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The modern banking industry is a network of financial institutions licensed by the state to supply banking services. The principal services offered relate to storing, transferring, extending credit against, or managing the risks associated with holding various forms of wealth. The precise bundle of financial services offered at any given time has varied considerably across institutions, across time, and across jurisdictions, evolving in step with changes in the regulation of the industry, the development of the economy, and advances in information and communications technologies.
Banks as financial intermediaries are party to a transfer of funds from the ultimate saver to the ultimate user of funds. Often, banks usefully alter the terms of the contractual arrangement as the funds move through the transfer process in a manner that supports and promotes economic activity. By issuing tradable claims (bank deposits) against itself, the bank can add a flexibility to the circulating media of exchange in a manner that enhances the performance of the payments system. These deposits may support the extension of personal credit to consumers (retail banking) or short-term credit to nonfinancial businesses (commercial banking). If so, the bank aids the management of liquidity, thus promoting household consumption and commerce. By facilitating the collection of funds from a large number of small savers, each for a short period, the bank promotes the pooling of funds to lend out in larger denominations for longer periods to those seeking to finance investment in larger capital projects. Financing investment may take the form of underwriting issues of securities (investment banking) or lending against real estate (mortgage banking). By specializing in the assessment of risk, the bank can monitor borrower performance; by diversifying across investment projects, the bank minimizes some types of risk and promotes the allocation of funds to those endeavours with the greatest economic potential. By extending trade credit internationally (merchant banking), the bank can facilitate international trade and commerce. As one last example, by lending to other banks in times of external pressures on liquidity, the bank can manage core liquidity in the financial system, thus potentially stabilizing prices and output (central banking).
To discharge its various functions, banks of all types manage highly leveraged portfolios of financial assets and liabilities. Some of the most crucial questions for the banking industry and state regulators center on questions of how best to manage the portfolio of deposit banks, given the vital role of these banks in extending commercial credit and enabling payments. With bank capital (roughly equal to the net value of its assets after deduction of its liabilities) but a small fraction of total assets, bank solvency is particularly vulnerable to credit risk, market risk, and liquidity risk. An increase in non-performing loans, a drop in the market price of assets, or a shortage of cash reserves that forces a distress sale of assets to meet depositors’ demand can each, if transpiring over a period of time too short for the bank to manage the losses, threaten bank solvency.
Origins of Modern Banking
The modern banking industry, offering a wide range of financial services, has a relatively recent history; elements of banking have been in existence for centuries, however. The idea of offering safe storage of wealth and extending credit to facilitate trade has its roots in the early practices of receiving deposits of objects of wealth (gold, cattle, and grain, for example), making loans, changing money from one currency to another, and testing coins for purity and weight.
The innovation of fractional reserve banking early in this history permitted greater profitability (with funds used to acquire income earning assets rather than held as idle cash reserves) but exposed the deposit bank to a unique risk when later paired with the requirement of converting deposits into currency on demand at par, since the demand at any particular moment may exceed actual reserves. Douglas Diamond and Philip Dybvig have, for example, shown in their 1983 article “Bank Runs, Liquidity, and Deposit Insurance” that in such an environment, a sufficiently large withdrawal of bank deposits can threaten bank liquidity, spark a fear of insolvency, and thus trigger a bank run.
Means of extending short-term credit to support trade and early risk-sharing arrangements afforded by such devices as marine insurance appear in medieval times. Italian moneychangers formed early currency markets in the twelfth century CE at cloth fairs that toured the Champagne and Brie regions of France. The bill of exchange, as a means of payment, was in use at this time as well.
Over the course of the seventeenth and eighteenth centuries, the industry transformed from a system composed of individual moneylenders financially supporting merchant trade and commerce, as well as royalty acquiring personal debt to finance colonial expansion, into a network of joint-stock banks with a national debt under the control and management of the state. The Bank of England, for example, as one of the oldest central banks, was a joint-stock bank initially owned by London’s commercial interests and had as its primary purpose the financing of the state’s imperial activities by taxation and the implementing of the permanent loan. This period was also marked by several experiments with bank notes (with John Law’s experiment in France in 1719–1720 among the most infamous) and the emergence of the check as simplified version of the bill of exchange.
Eighteenth-century British banking practices and structures were transported to North America and formed an integral part of the colonial economies from the outset. The first chartered bank was established in Philadelphia in 1781 and in Lower Canada in 1817. Experiments with free banking—as a largely unregulated business activity in which commercial banks could issue their own bank notes and deposits, subject to a requirement that these be convertible into gold—have periodically received political support and have appeared briefly in modern Western financial history. Public interest in minimizing the risk of financial panics and either limiting or channelling financial power to some advantage has more often, however, dominated and justified enhanced industry regulation.
Various forms of bank regulation include antitrust enforcement, asset restrictions, capital standards, conflict rules, disclosure rules, geographic and product line entry restrictions, interest rate ceilings, and investing and reporting requirements. The dominant view holds that enhanced regulation of this industry is necessary because there is clear public sector advantage, or for protecting the consumer by controlling abuses of financial power, or because there is a market failure in need of correction.
Where public sector advantage justifies the need for regulation, government intervention may appear in the form of reserve requirements imposed on deposit-taking institutions for facilitating the conduct of monetary policy or in the various ways in which governments steer credit to those sectors deemed important for some greater social purpose. Limiting concentration and controlling abuses of power and thus protecting the consumer have motivated such legislation as the American unit banking rules (whereby banks were limited physically to a single center of operation) and interest rate ceilings (ostensibly designed to prohibit excessive prices), as well as various reporting and disclosure requirements.
The latent threat of a financial crisis is an example of a market failure that regulation may correct. Here, the failure is in the market’s inability to properly assess and price risk. The systemic risk inherent in a bank collapse introduces social costs not accounted for in private sector decisions. The implication is that managers, when constructing their portfolios, will assume more risk than is socially desirable; hence, there exists a need for government-imposed constraint and control. State-sanctioned measures designed to minimize the threat of bank runs include the need for a lender of last resort function of the central bank to preserve system liquidity and the creation of a government-administered system of retail banking deposit insurance.
Regulation explicitly limiting the risk assumed by managers of banks includes restrictions that limit the types and amounts of assets an institution can acquire. A stock market crash will threaten solvency of all banks whose portfolios are linked to the declining equity values. Investment bank portfolios will be, in such a circumstance, adversely affected. The decline in the asset values of investment banks can spill over to deposit banks causing a banking crisis when the assets of deposit banks include marketable securities, as happened in the United States in the early 1930s.
The Bank Act of 1933 (the Glass-Steagall Act) in the United States as well as early versions of the Bank Act in Canada, for example, both prohibited commercial banks from acquiring ownership in nonfinancial companies, thus effectively excluding commercial banks from the investment banking activities of underwriting and trading in securities. This highly regulated and differentiated industry structure in twentieth-century North America contrasts sharply with the contemporaneous banking structures of Switzerland and Germany, for example, where the institutions known as universal banks offer a greater array of both commercial and investment banking services. The question for policymakers then is which industry structure best minimizes the risk of banking crises and better promotes macroeconomic stability and growth.
Banking and Macroeconomic Activity
The relationship between credit, bank notes, bank deposits, and macroeconomic stability has been the focus of much debate in the history of Western monetary thought. This debate grows more vigorous in the wake of financial panics and crises, when its focus turns to causality between banking crises and economic downturns.
Between 1929 and 1933 more than 40 percent of the American banks existing in 1929 failed. With no deposit insurance, bank failures wiped out savings and forced a severe contraction of the money supply. Milton Friedman and Anna Schwartz (1963) maintain that inaction by the American central bank permitted the sudden contraction of liquidity and magnification of real economic distress. Ben Bernanke (1983), too, believes that monetary conditions lead real economic activity, arguing that bank failures raise the cost of credit intermediation and therefore have an effect on the real economy. Charles Kindleberger (1986) alternatively suggests that non-monetary forces lie at the root of the problem, but that it was the failure of the Credit-Anstalt bank in Austria that proximately forced a sudden withdrawal of credit from the New York money markets and, in domino fashion, a contraction of credit throughout the United States. For Hyman Minsky (1982), the evolving margins of safety between the streams of asset income in relation to the contemporaneous changes in the cost of credit both characterize and explain financial instability.
Whichever the direction of primary causation, there is substantial agreement on the fact that there exists an important relationship between a sudden contraction of credit and liquidity and a considerable decline in economic activity. Consensus arises also around the likelihood that central bank last resort lending, in the manner suggested by Henry Thornton (1802) or by Walter Bagehot (1873), had it been exercised, might have substantially mitigated these effects.
Despite being subjected to similar nonmonetary shocks, and despite existing in an economy that roughly mirrored the American economy at the time, the Canadian banking system of the 1930s proved itself less vulnerable to collapse. Two factors may explain the relative stability of the Canadian banking sector: a lower level of integration of commercial and investment banking activities and a much more highly concentrated industry, with only a few large banks dominating the Canadian banking landscape. While Richard Sylla (1969) suggests that monopolistic elements in the post-bellum U.S. banking industry were present and may explain the apparent inefficiencies he observes in the data, Michael Bordo, Hugh Rockoff, and Angela Redish (1994), for example, argue for an absence of evidence in support of any similar claim that Canadian bank cartels created gross differences in pricing. Contrary to common suspicion, stability, it appears, was not at the cost of any significant loss in efficiency, at least in the Canadian industry. Nevertheless, American apprehension about concentrations of financial power continued to prevail. Legislation designed to minimize the future possibility of such crises focused instead on enforced portfolio adjustments.
The relationship between crises and economic downturns has its counterpart in a later debate about the financial structure and economic growth. In broad strokes, as an economy develops in scale and scope, formal financial arrangements gradually (however incompletely) replace informal ones. As the economy’s need for larger amounts of funds to finance larger capital projects rises, the increasing inefficiency of many informal financial systems yields to the efficiency of formal codified transactions. As Rondo Cameron and Hugh Patrick (1967, p. 1) explain in Banking in the Early Stages of Industrialization, A Study in Comparative Economic History, the proliferation of the number and variety of financial institutions and a substantial rise in the ratio of money and other financial assets relative to total output and tangible wealth are “apparently universal characteristics of the process of economic development in market-oriented economies.”
In “Finance and Growth: Theory and Evidence” Ross Levine (2005, p. 867) examines the theory and evidence and concludes, “better functioning financial systems ease the external financing constraints that impede firm and industrial expansion, suggesting that this is one mechanism through which financial development matters for growth.” Whether the industry is segmented (with an enhanced role for capital markets) or not (as with universal banking systems, and their greater role for banks), does not seem to matter much, however. Several mutually reinforcing changes have stimulated a renewed public interest in this question about the preferred industrial structure.
Post-1980 Industry Developments
The period from 1980 onward has been marked by increasing consolidation of banks, substantial loss in the share of financial activity to financial markets (disintermediation), greater market concentration, and considerable blurring of the traditional distinctions between banks and other financial institutions. Banks are increasingly offering a broader array of financial services in an increasing number of jurisdictions. The result is that banks in many countries where their scope was once limited are becoming more like universal banks.
Forces of change affecting the financial system since 1980 include market forces, legislative changes, and technological advances affecting communication and information. The dynamic tension and interplay between these forces have contributed significantly to the growth of new markets, new institutions, and new instruments, many of which fall outside the purview of existing regulation by virtue of their location or definition or both. The result is that an increasing amount of financial activity escapes regulation of any kind.
National responses have been largely to advocate and initiate deregulation of the domestic financial systems, justified by the same arguments that once supported the regulation. The elimination of interest rate ceilings, for example, should increase choice and competition, result in better and cheaper services for the customer, and increase the efficiency with which the economy allocates scarce funds. Permitting the integration of commercial and investment banking activities should produce greater efficiencies by permitting firms to capture greater economies of scale and scope. Notably, the legal separation of these activities was repealed in the United States with the 1999 Financial Services Modernization Act.
To date, international financial regulation is limited to the right-of-access rules negotiated by the European Union member states and by Canada, Mexico, and the United States, as part of the North American Free Trade Agreement, for example. Other international efforts have been largely and significantly restricted to international agreements to incorporate proposed rules into national legislation. The 1988 Basel Accord on the international convergence of capital measurements and standards, for example, recommended minimum common levels of capital for banks conducting international business. The twelve original signatories gradually adopted these capital requirements, as did several other countries. The second Accord, reached in 2004, broadened the scope of the earlier agreement and increased its flexibility to meet the objective of setting standards for minimizing both credit and operational risks. There remain, however, several markets and instruments in the international arena that have yet to be regulated or at least have the relevant national regulation coordinated.
The future may well see an increased extent and variety of the bundling of financial services as techniques and technologies of securitization, networking, and outsourcing offer new organizational possibilities. The result thus far has been a blurring of the traditional distinctions between banking and non-banking financial activity. Bank mergers and mergers of banks with other financial firms are occurring with increasing frequency and magnitude, suggesting that the future may well witness both a greater dominance of universal banking structures and a greater international concentration of financial assets.
Perhaps more profound is the potential for the blurring of any clear distinction between financial and nonfinancial activities. Nonfinancial retailers are joining forces with banks or opening their own lending facilities outright. Developments in electronic communications and software have the potential to erode the banking industry’s relative monopoly over bank deposits as the nation’s dominant medium of exchange. It may only be a matter of time before the provision of commercial and retail credit already offered by some nonfinancial communications companies effectively challenges even these most traditional of banking activities. Whatever the precise institutional details—and they will continue to vary from jurisdiction to jurisdiction—the difference between financial and nonfinancial enterprises may be expected to become increasingly difficult to define and regulate as the banking industry continues to evolve.
- Bagehot, Walter. 1873. Lombard Street, a Description of the Money Market. Homewood, IL: Richard D. Irwin, 1962.
- Bernanke, Ben S. 1983. Nonmonetary Effects of the Financial Crisis in Propagation of the Great Depression. American Economic Review 73 (3): 257–76.
- Bordo, Michael D., Hugh Rockoff, and Angela Redish. 1994. The U.S. Banking System from a Northern Exposure: Stability versus Efficiency. The Journal of Economic History 54 (2): 325–341.
- Cameron, Rondo E., and Hugh T. Patrick. 1967. Introduction. In Banking in the Early Stages of Industrialization, A Study in Comparative Economic History, eds. Rondo E. Cameron, Olga Crisp, Hugh T. Patrick, and Richard Tilly. New York: Oxford University Press.
- Diamond, Douglas, and Philip Dybvig. 1983. Bank Runs, Liquidity, and Deposit Insurance. Journal of Political Economy 91 (3): 401–419.
- Friedman, Milton, and Anna Jacobson Schwartz. 1963. A Monetary History of the United States, 1867–1960. Princeton, NJ: Princeton University Press.
- Kindleberger, Charles P. 1986. The World in Depression, 1929–1939. Rev. and enl. ed. Berkeley: University of California Press.
- Levine, Ross. 2005. Finance and Growth: Theory and Evidence. In Handbook of Economic Growth, eds. Philippe Aghion and Steven N. Durlauf, 865–934. Amsterdam: Elsevier.
- Minsky, Hyman. 1982. The Financial Instability Hypothesis: Capitalistic Processes and the Behavior of the Economy. In Financial Crises: Theory, History, and Policy, eds. Charles P. Kindleberger and Jean-Paul Laffargue, 13–39. Cambridge, U.K.: Cambridge University Press.
- Sylla, Richard. 1969. Federal Policy, Banking Market Structure, and Capital Mobilization in the United States, 1863–1913. Journal of Economic History 39 (4): 657–86.
- Thornton, Henry. 1802. An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, ed. Friedrich A. von Hayek. New York: Kelley, 1962.
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