By 1920 the ‘big five’, Westminster, National Provincial, Barclays, Lloyds, and Midland, accounted for around 80 per cent of all bank deposits in England and Wales. These five banks continued to dominate throughout the Great Depression of the 1930s and the Second World War. The high-street branch networks of the ‘big five’ and others proliferated during the 1950s and 1960s. The more recent evolution of the UK’s major high-street banks is traced in Figure 1.

1.  Evolution of UK retail banks.

The most important mutually-owned depository institutions in the UK were the building societies, which first emerged in the late 18th century, using members’ subscriptions to finance the construction of houses for members. The original building societies, which ceased trading when all members had acquired houses, were superseded during the 19th century by permanent building societies, which continued to trade on a rolling basis by acquiring new members. In the 1980s legislation was passed allowing building societies to demutualize, and acquire the status of limited companies like other commercial banks. Several of the larger building societies did so; others disappeared through acquisition or nationalization. Around forty independent UK building societies survived into the mid-2010s.

Meanwhile the Bank of England continued its evolution towards its current status as the government’s bank. The Bank acted as lender of last resort to the banking system for the first time, by lending cash to banks that were temporarily unable to meet the demands of their depositors for withdrawals, during the financial crisis of 1866. The Bank declined to bail out Overend Gurney, whose collapse had precipitated the crisis. In 1890, however, the Bank organized a bailout of Baring Brothers and Company. The Bank of England was eventually nationalized (taken into public ownership) in 1946. The first attempt to establish a government bank in the United States, the Bank of North America (1782), came almost a century after the creation of the Bank of England. It was succeeded by the First Bank of the United States (1791–1811) and the Second Bank of the United States (1816–36), both of which were refused renewals of their charters in the face of political opposition to the principle of federal (national) regulation of banking, as opposed to state regulation.

By contrast, the earliest US shareholder-owned commercial banks, the Bank of Massachusetts and the Bank of New York (both 1784), were formed and chartered at state level several decades before their English counterparts. The requirements for state chartering were eased during the 1830s leading to the ‘free banking era’ (1837–62), during which there was rapid growth in the banking industry, and an extension of a diverse patchwork of banknotes issued by state-chartered banks. Legislation passed in 1863 and 1864 allowed banks to be chartered at federal level, and created the conditions for the
emergence of a unified national currency.

The ‘national banking era’ (1863–1913) saw the emergence of the dual system that operates in the US today, in which federally- and state-chartered banks coexist. Deprived of their powers to issue banknotes, the state-chartered banks survived by expanding deposit-taking, and benefitting from capital requirements that were generally lighter than those of federally-chartered banks. For much of the national banking area, federally-chartered banks and state-chartered banks in most states were subject to double, multiple, or unlimited shareholder liability. Under double liability, shareholders of failed banks could lose both their original investment, and an additional sum that usually approximated to the original investment. Under multiple or unlimited liability, shareholder exposure in the event of failure was even greater. Such provisions were intended to act as a brake on risky banking practice, but the national banking era still witnessed a series of banking and financial crises. One of the most severe, the Panic of 1907, provided the impetus for the creation of a federally-chartered central bank that could act as lender of last resort during a banking crisis. Legislation passed in 1913 established the modern-day Federal Reserve System (see Chapter 4).

During the early 1930s, as the Great Depression gathered momentum, the banking industry entered a phase of renewed crisis. Reform was a key component of the incoming Roosevelt administration’s ‘New Deal’. Following the temporary closure of all US banks for several days in March 1933, measures to restore confidence included the creation of the Federal Deposit Insurance Corporation (FDIC) to provide deposit insurance, a scheme guaranteeing that small depositors are reimbursed if their bank collapses; the extension of federal regulatory oversight to all banks for the first time; and the separation of commercial from investment banking under the provisions of the Glass–Steagall Act (1933). Double and multiple shareholder liability fell out of favour during the 1930s, and was replaced almost everywhere by limited liability.

The reforms of the 1930s, together with stable currency values maintained by the post-Second World War Bretton Woods system of fixed currency exchange rates, provided the foundation for a phase of relatively stable and tightly regulated banking during the 1940s, 1950s, and 1960s. The demise of Bretton Woods in 1973, and a growing trend towards the liberalization and deregulation of financial markets from the 1970s onwards, created opportunities for the development of new financial services, as well as new sources of risk that were brought sharply into focus by the global financial crisis of 2007–9.

In the US mutuals include Savings and Loan (S&L) associations, also known as thrifts. S&Ls first  appeared during the 1830s, and were modelled on UK building societies. Members subscribed to shares,   purchased in monthly instalments, and could borrow funds for a house purchase in proportion to their shareholdings. Interest was charged, and the loan was repaid through continued monthly payments. Urban growth during the second half of the 19th century was accompanied by a proliferation of S&Ls. Many S&Ls disappeared during the S&L crisis of the late 1980s and early 1990s, due primarily to unsound mortgage lending (see Chapter 6). Other mutuals in the US include savings banks, the first of which was formed in Boston in 1816; and credit unions, which originated in the early 20th century. Credit union membership, defined by a ‘common bond’, is restricted to individuals who share some form of association, such as an employer, profession, or church.

Source: Banking: A Very Short Introduction (Very Short Introductions) 1st Edition by John O. S. Wilson   

Origins and function of banking

A bank is an institution that accepts deposits from savers, extends loans to borrowers, and provides a range of other financial services to its customers. Banks are a central part of the modern financial system. Banks play a key role in organizing the flows of funds between savers and borrowers, including households, companies, and the government. In recent decades advances in information technology have delivered major changes in the quality and range of banking services, and have generated cost savings for banks. Customers in many countries use electronic distribution channels, such as automated teller machines, telephone and mobile banking, and internet banking, to gain access to banking services, in preference to visiting traditional high-street branches. Innovations in payments have led to a shift away from cash and cheques to faster and more convenient electronic payment systems, such as credit and debit cards, and contactless payment technologies, in some cases linked directly to customer bank accounts. Those parts of society unable to access the new distribution channels, however, have been denied many of the benefits of technological progress. Less visible to the banking public has been the rise of the ‘shadow banking’ system, comprising financial institutions that offer similar services to banks, but operate without banking licenses and largely beyond the scope of regulation.

The recent history of banking has witnessed the inexorable growth of large banking organizations, the biggest of which now span the globe. Much of the growth of the largest banks has been fuelled by the acquisition of competitors, sometimes at the height of banking or financial crises when banks in financial difficulty have been bailed out or rescued. Even the largest banks are inherently fragile and vulnerable to the possibility of collapse. A bank’s depositors expect the bank will always be willing and able to cash their deposits quickly; but when a bank grants a loan to a borrower, the funds tied up in the loan may not be accessible to the bank for many years, until the loan is due for repayment. Provided all of the bank’s depositors do not demand to withdraw their deposits simultaneously, the bank should be able to meet its commitments to depositors, and remain solvent. However, banks are vulnerable to a possible loss of depositor confidence. If all depositors seek to withdraw their funds simultaneously, the bank may soon run out of the cash it needs to repay them.

Until 2007, many commentators would have agreed that modern, technologically sophisticated banks, operating within a system of light-touch regulation, would always be able to provide plentiful finance for borrowers seeking to invest. The global financial crisis of 2007–9 was a rude awakening, and has led to a fundamental reappraisal of this view. During the crisis many banks suffered huge losses, some went out of business, and others required large taxpayer-funded bailouts to avoid collapse. As many economies entered recession, governments encountered large public spending deficits and mounting public debt. The global financial crisis was followed by a sovereign debt crisis, affecting countries such as Greece, Ireland, Portugal, and Spain. Central banks around the world have implemented unconventional monetary policies in an attempt to boost economic activity. New laws have been passed, and new rules imposed, to constrain the freedom of banks to undertake risky lending. New supervisory frameworks have been developed to monitor not only the risk of individual banks, but also the stability of the entire financial system.

Society benefits when the banking system operates efficiently and borrowers and depositors are able to realize their aims. Economic growth and development are hindered if promising investment opportunities remain unexploited because entrepreneurs are unable to borrow the funds they need to exploit these opportunities. A poorly performing or underdeveloped financial system can present an obstacle to growth and prosperity, if loans are granted for unproductive purposes dictated by family connections, political influence, or cronyism.

The key role of banks in the financial system and the vulnerability of banks to sudden collapse, owing to a loss of confidence on the part of depositors or other providers of funding, are recurring themes throughout this Very Short Introduction. This book highlights the financial services banks provide, the risks they face, and the role of the central bank. The book describes the main events of the global financial crisis and the sovereign debt crisis, and investigates the ways in which the banks themselves, industry supervisors and regulators, central banks, governments, and international agencies have adapted to the harsh lessons learned from the upheavals of the past decade.

Source: Banking: A Very Short Introduction (Very Short Introductions) 1st Edition by John O. S. Wilson