Principles of banking

The development of trade and commerce drove the need for readily exchangeable forms of money. The concept of bank money originated with the Amsterdamsche Wisselbank (the Bank of Amsterdam), which was established in 1609 during Amsterdam’s ascent as the largest and most prosperous city in Europe. As an exchange bank, it permitted individuals to bring money or bullion for deposit and to withdraw the money or the worth of the bullion. The original ordinance that established the bank further required that all bills of 600 gulden or upward should be paid through the bank—in other words, by the transfer of deposits or credits at the bank. These transfers later came to be known as “bank money.” The charge for making the transfers represented the bank’s sole source of income.

In contrast to the earliest forms of money, which were commodity moneys based on items such as seashells, tobacco, and precious-metal coin, practically all contemporary money takes the form of bank money, which consists of checks or drafts that function as commercial or central bank IOUs. Commercial bank money consists mainly of deposit balances that can be transferred either by means of paper orders (e.g., checks) or electronically (e.g., debit cards, wire transfers, and Internet payments). Some electronic-payment systems are equipped to handle transactions in a number of currencies.

Circulating “banknotes,” yet another kind of commercial bank money, are direct claims against the issuing institution (rather than claims to any specific depositor’s account balance). They function as promissory notes issued by a bank and are payable to a bearer on demand without interest, which makes them roughly equivalent to money. Although their use was widespread before the 20th century, banknotes have been replaced largely by transferable bank deposits. In the early 21st century only a handful of commercial banks, including ones located in Northern Ireland, Scotland, and Hong Kong, issued banknotes. For the most part, contemporary paper currency consists of fiat money (from the medieval Latin term meaning “let it be done”), which is issued by central banks or other public monetary authorities.

All past and present forms of commercial bank money share the characteristic of being redeemable (that is, freely convertible at a fixed rate) in some underlying base money, such as fiat money (as is the case in contemporary banking) or a commodity money such as gold or silver coin. Bank customers are effectively guaranteed the right to seek unlimited redemptions of commercial bank money on demand (that is, without delay); any commercial bank refusing to honour the obligation to redeem its bank money is typically deemed insolvent. The same rule applies to the routine redemption requests that a bank makes, on behalf of its clients, upon another bank—as when a check drawn upon Bank A is presented to Bank B for collection.

While commercial banks remain the most important sources of convenient substitutes for base money, they are no longer exclusive suppliers of money substitutes. Money-market mutual funds and credit unions offer widely used money substitutes by permitting the persons who own shares in them to write checks from their accounts. (Money-market funds and credit unions differ from commercial banks in that they are owned by and lend only to their own depositors.) Another money substitute, traveler’s checks, resembles old-fashioned banknotes to some degree, but they must be endorsed by their users and can be used for a single transaction only, after which they are redeemed and retired.

For all the efficiencies that bank money brings to financial transactions and the marketplace, a heavy reliance upon it—and upon spendable bank deposits in particular—can expose economies to banking crises. This is because banks hold only fractional reserves of basic money, and any concerted redemption of a bank’s deposits—which could occur if the bank is suspected of insolvency—can cause it to fail. On a larger scale, any concerted redemption of a country’s bank deposits (assuming the withdrawn funds are not simply redeposited in other banks) can altogether destroy an economy’s banking system, depriving it of needed means of exchange as well as of business and consumer credit. Perhaps the most notorious example of this was the U.S. banking crisis of the early 1930s (see Banking panics and monetary contraction); a more recent example was the Asian currency crisis that originated in Thailand in 1997.

Bank loans, which are available to businesses of all types and sizes, represent one of the most important sources of commercial funding throughout the industrialized world. Key sources of funding for corporations include loans, stock and bond issues, and income. In the United States, for example, the funding that business enterprises obtain from banks is roughly twice the amount they receive by marketing their own bonds, and funding from bank loans is far greater still than what companies acquire by issuing shares of stock. In Germany and Japan bank loans represent an even larger share of total business funding. Smaller and more specialized sources of funding include venture capital firms and hedge funds.

Although all banks make loans, their lending practices differ, depending on the areas in which they specialize. Commercial loans, which can cover time frames ranging from a few weeks to a decade or more, are made to all kinds of businesses and represent a very important part of commercial banking worldwide. Some commercial banks devote an even greater share of their lending to real-estate financing (through mortgages and home-equity loans) or to direct consumer loans (such as personal and automobile loans). Others specialize in particular areas, such as agricultural loans or construction loans. As a general business practice, most banks do not restrict themselves to lending but acquire and hold other assets, such as government and corporate securities and foreign exchange (that is, cash or securities denominated in foreign currency units).