Banking

I

INTRODUCTION

Banking, the business of providing financial services to consumers and businesses. The basic services a bank provides are checking accounts, which can be used like money to make payments and purchase goods and services; savings accounts and time deposits that can be used to save money for future use; loans that consumers and businesses can use to purchase goods and services; and basic cash management services such as check cashing and foreign currency exchange. Four types of banks specialize in offering these basic banking services: commercial banks, savings and loan associations, savings banks, and credit unions.

A broader definition of a bank is any financial institution that receives, collects, transfers, pays, exchanges, lends, invests, or safeguards money for its customers. This broader definition includes many other financial institutions that are not usually thought of as banks but which nevertheless provide one or more of these broadly defined banking services. These institutions include finance companies, investment companies, investment banks, insurance companies, pension funds, security brokers and dealers, mortgage companies, and real estate investment trusts. This article, however, focuses on the narrower definition of a bank and the services provided by banks in Canada and the United States. (For information on other financial institutions, see Insurance; Investment Banking; and Trust Companies.)

Banking services are extremely important in a free market economy such as that found in Canada and the United States. Banking services serve two primary purposes. First, by supplying customers with the basic mediums-of-exchange (cash, checking accounts, and credit cards), banks play a key role in the way goods and services are purchased. Without these familiar methods of payment, goods could only be exchanged by barter (trading one good for another), which is extremely time-consuming and inefficient. Second, by accepting money deposits from savers and then lending the money to borrowers, banks encourage the flow of money to productive use and investments. This in turn allows the economy to grow. Without this flow, savings would sit idle in someone’s safe or pocket, money would not be available to borrow, people would not be able to purchase cars or houses, and businesses would not be able to build the new factories the economy needs to produce more goods and grow. Enabling the flow of money from savers to investors is called financial intermediation, and it is extremely important to a free market economy.

II

BANKING INSTITUTIONS

Banking institutions include commercial banks, savings and loan associations (SLAs), savings banks, and credit unions. The major differences between these types of banks involve how they are owned and how they manage their assets and liabilities. Assets of banks are typically cash, loans, securities (bonds, but not stocks), and property in which the bank has invested. Liabilities are primarily the deposits received from the bank’s customers. They are known as liabilities because they are still owned by, and can be withdrawn by, the depositors of the financial institution.

Until the early 1980s, the assets and liabilities of banks were tightly regulated. As a result, clear distinctions existed between the activities and types of services offered by these different types of banks. Although subsequent deregulation in the 1990s blurred these distinctions, differences do remain.

A

Commercial Banks

Commercial banks are so named because they specialize in loans to commercial and industrial businesses. Commercial banks are owned by private investors, called stockholders, or by companies called bank holding companies. The vast majority of commercial banks are owned by bank holding companies. (A holding company is a corporation that exists only to hold shares in another company.) In 1984, 62 percent of banks were owned by holding companies. In 2000, 76 percent of banks were owned by holding companies. The bank holding company form of ownership became increasingly attractive for several reasons. First, holding companies could engage in activities not permitted in the bank itself—for example, offering investment advice, underwriting securities, and engaging in other investment banking activities. But these activities were permitted in the bank if the holding company owned separate companies that offer these services. Using the holding company form of organization, bankers could then diversify their product lines and offer services requested by their customers and provided by their European counterparts. Second, many states had laws that restricted a bank from opening branches to within a certain number of miles from the bank’s main branch. By setting up a holding company, a banking firm could locate new banks around the state and therefore put branches in locations not previously available.

Commercial banks are “for profit” organizations. Their objective is to make a profit. The profits either can be paid out to bank stockholders or to the holding company in the form of dividends, or the profits can be retained to build capital (net worth). Commercial banks traditionally have the broadest variety of assets and liabilities. Their historical specialties have been commercial lending to businesses on the asset side and checking accounts for businesses and individuals on the liability side. However, commercial banks also make consumer loans for automobiles and other consumer goods as well as real estate (mortgage) loans for both consumers and businesses.

B

Savings and Loan Associations

Savings and loan associations (SLAs) are usually owned by stockholders, but they can be owned by depositors as well. (If owned by depositors, they are called “mutuals.”) If stock owned, the goal is to earn a profit that can either be paid out as a dividend or retained to increase capital. If owned by depositors, the objective is to earn a profit that can be used either to build capital or lower future loan rates or to raise future deposit rates for the depositor-owners. Until the early 1980s, regulations restricted SLAs to investing in real estate mortgage loans and accepting savings accounts and time deposits (savings accounts that exist for a specified period of time). As a result, historically SLAs have specialized in savings deposits and mortgage lending.

C

Savings Banks

Traditional savings banks, also known as mutual savings banks (MSBs), have no stockholders, and their assets are administered for the sole benefit of depositors. Earnings are paid to depositors after expenses are met and reserves are set aside to insure the deposits. During the 1980s savings banks were in a great state of flux, and many began to provide the same kinds of services as commercial banks.

Since 1982 savings banks have been permitted to convert to SLAs. SLAs also may convert to savings banks. Both SLAs and MSBs can now offer a full range of financial services, including multiple savings instruments; checking accounts; consumer, commercial, and agricultural loans; and trust and credit card services. See also Savings Institutions.

D

Credit Unions

Credit unions are not-for-profit, cooperative organizations that are owned by their members. Their goal is to minimize the rate members pay on loans and maximize the rate paid to members on deposits. Whatever surplus is earned is retained to build the capital of the credit union. Members must share a common bond. That bond is typically employment (members all work for the same employers) or geography (members all live in the same geographic area). Historically, credit unions specialized in providing automobile and other personal loans and savings deposits for their members. However, more recently credit unions have offered mortgage loans, credit card loans, and some commercial loans in addition to checking accounts and time deposits.

Credit unions, SLAs, and savings banks help encourage thriftiness by paying interest to consumers who put their money in savings deposits. Consequently, credit unions, SLAs, and savings banks are often referred to as thrift institutions.

Of the various types of banks in the United States, commercial banks account for the greatest single source of the financial industry’s assets. In 2000 the 8,528 commercial banks in the United States controlled 24 percent of the financial industry’s total assets. Commercial banks, however, have seen their share of financial-industry assets erode over time, as more money has shifted to money market and other mutual funds. In the mid-1990s, for example, the approximately 11,000 commercial banks then in existence controlled 27 percent of assets. In 1950 they controlled nearly 50 percent of financial assets. Savings institutions’ share of financial assets has also dropped from roughly 13 percent in 1950 to 5 percent in 2000. Credit unions’ share has remained fairly constant at 2 percent.

III

BANKING SERVICES

Commercial banks and thrifts offer various services to their customers. These services fall into three major categories: deposits, loans, and cash management services.

A

Deposits

There are four major types of deposits: demand deposits, savings deposits, hybrid checking/savings deposits, and time deposits. What distinguishes one type from another are the conditions under which the deposited funds may be withdrawn.

A demand deposit is a deposit that can be withdrawn on demand at any time and in any amount up to the full amount of the deposit. The most common example of a demand deposit is a checking account. Money orders and traveler’s checks are also technically demand deposits. Checking accounts are also considered transaction accounts in that payments can be made to third parties—that is, to someone other than the depositor or the bank itself—via check, telephone, or other authorized transfer instruction. Checking accounts are popular because as demand deposits they provide perfect liquidity (immediate access to cash) and as transaction accounts they can be transferred to a third party as payment for goods or services. As such, they function like money.

Savings accounts pay interest to the depositor, but have no specific maturity date on which the funds need to be withdrawn or reinvested. Any amount can be withdrawn from a savings account up to the amount deposited. Under normal circumstances, customers can withdraw their money from a savings account simply by presenting their “passbook” or by using their automated teller machine (ATM) card. Savings accounts are highly liquid. They are different from demand deposits, however, because depositors cannot write checks against regular savings accounts. Savings accounts cannot be used directly as money to purchase goods or services.

The hybrid savings and checking account allows customers to earn interest on the account and write checks against the account. These are called either negotiable order of withdrawal (NOW) accounts, or money market deposit accounts, which are savings accounts that allow a maximum of three third-party transfers each month.

Time deposits are deposits on which the depositor and the bank have agreed that the money will not be withdrawn without substantial penalty to the depositor before a specific date. These are frequently called certificates of deposits (CDs). Because of a substantial early withdrawal penalty, time deposits are not as liquid as demand or savings deposits nor can depositors write checks against them. Time deposits also typically require a minimum deposit amount.

B

Loans

Banks and thrifts make three types of loans: commercial and industrial loans, consumer loans, and mortgage loans. Commercial and industrial loans are loans to businesses or industrial firms. These are primarily short-term working capital loans (loans to finance the purchase of material or labor) or transaction or longer-term loans (loans to purchase machines and equipment). Most commercial banks offer a variable rate on these loans, which means that the interest rate can change over the course of the loan. Whether a bank will make a loan or not depends on the credit and loan history of the borrower, the borrower’s ability to make scheduled loan payments, the amount of capital the borrower has invested in the business, the condition of the economy, and the value of the collateral the borrower pledges to give the bank if the loan payments are not made.

Consumer loans are loans for consumers to purchase goods or services. There are two types of consumer loans: closed-end credit and open-end credit.

Closed-end credit loans are loans for a fixed amount of money, for a fixed period of time (usually not more than five years), and for a fixed purpose (for example, to buy a car). Most closed-end loans are called installment loans because they must be repaid in equal monthly installments. The item purchased by the consumer serves as collateral for the loan. For example, if the consumer fails to make payments on an automobile, the bank can recoup the cost of its loan by taking ownership of the car.

Open-end credit loans are loans for variable amounts of money up to a set limit. Unlike closed-end loans, open-end credit does not require a borrower to specify the purpose of the loan and the lender cannot foreclose on the loan. Credit cards are an example of open-end credit. Most open-end loans carry fixed interest rates–that is, the rate does not vary over the term of the loan. Open-end loans require no collateral, but interest rates or other penalties or fees may be charged—for example, if credit card charges are not paid in full, interest is charged, or if payment is late, a fee is charged to the borrower. Open-end credit interest rates usually exceed closed-end rates because open-end loans are not backed by collateral.

Mortgage loans or real estate loans are loans used to purchase land or buildings such as houses or factories. These are typically long-term loans and the interest rate charged can be either a variable or a fixed rate for the term of the loan, which often ranges from 15 to 30 years. The land and buildings purchased serve as the collateral for the loan. See Mortgage.

C

Cash Management and Other Services

Although deposits and loans are the basic banking services provided by banks and thrifts, these institutions provide a wide variety of other services to customers. For consumers, these include check cashing, foreign currency exchange, safety deposit boxes in which consumers can store valuables, electronic wire transfer through which consumers can transfer money and securities from one financial institution to another, and credit life insurance which automatically pays off loans in the event of the borrower’s death or disability.

In recent years, banks have made their services increasingly convenient through electronic banking. Electronic banking uses computers to carry out transfers of money. For example, automated teller machines (ATMs) enable bank customers to withdraw money from their checking or savings accounts by inserting an ATM card and a private electronic code into an ATM. The ATMs enable bank customers to access their money 24 hours a day and seven days a week wherever ATMs are located, including in foreign countries. Banks also offer debit cards that directly withdraw funds from a customer’s account for the amount of a purchase, much like writing a check. Banks also use electronic transfers to deposit payroll checks directly into a customer’s account and to automatically pay a customer’s bills when they are due. Many banks also use the Internet to enable customers to pay bills, move money between accounts, and perform other banking functions.

For businesses, commercial banks also provide specialized cash management and credit enhancement services. Cash management services are designed to allow businesses to make efficient use of their cash. For example, under normal circumstances a business would sell its product to a customer and send the customer a bill. The customer would then send a check to the business, and the business would then deposit the check in the bank. The time between the date the business receives the check and deposits the check in the bank could be several days or a week. To eliminate this delay and allow the business to earn interest on its money sooner, commercial banks offer services to businesses whereby customers send checks directly to the bank, not the business. This practice is referred to as “lock box” services because the payments are mailed to a secure post office box where they are picked up by bank couriers for immediate deposit.

Another important business service performed by banks is a credit enhancement. Commercial banks back up the performance of businesses by promising to pay the debts of the business if the business itself cannot pay. This service substitutes the credit of the bank for the credit of the business. This is valuable, for example, in international trade where the exporting firm is unfamiliar with the importing firm in another country and is, therefore, reluctant to ship goods without knowing for certain that the importer will pay for them. By substituting the credit of a foreign bank known to the exporter’s bank, the exporter knows payment will be made and will ship the goods. Credit enhancements are frequently called standby letters of credit or commercial letters of credit.

IV

BENEFITS FOR THE ECONOMY

The deposit and loan services provided by banks benefit an economy in many ways. First, checking accounts, because they act like cash, make it much easier to buy goods and services and therefore help both consumers and businesses, who would find it inconvenient to carry or send through the mail huge amounts of cash. Second, loans enable consumers to improve their standard of living by borrowing money to purchase cars, houses, and other expensive consumer goods that they otherwise could not afford. Third, loans help businesses finance plant expansion and production of new goods, and therefore increase employment and economic growth. Finally, since banks want loans repaid, banks choose borrowers carefully and monitor performance of a company’s managers very closely. This helps ensure that only the best projects get financed and that companies are run efficiently. This creates a healthy, efficient economy. In addition, since the owners (stockholders) of a company receiving a loan want their company to be profitable and managed efficiently, bankers act as surrogate monitors for stockholders who cannot be present on a regular basis to watch the company’s managers.

The checking account services offered by banks provide an additional benefit to the economy. Because checks are widely accepted as payment for goods and services, the checking accounts offered by banks are functionally equivalent to real money—that is, currency and coin. When banks issue checking accounts they, in effect, create money without the federal government having to print more currency. Under government regulations in many countries, banks must hold a reserve of paper currency and coin equal to at least 10 percent of their checking account deposits. In the United States banks keep these reserves in their own vaults or on deposit with the U.S. government’s central bank known as the Federal Reserve, or the Fed. If someone wants a $10 loan, the bank can give that person a $10 checking account with only $1 of currency in its vault. As a result U.S. banks can create at least $10 of checking account money for every $1 of real money (currency or coin) actually printed by the federal government. This arrangement, which allows extra deposit money to be created by banks, is referred to as a fractional reserve banking system.

Because banks attract large amounts of savings from depositors, banks can make many loans to many different customers in various amounts and for various maturities (dates when loans are due). Banks can thereby diversify their loans, and this in turn means that a bank is at less risk if one of its customers fails to repay a loan. The lowering of risk makes bank deposits safer for depositors. Safety encourages even more bank deposits and therefore even more loans. This flow of money from savers through banks to the ultimate borrower is called financial intermediation because money flows through an intermediary—that is, the bank.

V

BANKING REGULATION

Banking is one of the most heavily regulated industries in the United States, and the regulatory structure is quite complex. This owes in part to the fact that the United States has a dual banking system. A dual banking system means that banks and thrifts can be chartered and therefore regulated either by the state in which they operate or by a national chartering agency.

The Office of the Comptroller of the Currency (OCC) in the U.S. Department of Treasury is the federal chartering agency for national banks. The Office of the Comptroller of the Currency provides general supervision of national banks, including periodic bank examinations to determine compliance with rules and regulations and the soundness of bank operations. The Office of Thrift Supervision (OTS) in the Treasury Department charters national savings and loans (SLAs) and savings banks.

The agencies that insure deposits in banks and thrifts also have a role in regulating them. Almost all banks and thrifts are federally insured by the Federal Deposit Insurance Corporation (FDIC). The FDIC insures each depositor (not each separate deposit) for up to $100,000 in each bank or thrift in which the depositor has deposits and up to $250,000 for individual retirement accounts (IRAs) held in a bank or savings association. The Bank Insurance Fund (BIF) in the FDIC insures commercial bank and savings bank deposits. The Savings Association Insurance Fund (SAIF) in the FDIC insures savings and loan deposits. The National Credit Union Share Insurance Fund (NCUSIF) in the National Credit Union Administration (NCUA) insures credit union deposits.

The Federal Reserve is also responsible for regulating commercial banks that are members of the Federal Reserve System and bank holding companies. As a result, a nationally chartered, federally insured, Federal Reserve member bank is subject to the regulations of the OCC, BIF, and the Federal Reserve.

The regulatory landscape is complicated further by the fact that state banking authorities regulate state-chartered banks and frequently conduct their own examinations of state banks. To help sort out the maze of potential regulators, banks are assigned one regulator with primary responsibility for examining the bank. The primary regulator of nationally chartered banks and thrifts is the OCC. The primary regulator of state-chartered banks that belong to the Federal Reserve is the Federal Reserve. The primary regulator of state-chartered banks that are not Fed members but are FDIC insured is the FDIC, while the primary regulator of state-chartered, noninsured banks is the state.

The regulatory agencies also enforce legislation passed by the U.S. Congress. Such legislation attempts to ensure that lending institutions act fairly and that bank customers are well informed about banking services and practices. For example, the Truth-in-Lending Act (1968) and the Fair Credit and Charge Card Disclosure Act (1988) require lenders to disclose the true interest rate on loans on a uniform basis so that borrowers know the true cost of credit.

The Fair Housing Act (1968) and the Equal Credit Opportunity Act (1976) prohibit discrimination against borrowers on the basis of race, color, religion, national origin, sex, marital status, age, or receipt of public assistance. The Community Reinvestment Act (1977) requires banks, savings and loans, and savings banks to meet the credit needs of their local communities. This act was intended to prevent banks located in low-income areas from refusing loans to local residents, who were often members of minority groups. The Truth-in-Savings Act (1991) mandates uniform disclosure of the terms and conditions that banking institutions impose on their deposit accounts so that depositors know the true interest rate they receive on their deposits.

VI

CENTRAL BANKING

Governments create central banks to perform a variety of functions. The functions actually performed vary considerably from country to country. Broadly speaking, central banks serve as the government’s banker, as the banker to the banking system, and as the policymaker for monetary and financial matters.

As the government’s banker, the central bank can act as the repository for government receipts, as the collection agent for taxes, and as the auctioneer for government debt. It can also act as a lender to the government and as the government’s advisor on financial matters. As the banker for the country’s banks, the central bank can act as the repository for bank reserves, as the supervisor and regulator of banks, as the facilitator of interbank services such as check clearing and money transfers, and as a lender when banks need money to honor deposit withdrawals or other needs for liquidity.

As the country’s monetary policymaker, the central bank controls the amount of credit and money available, the level of interest rates, and the exchange rate (the rate at which one nation’s currency can be exchanged for another nation’s). To achieve its monetary policy objectives, central bankers use a combination of policy tools. For example, the central bank may increase or decrease the amount of money (coin and currency) in circulation by buying or selling government debt instruments, such as bonds, on the open market. This policy tool is known as open market operations. Since interest rates are usually related to how much money and credit are available in the economy, the central bank can usually lower interest rates by buying bonds from the public with money. This increases the amount of money in the economy and lowers interest rates. To raise rates, the authority would sell bonds, thereby reducing the amount of money available to the public. The central bank could also cause a lowering or raising of interest rates by increasing or decreasing the amount of money banks must hold as a reserve against their deposits. By increasing reserves, the central bank forces banks to hold more money in their vaults, which means they can lend less money. Less money available for loans makes loans harder to get which, in turn, causes banks and other lenders to raise interest rates on loans.

Central banks can be either privately owned or owned by the government. In Europe, central banks are owned and operated by the government. In the United States, commercial banks own the central bank, which is called the Federal Reserve. The Federal Reserve, established in 1913, consists of a seven-person Board of Governors located in Washington, D.C., and the presidents of 12 regional Federal Reserve Banks. Each member of the Board of Governors is appointed by the U.S. president and confirmed by the U.S. Senate for staggered 14-year terms. From among the seven governors, the president also designates and the Senate confirms a chairman of the board for a four-year term. The Federal Reserve’s primary policy group is called the Federal Open Market Committee (FOMC). It consists of the seven governors plus five regional Federal Reserve Bank presidents. The FOMC is responsible for controlling the money supply and interest rates in the United States.

Because central banks control the money supply, there is always the danger that central banks will simply create more money and then lend it to the government to finance its expenditures. This often leads to excessive money creation and inflation (a continuous increase in the prices of goods), which can be caused by having too much money available to purchase goods. Inflation occurred in the United States when the government printed Continental dollars to pay for the Revolutionary War. So many were printed that they became worthless, and a popular slogan of the day was “It’s not worth a Continental.” The danger of inflation is particularly acute in countries where the government owns the central bank. Government ownership of the central bank is illegal in the United States, except in national emergencies. European countries agreed in the Maastricht Treaty of 1992 not to allow central banks to lend money to their governments.

VII

BANKING IN OTHER COUNTRIES

A

Canada

Because of Canada’s close historical relationship with the United States and the United Kingdom, development of the Canadian banking system has been influenced by both countries. Unlike the United States, however, Canada always had a branch-banking system. Until 1994 banks in the United States were restricted to opening branches only in the city or state where they were incorporated. One of the first laws passed by Canada’s Parliament after confederation, in 1867, allowed any Canadian-chartered bank to operate in any part of the dominion. This law encouraged the growth of Canada’s branch-banking system, in which a few large banks operate all the country’s banking offices. In 2000 there were only 13 domestic banks in Canada, and the six largest controlled more than 90 percent of all bank assets in Canada. The remaining seven domestic banks accounted for about 2 percent of bank assets, and foreign banks accounted for about 7 percent of bank assets.

The largest commercial banks of Canada operate extensively in foreign countries, particularly in the West Indies, Asia, and the United States. In addition to the usual business of commercial loans, Canadian banks operating in foreign countries have specialized in investment banking and wealth-management activities.

The regulator of federally chartered Canadian banks and financial institutions is the Office of the Superintendent of Financial Institutions (OSFI), which was established in 1987. Since 1967 deposit insurance has been provided by the Canada Deposit Insurance Corporation (CBIC), which insures up to $60,000 Canadian per depositor per institution. Both the OSFI and the CBIC are Crown Corporations owned by the government.

The central bank of Canada is the Bank of Canada. Created in 1935, it is owned by the Ministry of Finance and is responsible for Canadian monetary policy. Unlike the U.S. Federal Reserve, the Bank of Canada is also responsible for issuing and managing the national debt. In the United States, this function is performed by the Department of the Treasury. The primary policy group of the Bank of Canada is called the Governing Council. This group consists of the governor of the Bank of Canada, the senior deputy governor, and four deputy governors. The Bank of Canada is less independent of the government than is the U.S. Federal Reserve because it must consult with the minister of finance on policy matters.

B

The European Continent

Until recently, European banking was very different from banking in the United States. European banks were frequently owned by the government and could engage in activities that were prohibited to banks in the United States. Most of these prohibited activities involved investment banking such as security underwriting (selling a firm’s stock or bonds at a guaranteed price) or security placement (finding buyers for a firm’s stock or bonds). These services are important to businesses and being able to provide them gave European banks an advantage over U.S. banks. These differences are rapidly disappearing. Most European banks are now privately owned and recent U.S. legislation has allowed U.S. banks to engage in investment-banking activities through the bank holding company form of organization.

Two differences remain between U.S. and European banking. The first is that many European banks can own nonbank commercial and industrial businesses. Such ownership is still prohibited, for the most part, for U.S. banks and holding companies. As a result, banks in Europe tend to be more business oriented and much more involved with corporate governance (corporate decision-making) than their U.S. counterparts. This also explains why most European companies rely more heavily on bank loans to finance their activities than do U.S. companies which rely more on funds raised by selling stocks and bonds in financial markets.

The second difference is that banking is much more concentrated in Europe. In other words, banking markets are dominated by a few large banks whereas in the United States many banks compete for a customer’s deposits and loans. This stems from the fact that European countries have had very liberal branching laws allowing banks to have extensive deposit-gathering networks in their home country and also from the fact that most European countries are not as concerned about monopolies as are U.S. regulators. It is not clear how long this difference will last, however, as legislation in the United States in 1994 allowed banks to establish banks and branches in other states.

The establishment of the Economic and Monetary Union (EMU) in 1992 created a new banking system in Europe that parallels that of the United States in many ways. The EMU created a new European Central Bank (ECB) that will coordinate monetary policy throughout most of continental Europe. It also established a uniform currency in Europe called the euro that beginning in 2002 was the currency used throughout Western Europe, except in Denmark, Sweden, and the United Kingdom. The EMU also allowed banks to branch throughout Europe and not just in their home country.

C

United Kingdom

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

Aside from the central Bank of England, which was incorporated, early English banks were privately owned rather than stock-issuing firms. Bank failures were common; so in the early 19th century, stock-issuing 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 money, a prerogative monopolized by the Bank of England. Corporate banking flourished after legislation in 1858 approved limited liability for stock-issuing banks. The banking system, however, failed to preserve the large number of institutions typical of U.S. banking. At the turn of the 20th century, a wave of bank mergers reduced both the number of private and stock-issuing 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 the Bank of England. Clearing banks sort and then forward checks to the bank from which they were originally drawn for payment. Two changes have occurred since then: The Bank of England was nationalized (became government-owned) in 1946 by the postwar Labour government; and in 1968 a merger among the largest five clearing banks left the industry in the hands of four: 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).

The larger clearing banks, with their national branch networks, dominate British banking. 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 such as consumer and housing finance and merchant banking. The dominance of the clearing banks was challenged in recent years by the rise of “parallel markets,” encompassing financial activities by smaller banking houses, building societies (banking institutions similar to SLAs in the United States), and other financial concerns, as well as local government authorities. The major banks responded to this competition by offering new services and competitive terms.

A restructuring in the banking industry took place in the late 1970s. The Banking Act of 1979 formalized Bank of England control over the British banking system, which was 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.

D

Developing Countries

The type of national economic system that characterizes developing countries plays a crucial role in determining the nature of the banking system in those countries. In capitalist countries a system of private enterprise in banking prevails. In state-managed economies, banks have been nationalized. Other countries have patterned themselves after the social-democracies of Europe; in Egypt, Peru, and Kenya, for instance, government-owned and privately owned banks coexist. In many countries, the banking system developed under colonialism, with banks owned by institutions in the parent country. In some, such as Zambia and Cameroon, this heritage continued, although modified, after decolonization. In other nations, such as Nigeria and Saudi Arabia, the rise of nationalism led to mandates for majority ownership by the indigenous population.

Banks in developing countries are similar to their counterparts in developed nations. Commercial banks accept and transfer deposits and are active lenders, especially for short-term purposes. Other financial intermediaries, particularly government-owned development banks, arrange long-term loans. Banks are often used to finance government expenditures. The banking system may also play a major role in financing exports.

VIII

INTERNATIONAL BANKING

The expansion of trade in recent decades has been paralleled by the growth of multinational banking. Banks have historically financed international trade, but a notable recent development has been the expansion of branches and subsidiaries that are physically located abroad, as well as the increased volume of loans to foreign borrowers. In 1960 only eight U.S. banks had foreign offices with a total of 131 branches. By 1998 about 82 U.S. banks had about 935 foreign branches.

Similarly, the number of foreign banks with offices in the United States has increased dramatically. In 1975, 79 foreign banks were chartered in the United States, accounting for 5 percent of U.S. bank assets. In 1998, 243 foreign banks had U.S. offices, accounting for 23 percent of U.S. bank assets. Most of these banks are business-oriented banks, but some have also engaged in retail banking. In 1978 the U.S. Congress passed the International Banking Act, which imposed constraints on the activities of foreign banks in the United States, removing some of the advantages they had acquired in relation to U.S. banks.

As banks make more international loans, many experts believe that there must be greater international cooperation regarding standards and regulations to lower the risk of bank failure and international financial collapse. In 1988 the Basel Committee on Banking Supervision, an international organization of bank regulators based in Basel, Switzerland, took the first steps in this direction with the Basel Capital Accord. The accord established a global standard for assessing the financial soundness of banks and required banks to maintain a minimum ratio of capital to risky assets. Many banking experts believe this accord became the primary tool for strengthening the safety of international banking. The accord was eventually adopted by 100 countries. In 2001 the Basel Committee recommended a new set of regulations known as the New Basel Capital Accord to replace the 1988 agreement.

IX

HISTORY OF BANKING

A

Origins of Banking

Many of today’s banking services were first practiced in ancient Lydia, Phoenicia, China, and Greece, where trade and commerce flourished. The temples in Babylonia made loans from their treasuries as early as 2000 bc. The temples of ancient Greece served as safe-deposit vaults for the valuables of worshipers. The Greeks also coined money and developed a system of credit. The Roman Empire had a highly developed banking system, and its bankers accepted deposits of money, made loans, and purchased mortgages. Shortly after the fall of Rome in ad 476, banking declined in Europe.

The increase of trade in 13th-century Italy prompted the revival of banking. The moneychangers of the Italian states developed facilities for exchanging local and foreign currency. Soon merchants demanded other services, such as lending money, and gradually bank services were expanded.

The first bank to offer most of the basic banking functions known today was the Bank of Barcelona in Spain. Founded by merchants in 1401, this bank held deposits, exchanged currency, and carried out lending operations. It also is believed to have introduced the bank check. Three other early banks, each managed by a committee of city officials, were the Bank of Amsterdam (1609), the Bank of Venice (1587), and the Bank of Hamburg (1619). These institutions laid the foundation for modern banks of deposit and transaction.

For more than 300 years, banking on the European continent was in the hands of powerful statesmen and wealthy private bankers, such as the Medici family in Florence and the Fuggers in Germany. During the 19th century, members of the Rothschild family became the most influential bankers in all Europe and probably in the world. This international banking family was founded by German financier Mayer Amschel Rothschild (1743-1812), but it soon spread to all the major European financial capitals.

The Bank of France was organized in 1800 by Napoleon. The bank had become the dominant financial institution in France by the mid-1800s. In Germany, banking experienced a rapid development about the middle of the 19th century with the establishment of several strong stock-issuing, or publicly owned, banks.

Banking in the British Isles originated with the London goldsmiths of the 16th century. These men made loans and held valuables for safekeeping. By the 17th century English goldsmiths created the model for today’s modern fractional reserve banking—that is, the practice of keeping a fraction of depositors’ money in reserve while extending the remainder to borrowers in the form of loans. Customers deposited gold and silver with the goldsmiths for safekeeping and were given deposit receipts verifying their ownership of the gold deposited with the goldsmith. These receipts could be used as money because they were backed by gold. But the goldsmiths soon discovered that they could take a chance and issue additional receipts against the gold to other people who needed to borrow money. This worked as long as the original depositors did not withdraw all their gold at one time. Hence, the amount of receipts or claims on the gold frequently exceeded the actual amount of the gold, and the idea that bankers could create money was born.

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History of Banking in the United States

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Bank of North America

The first important bank in the United States was the Bank of North America, established in 1781 by the Second Continental Congress. It was the first bank chartered by the U.S. government. Other banks existed in the colonies prior to this, most notably the Bank of Pennsylvania, but these banks were chartered by individual states. In 1787 the Bank of North America changed to a Pennsylvania charter following controversy about the legality of a congressional charter. Other large banks were chartered in the early 1780s by the various states, primarily to issue paper money called bank notes. These notes supplemented the coins then in circulation and assisted greatly in business expansion. The banks were also permitted to accept deposits and to make loans.

Because there were no minimum reserve requirements on deposits, bank notes were secured by the assets of the issuing banks. Most assets took the form of business loans. The only restraint on a bank’s ability to extend loans was the public’s unwillingness to accept its notes. Acceptance of a bank’s notes usually was determined by the bank’s record in exchanging the notes for coins when called upon to do so. Since most of them were able to do this, the early banks enjoyed wide latitude in granting loans.

In 1791 the federal government chartered the Bank of the United States, commonly referred to as the “First” Bank of the United States, to serve both the government and the public. One-fifth of the bank’s capital was supplied by the federal government. The bank was a repository of government funds and a source of loans for individuals and the federal and state governments. The charter of the “First” Bank of the United States was allowed to lapse in 1811, in part because half of its stock was owned by foreigners but also because of opposition to the bank by more than 80 state-chartered banks. The main reason for the conflict between state banks and the “First” Bank of the United States was that the public preferred the notes of the Bank of the United States because of the bank’s excellent reputation. This made it difficult for state banks to attract customers.

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Second Bank of the United States

During the War of 1812, hard currency (coins) became scarce and many state banks stopped redeeming their notes for coins. This brought into question the underlying value of bank notes and limited their use as money. At the same time, however, banks began increasing the amount of notes they issued. This rapid increase in paper money caused prices to rise and created inflation. These developments created a demand for establishing the “Second” Bank of the United States, which was chartered in 1816. The bank had a stormy career. Many local bankers who had to compete with this government-sponsored bank opposed it, as did President Andrew Jackson. As a result of Jackson’s opposition, the federal government withdrew its deposits in 1833, and three years later, when the bank’s charter was not renewed, it went out of existence.

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Free Banking and the Safety Fund System

In 1838 New York State passed a free banking law. Before this date all incorporated banks had been chartered by states and had been granted the note-issuing privilege. Under free banking, charters could be obtained without a special act of the state legislature. The main requirement for new banks was that they post collateral of government bonds equal in value to the notes to be issued. In principle, noteholders were protected because, if the bank failed, proceeds from the sale of the collateral would be used to reimburse them. Free banking was soon adopted by other states. Because there was little regulation of new banks, many banks failed and bank fraud occurred. The free-banking years of 1837 to 1863 are also known as the Wildcat Banking era.

In New England, however, the Suffolk Bank in Boston, Massachusetts, had redeemed bank notes of out-of-town banks only if they kept on deposit amounts large enough to cover the redemptions. Since Boston was a trade center, the pressure was great on all New England banks to accept this system, known as the Suffolk banking system. Practically all New England banks had joined the system by 1825.

In the early 1800s New York State also developed the safety fund system, under which each member bank contributed a small percentage of its capital annually to a state-managed fund. The purpose of the fund was to protect noteholders in the event of bank failure. In 1842 Louisiana enacted legislation to limit the number of banks and to require them to maintain one-third of their assets in cash and two-thirds in short-term obligations.

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The National Banking Act of 1863

The Civil War (1861-1865) brought about the National Banking Act of 1863, and with it a fundamental change in the structure of commercial banking in the United States. Originally named the National Currency Act, but later amended and renamed, the National Banking Act created the system known as dual banking, in which banks could have either a state or federal charter. This system still exists in the United States. The act established the Office of the Comptroller of the Currency in the Department of the Treasury and gave it the power to issue national bank charters to any bank that met minimum requirements. The philosophy of relatively “free banking” continued until 1935 when Congress made it more difficult to obtain a bank charter. The 1863 act allowed nationally chartered banks to issue a uniform bank note backed by U.S. government bonds. The amount of the notes was not to exceed 90 percent of the value of the bonds. Officials hoped that the issuance of uniform bank notes backed by the U.S. government would guarantee the value of bank notes and thereby produce a useful nationwide currency, while also inducing state banks to take out national charters. However, because the regulations accompanying a national charter were much stricter than state charters, a movement toward federal charters did not happen as planned. In 1865 the U.S. Congress enacted a 10 percent tax on any bank or individual paying out or using state bank notes. As a result of the tax, many banks converted to national charters, but many others simply stopped issuing their own notes. Instead, these state banks began to issue their customers demand deposit money—that is, checking accounts, instead of bank notes.

By the 1870’s, deposits were well established as a substitute for paper or coin currency, and state banks experienced a revival. State charters contained several advantages over federal charters. State-chartered banks were allowed to hold lower cash reserves relative to deposits, and less capital. State-chartered banks had more flexible branching opportunities and fewer restrictions on the types of loans that could be made.

The National Banking Act was successful in correcting some failings of the pre-Civil War commercial banking system. It produced a unified national paper currency consisting primarily of national bank notes. Bank crises, however, did not disappear. Panics occurred in 1873, 1884, 1893, and 1907, although the causes of these crises varied. Between 1873 and 1907, demand deposits far outweighed bank note circulation. At times some banks were unable to make immediate payment of demands on these deposits. Consequently these banks failed, and their depositors suffered losses of all or part of the money in their accounts.

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Federal Reserve Act of 1913

The financial panic of 1907 resulted in the Federal Reserve Act of 1913. This act went further than any earlier legislation in recognizing the importance of stable money and credit conditions to the health of the national economy. Under the Federal Reserve Act, a central bank was reestablished for the United States, the first since the “Second” Bank of the United States. The new bank was charged with maintaining sound credit conditions. To achieve this goal, the Federal Reserve System was given control over the minimum amount of reserves that member banks must hold for each dollar of deposits. It also obtained the power to lend money to member banks and regulate the types of assets they can hold. Members of the Federal Reserve System include national banks, whose membership is required, and state banks, whose membership is optional. Membership requires a bank to buy stock in the Federal Reserve System. Most large banks under state charter have joined the system.

World War I (1914-1918) brought about inflation and a sharp postwar recession (economic slowdown). Although the banks had bought large quantities of U.S. government bonds during the war, they also lent large amounts of money to individuals engaged in stock market speculation. By investing in bonds, banks helped finance government expenditures during the war and the attendant expansion of American productive resources in the decade following World War I. By lending money to speculators, they became a major factor in the climb of stock prices and the wave of speculation that resulted in the crash of 1929.

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Banking During the Great Depression

The Great Depression of the 1930s dealt a severe blow to the commercial banking industry. Many banks failed (went out of business) when their loans could not be repaid. The number of commercial banks declined from 26,000 in 1928 to about 14,000 in 1933. Total deposits in these banks declined by about 35 percent. Depositors rushed to retrieve their money, a process known as a run on the banks, and the federal government was forced to close all the banks for four days in 1933 to stem the panic. It became apparent to observers that the Federal Reserve System had not solved all the problems of bank stability.

Consequently, during the Great Depression, Congress recognized the importance of a sound banking system and created a number of agencies to restore public confidence in the banking system. Among the first of these was the Federal Housing Administration, which was created in 1934 to insure payment on home loans made by private lending institutions. The guarantee helped preserve the value of bank loans and enabled banks to continue to lend money to homebuyers.

The Banking Act of 1933, also known as the Glass-Steagall Act, created the Federal Deposit Insurance Corporation (FDIC) to insure bank deposits, increase the confidence of depositors, and therefore prevent bank runs. Federal Reserve member banks were required to join the FDIC. Membership was optional for other banks. The Glass-Steagall Act also set interest rate ceilings on deposits to reduce competition among banks, which was considered a cause of bank failures during the Great Depression. It also prevented banks from becoming too involved in investment-banking activities, such as underwriting stocks or bonds for companies. Underwriting, which typically involves selling stocks or bonds at a guaranteed price, can be risky and can cause banks to fail. The act also prevented banks from buying stock, which is a risky activity if the stock market crashes. This prohibition on investment-banking activities lasted until the 1980s.

The banking system began to recover in 1934. By 1937 deposits had reached pre-Depression levels. During World War II (1939-1945), deposits increased rapidly and more than doubled from 1941 to 1946. For the next 40 years the U.S. banking system went through a continuous expansion and modernization. In particular, there was an enormous increase in lending to consumers, through installment loans (loans for a fixed amount repaid in equal monthly payments) and credit card loans (loans for a varied amount repaid more flexibly).

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Banking After World War II

Some of the legislation enacted during the Great Depression and in the immediate postwar period began to have negative repercussions on the banking industry by the 1970s, according to some experts. Interest ceilings on deposits, which were required by the Glass-Steagall Act, prevented banks from competing with unregulated money market funds or even bonds issued by the U.S. Treasury. As people withdrew deposits to earn higher interest elsewhere (a process known as disintermediation), SLAs found it increasingly difficult to raise funds to make mortgage loans. Many SLAs went out of business. Disintermediation was not the only problem SLAs faced, however. Many SLAs decided to venture into business lending in the early 1980s with drastic consequences as commercial real estate markets collapsed. Many business loans went bad and forced even more SLAs out of business. In 1980, 3,998 SLAs existed in the United States. By 1992 the number had dwindled to only 2,039. There were 672 SLA failures from 1989 to 1992 alone and over 1,200 overall. The SLA crisis ultimately led to the collapse of the Federal Savings and Loan Insurance Corporation. It necessitated a restructuring of deposit insurance in the United States and a government bailout of the SLA industry that cost taxpayers an estimated $200 billion.

Restrictions on how banks could expand geographically also affected the industry. The Bank Holding Company Act of 1956 prohibited bank holding companies from acquiring banks across state lines. As a result of geographic limitations on expansions, banks were forced to operate primarily in local markets, which made banks particularly susceptible to local economic downturns. This act also restricted the activities of bank holding companies, limiting them to only those activities that were closely related to banking.

Legislation enacted in the 1980s and 1990s began to address these issues. The Depository Deregulation and Monetary Control Act of 1980 eliminated ceilings on interest rates. The 1994 Riegle-Neal Interstate Banking and Branching Efficiency Act legalized interstate banking, allowing banks to diversify geographically.

The most sweeping legislation, however, took place in 1999 when Congress removed most of the remaining provisions of the Glass-Steagall Act and replaced it with the Gramm-Leach-Bliley Act, named after Republican Party sponsors Phil Gramm, Jim Leach, and Thomas Bliley, Jr. The act also removed some of the restrictions of the Bank Holding Company Act of 1956 by permitting bank holding companies to engage in the full range of financial services, including lending, deposit taking, investment advising, insurance, stock and bond underwriting, and other investment banking services. The act did not, however, allow bank holding companies to own nonfinancial businesses. Many observers believe that the new law will increase the dominance of bank holding companies and lead to the establishment of so-called universal banks that offer a full array of financial services, including traditional banking services, insurance, investment advice, and stock and bond brokerage services. Critics of the law, however, caution that the new law, combined with the provisions of the 1994 act that ended restrictions on branching and allowed nationwide banking, may ultimately diminish competition for financial services in the United States.