Banking

I

Introduction

Banking, transactions carried on by any individual or firm engaged in providing financial services to consumers, businesses, or government enterprises. In the broadest sense, banking consists of safeguarding and transfer of funds, lending or facilitating loans, guaranteeing creditworthiness, and exchange of money. These services are provided by such institutions as commercial banks, savings banks, trust companies, finance companies, and merchant banks or other institutions engaged in investment banking. A narrower and more common definition of banking is the acceptance, transfer, and, most important, creation of deposits. This includes such depository institutions as commercial banks, savings and loan associations (more common in the United States), building societies, and mutual savings banks. All countries subject banking to government regulation and supervision, normally implemented by central banking authorities. For further information on central banks and investment banking, see the relevant articles.

II

Aspects of Banking

The most basic role of banking, safeguarding funds, is done through vaults, safes, and secure facilities that physically store money. These physical deposits are in most cases insured against theft, and in most cases against the bank being unable to repay the funds. In some banks the service is extended to safe deposit boxes for valuables. Interest given on savings accounts, a percentage return on the bank’s investments with the money, gives an additional incentive to save. Transfer of funds can be handled through negotiable instruments, cheques, or direct transfers performed electronically. Credit cards and account debit cards, electronic cash tills, computer online banking, and other services provided by banks extend their usefulness by offering customers additional ways of gaining access to and using their funds. Automated clearing houses perform similar services for business customers by handling regular payments, such as wages, for a company banking with the bank. Longer-term schemes for providing regular income on savings are often offered through trust funds or other investment schemes.

Loans to bank customers are drawn on the funds deposited with the bank and yield interest, which provides the profits for the banking industry and the interest on savings accounts. Banks also provide foreign exchange facilities for individual customers, as well as handling large international money transfers. Investment banks engage chiefly in financing businesses and trading in securities.

III

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 Templar, an international 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 Medici in Florence, 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).

In the 17th century, English goldsmiths provided the model for contemporary banking. Gold was stored with these artisans for safe keeping, and 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, though a risk of creating too much money is a rise in 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; at the same time, it opens banks to the risk of a liquidity crisis. When depositors en masse request payment, the inability of a bank to respond because it lacks sufficient liquidity means that it must either renege on its promises to pay or pay until it fails. A key role of the central bank in most countries is to regulate the commercial banking sector to minimize the likelihood of a run on a bank, which could undermine the entire banking system. The central bank will often stand prepared to act as lender of last resort to the banking system to provide the necessary liquidity in the event of a widespread withdrawal of funds. This does not equal a permanent safety net to save any bank from collapse, as was demonstrated by the Bank of England’s refusal to rescue the failed investment bank Barings in 1995.

IV

Banking in Britain

Since the 17th century Britain has been known for its prominence in banking. London still remains a major financial centre, and virtually all the world’s leading commercial banks are represented.

Aside from the Bank of England, which was incorporated, early English banks were privately owned rather than stock-issuing firms. Bank failures were not uncommon; 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 a large number of institutions; at the turn of the 20th 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 post-war Labour government; and in 1968 a merger among the largest five clearing banks left the industry in the hands of four players: Barclays, Lloyds (now Lloyds TSB Group), Midland (now part of HSBC Holdings), and National Westminster (taken over by the Royal Bank of Scotland in 2000). Financial liberalization in the 1980s resulted in the growth of building societies, which in many ways now carry out similar functions to the traditional clearing banks.

The clearing banks, with their national branch networks, play a critical role in the British banking system. 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, corporate finance and investment, factoring, and leasing.

A restructuring in the banking industry took place in the late 1970s. The Banking Act of 1979 formalized the Bank of England’s 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.

Like many central banks, the issue of the Bank of England’s independence in setting interest rates and so influencing inflation and demand-side economics has long been an issue of debate. For a central bank to be able to ensure monetary and financial stability for the nation requires the political bias of government decision-making to be removed. As a result of a series of costly decisions by the British Conservative government in 1992, which saw Britain being forced to withdraw from the Exchange Rate Mechanism of the European Union, greater power was granted to the Bank of England to control inflation. In 1997 a new, Labour government handed operational independence to the Bank of England and an annual remit to set interest rates to ensure inflation does not rise above 2.5 per cent. This is done by the Monetary Policy Committee.

London has become the centre of the Eurodollar market; participants include financial institutions from all over the world. This market, which began in the late 1950s and has since grown dramatically, borrows and lends dollars and other currencies outside the currency’s home country.