The Banking System: The Evolution of Banking

The Evolution of Banking In the Middle Ages, gold and silver were used as money in most European nations and for international trade. To avoid the inconvenience (and risk) of carrying around a wheelbarrow full of gold and coins, most merchants preferred to keep it in a sate place. They usually left it with goldsmiths or money changers who first placed it on benches (or counters) so it could be examined and weighed. This practice evolved into what is now known as banking. The word bank is derived from the Italian word for bench, which is banco. The goldsmiths of medieval England and the money changers of medieval Italy assessed the purity of the gold or coins before issuing depositors official receipts certifying the deposits. The depositors paid a fee for the storage service, just as you pay a fee for your checking account and other services at your bank. The deposit receipts soon began to circulate as a medium of exchange, which reduced the transaction costs by avoiding the inconvenience and risk of physically transporting gold in payment for goods and services. The holders of the receipts could at any time go to the goldsmiths and redeem the receipts for the stored gold. In effect, the receipts for the gold became paper currency.' At first, these early bankers issued no more receipts than the gold they had in the vault. If they had 10,000 ounces stored, the total receipts in circulation were for no more than 10,000 ounces. However, some of the more astute goldsmiths observed that while receipts were presented each day for redemption of gold, new deposits of gold offset the decline from the outflow and resulted in issuance of new receipts. This meant the goldsmiths could either loan out a portion of the gold on deposit for the use of others or issue more gold receipts than the actual gold available in the vault. On any given day the inflows and outflows of gold were quite predictable, and it was rare for more than 25 percent of the gold receipts outstanding to end up as net withdrawals on a given day. By making loans the goldsmiths could add to profits but would run little risk of being unable to meet the demand for withdrawals. The goldsmith made loans by issuing more receipts for gold than the actual gold in the vault. Because the gold receipts circulated as money, the goldsmiths actually created money by issuing receipts to borrowers for more gold than was in the vault! Fractional Reserve Banking The medieval goldsmiths and money changers were the first people to practice fractional reserve banking, in which a banking system can create checkable deposits by making loans in some multiple of the reserves it actually has on hand to pay withdrawals. If goldsmiths fully backed all their receipts (used 100-percent reserve banking), they would be unable to issue more gold receipts than the amount of gold in their vaults. They would have to keep enough reserves on hand to pay out all their deposits in cash on a given day. But suppose goldsmiths made loans equal to all the gold they had in their vaults. They would have created receipts for deposits even though the people receiving the loan proceeds would not have actually deposited gold in their vaults. If a goldsmith with 10,000 ounces of gold in the vault makes loans of 10,000 ounces to people who don't actually deposit gold, the goldsmith, who can now be called a banker, credits the accounts of the people receiving the loans with a "deposit" for 10,000 ounces of gold even though the customers don't actually deposit any gold. The borrowers are now free to use receipts for these "created"' deposits as money in making purchases. The fractional reserve ratio the banker is operating under is the ratio of actual cash reserves (which in this case is the gold) in the vault to total receipts for deposits. In this case the fractional reserve ratio would be The gold held in the vault is sufficient to pay out only half the actual receipts the banker has issued. The fractional reserve is only 50 percent of actual deposit receipts. This sounds very risky, but it really isn't. The banker knows from experience that because of daily inflows of new deposits, the new outflow of the reserves is almost never more than 25 percent of the gold receipts that have been issued. A banker who wants to earn even more interest income on loans may use a lower fractional reserve ratio. If it's highly unlikely that more than 20 percent of receipts issued for deposits will be redeemed in gold on any given day, the banker may find it prudent and profitable to loan out four times as much gold as is actually in the vault! The fractional reserve ratio for this banker would be 0.20. The banker would issue receipts for the 10,000 ounces of gold on deposit plus receipts for an additional 40,000 ounces of loans for which no gold is deposited. The fractional reserve ratio is, therefore, 10,000/50,000 = 0.20. A banking system that held 100-percent cash reserves for currency deposited by its customers would be unable to create checkable deposits to make loans. The 100-percent reserve system would be very safe for a banking system because the system could meet its customers' demand for currency in the unlikely event that all customers would simultaneously close their accounts. But like most businesses, banks must weigh safety considerations against profitability. Banks therefore use a fractional reserve system and earn interest income on the checkable deposits they create when they make loans. In the United States, banking operations and practices are closely supervised by the Federal Reserve System, the U.S. Comptroller of the Currency, the Federal Deposit Insurance Corporation, and a multitude of state regulatory agencies. The purpose is to maintain confidence in the banking system to prevent "panics" that might cause depositors to try to withdraw abnormally high percentages of total deposits on a given day.