The “Money and Currency” series has attracted a lot of email. To date, we have:
- This discussion of the properties of money and currency;
- This discourse on Gresham’s Law and bimetallism;
- This narration of the transition to a fiat dollar.
I was tempted to continue on into the sociopolitical pressures that have propelled the massive inflation of the post-Federal Reserve Act century, but it occurred to me that a discussion of the quintessential financial institution, the bank, really ought to precede further discussion of the commodity with which we transact and (attempt to) save.
Before people began to think about borrowing or saving in organized terms, they worried about protecting their accumulated precious metals. It was unwise to keep significant quantities of gold or silver in “casual” storage, especially in locales where there was a possibility of incursion by a raider band. Thus there arose interest in the safekeeping of one’s store of value.
The local jeweler provided a solution. His trade required that he keep such stocks, and of course that he keep them safe from predation. If he had excess storage capacity, he might be persuaded to rent it to you, for a modest fee. You and he would agree on the fee, on how much metal he would store for you, on how long he would store it, and on how the deal was to be recorded; you would hand over your gold and silver; he would lock it away; and off you’d both go to your proper concerns. Thus were born two of the ubiquitous features of commercial societies: banking and bookkeeping.
But a jeweler who made banking into a significant side business would eventually contemplate the possibilities of having so much of other people’s money in his hands. Why should it just sit there, taking up space and doing nothing? Especially as others were aware of it, an uncomfortable situation that increased the probability of an attack on the jeweler’s vault. Better to “put it to work,” simultaneously reducing the vault’s attractiveness as a target and earning something from otherwise inert assets.
If the jeweler could be certain of holding X ounces of gold for Y days, he could lend it out, at interest, for Y-1 days — assuming it would be paid back, of course. The creditworthiness of the prospective borrower had to be assured to a high degree of confidence, for a loan not repaid by the borrower must perforce be repaid to the depositors out of the jeweler’s own funds. However, the usage fee for the borrowed funds, or usury, could help to protect the jeweler/banker: enough borrowers at a sufficiently high usury would return a sufficient profit margin to prevent a small number of bad loans from bankrupting the jeweler/banker.
Note in particular all the following:
- The jeweler/banker could not lend for a longer term than the term agreed upon with his depositors;
- He had to accept that his judgment of borrowers would occasionally be wrong, resulting in a “bad loan” that would not be repaid;
- The usury had to be set high enough to compensate for that inevitability;
- However, it could not be set too high, because:
- That would discourage borrowing by creditworthy clients;
- Competitive forces — i.e., other jeweler/bankers — would reduce his lending volume and thus his profits.
As jeweler/bankers mastered the intricacies of their new trade and gradually abandoned their jewelry businesses, thus was born the financial industry of today, albeit in a very early and simplified form.
Profit is a seductive thing; profit accrued from others’ assets is perhaps the most powerful of all. Bankers soon began to look for ways to increase the volume of their lending businesses beyond what the above prototype made possible. One constraint upon a bank’s actions was the volume of its deposits. Should those increase, so also could the bank’s lending, and therefore its profits.
The Law of Supply and Demand suggested that lowering the fees charged to depositors would stimulate a greater volume of deposits. Eventually, the cleverer bankers realized that rather than charge depositors a fee, they could pay usury to depositors, as long as the rate was sufficiently below the rate they could charge borrowers, and still increase their profits. By implication, this transformed the bank from a paid sentry into a borrower, a point that’s reflected in bankers’ accounting practice of treating cash on hand as a debit.
Many other changes arose with time. Some of them were ordinary and harmless; others have been unbelievably pernicious. Possibly the worst of all is the trend to “borrow short” but “lend long:” in modern practice, to allow on-demand withdrawals by depositors while committing to loans of many years’ duration, while keeping only a small fraction of depositors’ funds on hand in the practice called fractional-reserve banking. That practice, and depositors’ uneasy awareness of it, are what make possible the greatly feared bank run.
At the core of modern banking practices is reliance upon interbanking: the aggregation of financial institutions into a league of mutual protection, originally against runs but, as the practice of fractional-reserve banking proliferated, against panics as well. Ultimately, bankers realized that no matter how many of them banded together to protect one another from such things, it was always possible in a fractional-reserve system for a few undisciplined banks — sometimes known as wildcat banks, to create the preconditions for a panic that would bring the lot of them tumbling down.
One sensible response to the possibility of a run was to demand security for a loan: either real estate of demonstrated value or a chattel: a valuable item of movable property. Such security could be demanded in satisfaction of a loan the borrower could not repay. However, the intent was more to “keep the borrower honest” than to provide for genuine protection for the bank, as no bank wants to be in the business of selling tangibles. Over time, secured loans became a progressively smaller part of a bank’s lending volume — this was one of the unintended consequences of interbanking — and threats to the system proliferated once more.