Banking - Origins and History

A world without money would be worse, much worse, than our present world. It is wrong to think of all lenders of money as mere leeches, sucking the life’s blood out of unfortunate debtors. Loan sharks may behave that way, but banks have evolved since the days of the Medici precisely in order (as the 3rd Lord Rothschild succintly put it), to ‘faciliate the movement of money from point A, where it is, to point B, where it is needed’.

Behind each great historical phenomenon, there lies a financial secret. For example, the Renaissance created such a boom in the market for art and architecture because Italian bankers like the Medici made fortues by applying Oriental mathematics to money.

It was Nathan Rothschild as much as the Duke of Wellington who defeated Napoleon at Waterloo.

How did moneylenders learn to overcome the fundamental conflict: if they were too generous, they made no money; if they were too hard-nosed, people eventually called in the police? The answer is by growing big - and growing powerful.

The evolution of banking was the essential first step in the ascent of money.

Three innovations in banking

These innovations occurred in the seventeenth century and they are the basis for our understanding of banking today.

1. Banking - Credit creation - cashless intra bank and inter bank transactions (link)
2. Banking - Fractional Reserve Banking (link)
3. Banking - central bank monopolies on note issue (link)

To understand the power of these three innovations, first-year MBA students at Harvard Business School play a simplified money game. It begins with a notional central bank paying the professor $100 on behalf of the government, for which he has done some not very lucrative consulting. The professor takes the banknotes to a bank notionally operated by one of his students and deposits them there, receiving a deposit slip. Assuming, for the sake of simplicity, that this bank operates at a 10% reserve ratio (i.e., it wishes to maintain the ratio of its reserves to its total liabilities at 10%), it deposits $10 with the central bank and lends the other $90 to one of its clients. While the client decides what to do with his loan, he deposits the money in another bank. This bank also has a 10% reserve rule, so it deposits $9 at the central bank and lends out the remaining $81 to another of its clients. After several more rounds, what is the increase in the supply of money?

Modern monetary theory and definitions of money supply (link)

By the time money has been deposited at 3 different student banks, M0 is equal to $100 but M1 is equal to $271 ($100 + $90 + $81). This illustrates how modern fractional reserve banking allows the creation of credit and hence of money.

Now, here comes the surpise. The professor asks the first student for his $100 back. The student has to draw on his reserves and call in his loan to the second student, setting off a domino effect that causes M1 to contract as swiftly as it expanded. This illustrates the danger of a bank run. Since the first bank had only one depositor, his attempted withdrawl constitued a call 10 times larger than its reserves. The survival of the first banker clearly depends on his being able to call in the loan he had made to his client, who in turn had to withdraw all of his deposit from the second bank, and so on. When making the loan, the bankers should have thought more carefully about how easily they could call back the money - essentially a question about the liquidity of the loan.

The technicalities between M0, M1, M2, M3, … need not detain us here. The important point to grasp is that with the spread throughout the Western world of the innovations mentioned above, the very nature of money evolved in a profoundly important way. No longer was money to be understood as precious metal that had been dug up, melted down and minted into coins - as the Spaniards had understood in the sixteenth century. Now, money represented the sum total of specific liabilities (deposits and reserves) incurred by banks. Credit was, quite simply, the total of banks’s assets (loans). Some of this money might indeed still consist of precious metal, though a rising proportion of that would be held in the central bank’s vault. But most of it would be made up of those banknotes and token coins recognized as legal tender along with the invisible money that existed only in deposit account statements. Financial innovation had taken the invert silver of the old world and turned it into the basis for a modern monetary system, with relationships between debtors and creditors brokered or ‘intermediated’ by increasingly numerous institutions called banks. The core function of these institutions was now information gathering and risk management. Their source of profits lay in maximizing the difference between the costs of their liabilities and the earnings on their assets, without reducing reserves to such an extent that the bank became vulnerable to a run - a crisis of confidence in a bank’s ability to satisfy depositors, which leads to escalating withdrawls and ultimately bankrupcy: literally the breaking of the bank.