article on banking

8/8/2019 Article on Banking

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BankingI INTRODUCTIONBanking, the business of providing financial services to consumersand businesses. The basic services a bank provides are checkingaccounts, which can be used like money to make payments andpurchase goods and services; savings accounts and time depositsthat can be used to save money for future use; loans thatconsumers and businesses can use to purchase goods and services;and basic cash management services such as check cashing andforeign currency exchange. Four types of banks specialize inoffering these basic banking services: commercial banks, savingsand loan associations, savings banks, and credit unions.A broader definition of a bank is any financial institution thatreceives, collects, transfers, pays, exchanges, lends, invests, orsafeguards money for its customers. This broader definitionincludes many other financial institutions that are not usuallythought of as banks but which nevertheless provide one or more ofthese broadly defined banking services. These institutions includefinance companies, investment companies, investment banks,insurance companies, pension funds, security brokers and dealers,mortgage companies, and real estate investment trusts. Thisarticle, however, focuses on the narrower definition of a bank andthe 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 economysuch as that found in Canada and the United States. Bankingservices serve two primary purposes. First, by supplying customerswith the basic mediums-of-exchange (cash, checking accounts, andcredit cards), banks play a key role in the way goods and servicesare purchased. Without these familiar methods of payment, goodscould only be exchanged by barter (trading one good for another),which is extremely time-consuming and inefficient. Second, byaccepting money deposits from savers and then lending the moneyto borrowers, banks encourage the flow of money to productive useand investments. This in turn allows the economy to grow. Withoutthis flow, savings would sit idle in someones safe or pocket, moneywould not be available to borrow, people would not be able topurchase cars or houses, and businesses would not be able to buildthe new factories the economy needs to produce more goods andgrow. Enabling the flow of money from savers to investors is calledfinancial intermediation, and it is extremely important to a free


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market economy.II BANKING INSTITUTIONSBanking institutions include commercial banks, savings and loanassociations (SLAs), savings banks, and credit unions. The majordifferences between these types of banks involve how they areowned and how they manage their assets and liabilities. Asse ts ofbanks are typically cash, loans, securities (bonds, but not stocks),and property in which the bank has invested. L iab i l i t ies areprimarily the deposits received from the banks customers. They areknown as liabilities because they are still owned by, and can bewithdrawn by, the depositors of the financial institution.Until the early 1980s, the assets and liabilities of banks weretightly regulated. As a result, clear distinctions existed betweenthe activities and types of services offered by these different typesof banks. Although subsequent deregulation in the 1990s blurredthese distinctions, differences do remain.A Commercial BanksCommercial banks are so named because they specialize in loans tocommercial and industrial businesses. Commercial banks are ownedby private investors, called stockholders, or by companies calledbank holding companies. The vast majority of commercial banks areowned by bank holding companies. (A ho l d i ng com pany is acorporation that exists only to hold shares in another company.) In1984, 62 percent of banks were owned by holding companies. In2000, 76 percent of banks were owned by holding companies. Thebank holding company form of ownership became increasinglyattractive for several reasons. First, holding companies couldengage in activities not permitted in the bank itselffor example,offering investment advice, underwriting securities, and engaging inother investment banking activities. But these activities werepermitted in the bank if the holding company owned separatecompanies that offer these services. Using the holding companyform of organization, bankers could then diversify their productlines and offer services requested by their customers and providedby their European counterparts. Second, many states had laws thatrestricted a bank from opening branches to within a certain numberof miles from the banks main branch. By setting up a holdingcompany, a banking firm could locate new banks around the stateand therefore put branches in locations not previously available.Commercial banks are for profit organizations. Their objective isto make a profit. The profits either can be paid out to bank


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stockholders or to the holding company in the form of dividends, orthe profits can be retained to build capital (net worth). Commercialbanks traditionally have the broadest variety of assets andliabilities. Their historical specialties have been commerciallending to businesses on the asset side and checking accounts forbusinesses and individuals on the liability side. However,commercial banks also make consumer loans for automobiles andother consumer goods as well as real estate (mortgage) loans forboth consumers and businesses.B Savings and Loan AssociationsSavings and loan associations (SLAs) are usually owned bystockholders, but they can be owned by depositors as well. (Ifowned by depositors, they are called mutuals.) If stock owned, thegoal is to earn a profit that can either be paid out as a dividend orretained to increase capital. If owned by depositors, the objectiveis to earn a profit that can be used either to build capital or lowerfuture loan rates or to raise future deposit rates for the depositor-owners. Until the early 1980s, regulations restricted SLAs toinvesting in real estate mortgage loans and accepting savingsaccounts and t i m e depos i t s (savings accounts that exist for aspecified period of time). As a result, historically SLAs havespecialized in savings deposits and mortgage lending.C Savings BanksTraditional savings banks, also known as mutual savings banks(MSBs), have no stockholders, and their assets are administered forthe sole benefit of depositors. Earnings are paid to depositors afterexpenses are met and reserves are set aside to insure the deposits.During the 1980s savings banks were in a great state of flux, andmany began to provide the same kinds of services as commercialbanks.Since 1982 savings banks have been permitted to convert to SLAs.SLAs also may convert to savings banks. Both SLAs and MSBs cannow offer a full range of financial services, including multiplesavings instruments; checking accounts; consumer, commercial,and agricultural loans; and trust and credit card services. S ee a l soSavings Institutions.D Credit UnionsCredit unions are not-for-profit, cooperative organizations that areowned by their members. Their goal is to minimize the rate memberspay on loans and maximize the rate paid to members on deposits.


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Whatever surplus is earned is retained to build the capital of thecredit union. Members must share a common bond. That bond istypically employment (members all work for the same employers) orgeography (members all live in the same geographic area).Historically, credit unions specialized in providing automobile andother 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 tochecking accounts and time deposits.Credit unions, SLAs, and savings banks help encourage thriftinessby paying interest to consumers who put their money in savingsdeposits. Consequently, credit unions, SLAs, and savings banks areoften referred to as thrift institutions.Of the various types of banks in the United States, commercialbanks account for the greatest single source of the financialindustrys assets. In 2000 the 8,528 commercial banks in the UnitedStates controlled 24 percent of the financial industrys total assets.Commercial banks, however, have seen their share of financial-industry assets erode over time, as more money has shifted tomoney market and other mutual funds. In the mid-1990s, forexample, the approximately 11,000 commercial banks then inexistence controlled 27 percent of assets. In 1950 they controllednearly 50 percent of financial assets. Savings institutions share offinancial assets has also dropped from roughly 13 percent in 1950to 5 percent in 2000. Credit unions share has remained fairlyconstant at 2 percent.III BANKING SERVICESCommercial banks and thrifts offer various services to theircustomers. These services fall into three major categories:deposits, loans, and cash management services.A DepositsThere are four major types of deposits: demand deposits, savingsdeposits, hybrid checking/savings deposits, and time deposits. Whatdistinguishes one type from another are the conditions under whichthe deposited funds may be withdrawn.A demand deposit is a deposit that can be withdrawn on demand atany time and in any amount up to the full amount of the deposit. Themost common example of a demand deposit is a checking account.Money orders and travelers checks are also technically demanddeposits. Checking accounts are also considered transaction


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accounts in that payments can be made to third partiesthat is, tosomeone other than the depositor or the bank itselfvia check,telephone, or other authorized transfer instruction. Checkingaccounts are popular because as demand deposits they provideperfect l i qu id i ty (immediate access to cash) and as transactionaccounts they can be transferred to a third party as payment forgoods or services. As such, they function like money.Savings accounts pay interest to the depositor, but have no specificmaturity date on which the funds need to be withdrawn orreinvested. Any amount can be withdrawn from a savings accountup to the amount deposited. Under normal circumstances,customers can withdraw their money from a savings account simplyby presenting their passbook or by using their automated tellermachine (ATM) card. Savings accounts are highly liquid. They aredifferent from demand deposits, however, because depositorscannot write checks against regular savings accounts. Savingsaccounts cannot be used directly as money to purchase goods orservices.The hybrid savings and checking account allows customers to earninterest 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 savingsaccounts that allow a maximum of three third-party transfers eachmonth.Time deposits are deposits on which the depositor and the bankhave agreed that the money will not be withdrawn withoutsubstantial penalty to the depositor before a specific date. Theseare frequently called certificates of deposits (CDs). Because of asubstantial early withdrawal penalty, time deposits are not as liquidas demand or savings deposits nor can depositors write checksagainst them. Time deposits also typically require a minimumdeposit amount.B LoansBanks and thrifts make three types of loans: commercial andindustrial loans, consumer loans, and mortgage loans. Commercialand industrial loans are loans to businesses or industrial firms.These are primarily short-term working capital loans (loans tofinance the purchase of material or labor) or transaction or longer-term loans (loans to purchase machines and equipment). Mostcommercial banks offer a variable rate on these loans, which meansthat 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


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loan history of the borrower, the borrowers ability to makescheduled loan payments, the amount of capital the borrower hasinvested in the business, the condition of the economy, and thevalue of the collateral the borrower pledges to give the bank if theloan payments are not made.Consumer loans are loans for consumers to purchase goods orservices. There are two types of consumer loans: closed-end creditand open-end credit.Closed-end credit loans are loans for a fixed amount of money, for afixed period of time (usually not more than five years), and for afixed purpose (for example, to buy a car). Most closed-end loans arecalled installment loans because they must be repaid in equalmonthly installments. The item purchased by the consumer servesas collateral for the loan. For example, if the consumer fails tomake payments on an automobile, the bank can recoup the cost ofits loan by taking ownership of the car.Open-end credit loans are loans for variable amounts of money up toa set limit. Unlike closed-end loans, open-end credit does notrequire a borrower to specify the purpose of the loan and the lendercannot foreclose on the loan. Credit cards are an example of open-end credit. Most open-end loans carry fixed interest ratesthat is,the rate does not vary over the term of the loan. Open-end loansrequire no collateral, but interest rates or other penalties or feesmay be chargedfor example, if credit card charges are not paid infull, interest is charged, or if payment is late, a fee is charged tothe 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 landor buildings such as houses or factories. These are typically long-term loans and the interest rate charged can be either a variable ora fixed rate for the term of the loan, which often ranges from 15 to30 years. The land and buildings purchased serve as the collateralfor the loan. S ee Mortgage.C Cash Management and Other ServicesAlthough deposits and loans are the basic banking servicesprovided by banks and thrifts, these institutions provide a widevariety of other services to customers. For consumers, theseinclude check cashing, foreign currency exchange, safety depositboxes in which consumers can store valuables, electronic wiretransfer through which consumers can transfer money andsecurities from one financial institution to another, and credit life


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insurance which automatically pays off loans in the event of theborrowers death or disability.In recent years, banks have made their services increasinglyconvenient through e l ec t ron ic bank i ng . Electronic banking usescomputers to carry out transfers of money. For example, automatedteller machines (ATMs) enable bank customers to withdraw moneyfrom their checking or savings accounts by inserting an ATM cardand a private electronic code into an ATM. The ATMs enable bankcustomers to access their money 24 hours a day and seven days aweek wherever ATMs are located, including in foreign countries.Banks also offer debit cards that directly withdraw funds from acustomers account for the amount of a purchase, much like writinga check. Banks also use electronic transfers to deposit payrollchecks directly into a customers account and to automatically paya customers bills when they are due. Many banks also use theInternet to enable customers to pay bills, move money betweenaccounts, and perform other banking functions.For businesses, commercial banks also provide specialized cashm a n a g e m e n t and cred i t enhancem ent services. Cash managementservices are designed to allow businesses to make efficient use oftheir cash. For example, under normal circumstances a businesswould sell its product to a customer and send the customer a bill.The customer would then send a check to the business, and thebusiness would then deposit the check in the bank. The timebetween the date the business receives the check and deposits thecheck in the bank could be several days or a week. To eliminatethis delay and allow the business to earn interest on its moneysooner, commercial banks offer services to businesses wherebycustomers send checks directly to the bank, not the business. Thispractice is referred to as lock box services because the paymentsare mailed to a secure post office box where they are picked up bybank couriers for immediate deposit.Another important business service performed by banks is a cred i te n h a n c e m e n t. Commercial banks back up the performance ofbusinesses by promising to pay the debts of the business if thebusiness itself cannot pay. This service substitutes the credit of thebank for the credit of the business. This is valuable, for example, ininternational trade where the exporting firm is unfamiliar with theimporting firm in another country and is, therefore, reluctant to shipgoods without knowing for certain that the importer will pay forthem. By substituting the credit of a foreign bank known to theexporters bank, the exporter knows payment will be made and willship the goods. Credit enhancements are frequently called standby


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letters of credit or commercial letters of credit.IV BENEFITS FOR THE ECONOMYThe deposit and loan services provided by banks benefit aneconomy in many ways. First, checking accounts, because they actlike cash, make it much easier to buy goods and services andtherefore help both consumers and businesses, who would find itinconvenient to carry or send through the mail huge amounts ofcash. Second, loans enable consumers to improve their standard ofliving by borrowing money to purchase cars, houses, and otherexpensive consumer goods that they otherwise could not afford.Third, loans help businesses finance plant expansion and productionof new goods, and therefore increase employment and economicgrowth. Finally, since banks want loans repaid, banks chooseborrowers carefully and monitor performance of a companysmanagers very closely. This helps ensure that only the best projectsget financed and that companies are run efficiently. This creates ahealthy, efficient economy. In addition, since the owners(stockholders) of a company receiving a loan want their company tobe profitable and managed efficiently, bankers act as surrogatemonitors for stockholders who cannot be present on a regular basisto watch the companys managers.The checking account services offered by banks provide anadditional benefit to the economy. Because checks are widelyaccepted as payment for goods and services, the checking accountsoffered by banks are functionally equivalent to real moneythat is,currency and coin. When banks issue checking accounts they, ineffect, create money without the federal government having to printmore currency. Under government regulations in many countries,banks must hold a reserve of paper currency and coin equal to atleast 10 percent of their checking account deposits. In the UnitedStates banks keep these reserves in their own vaults or on depositwith the U.S. governments central bank known as the FederalReserve, or the Fed. If someone wants a $10 loan, the bank can givethat person a $10 checking account with only $1 of currency in itsvault. As a result U.S. banks can create at least $10 of checkingaccount money for every $1 of real money (currency or coin)actually printed by the federal government. This arrangement, whichallows extra deposit money to be created by banks, is referred to asa fractional reserve banking system.Because banks attract large amounts of savings from depositors,banks can make many loans to many different customers in variousamounts and for various matur i t ies (dates when loans are due).Banks can thereby diversify their loans, and this in turn means that


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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 evenmore loans. This flow of money from savers through banks to theultimate borrower is called financial intermediation because moneyflows through an intermediarythat is, the bank.V BANKING REGULATIONBanking is one of the most heavily regulated industries in theUnited States, and the regulatory structure is quite complex. Thisowes in part to the fact that the United States has a dual bankingsystem. A dual banking system means that banks and thrifts can bechartered and therefore regulated either by the state in which theyoperate 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 nationalbanks. The Office of the Comptroller of the Currency providesgeneral supervision of national banks, including periodic bankexaminations to determine compliance with rules and regulationsand the soundness of bank operations. The Office of ThriftSupervision (OTS) in the Treasury Department charters nationalsavings and loans (SLAs) and savings banks.The agencies that insure deposits in banks and thrifts also have arole in regulating them. Almost all banks and thrifts are federallyinsured by the Federal Deposit Insurance Corporation (FDIC). TheFDIC insures each depositor (not each separate deposit) for up to$100,000 in each bank or thrift in which the depositor has depositsand up to $250,000 for individual retirement accounts (IRAs) held ina bank or savings association. The Bank Insurance Fund (BIF) in theFDIC insures commercial bank and savings bank deposits. TheSavings Association Insurance Fund (SAIF) in the FDIC insuressavings and loan deposits. The National Credit Union ShareInsurance Fund (NCUSIF) in the National Credit UnionAdministration (NCUA) insures credit union deposits.The Federal Reserve is also responsible for regulating commercialbanks that are members of the Federal Reserve System and bankholding companies. As a result, a nationally chartered, federallyinsured, Federal Reserve member bank is subject to the regulationsof the OCC, BIF, and the Federal Reserve.The regulatory landscape is complicated further by the fact thatstate banking authorities regulate state-chartered banks andfrequently conduct their own examinations of state banks. To help


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sort out the maze of potential regulators, banks are assigned oneregulator with primary responsibility for examining the bank. Theprimary regulator of nationally chartered banks and thrifts is theOCC. The primary regulator of state-chartered banks that belong tothe Federal Reserve is the Federal Reserve. The primary regulatorof state-chartered banks that are not Fed members but are FDICinsured 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 lendinginstitutions act fairly and that bank customers are well informedabout banking services and practices. For example, the Truth-in-Lending Act (1968) and the Fair Credit and Charge Card DisclosureAct (1988) require lenders to disclose the true interest rate onloans on a uniform basis so that borrowers know the true cost ofcredit.The Fair Housing Act (1968) and the Equal Credit Opportunity Act(1976) prohibit discrimination against borrowers on the basis ofrace, color, religion, national origin, sex, marital status, age, orreceipt of public assistance. The Community Reinvestment Act(1977) requires banks, savings and loans, and savings banks tomeet the credit needs of their local communities. This act wasintended to prevent banks located in low-income areas fromrefusing loans to local residents, who were often members ofminority groups. The Truth-in-Savings Act (1991) mandates uniformdisclosure of the terms and conditions that banking institutionsimpose on their deposit accounts so that depositors know the trueinterest rate they receive on their deposits.VI CENTRAL BANKINGGovernments create central banks to perform a variety of functions.The functions actually performed vary considerably from country tocountry. Broadly speaking, central banks serve as the governmentsbanker, as the banker to the banking system, and as thepolicymaker for monetary and financial matters.As the governments banker, the central bank can act as therepository for government receipts, as the collection agent fortaxes, and as the auctioneer for government debt. It can also act asa lender to the government and as the governments advisor onfinancial matters. As the banker for the countrys banks, the centralbank can act as the repository for bank reserves, as the supervisorand regulator of banks, as the facilitator of interbank services suchas check clearing and money transfers, and as a lender when banks


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need money to honor deposit withdrawals or other needs forliquidity.As the countrys monetary policymaker, the central bank controlsthe amount of credit and money available, the level of interestrates, and the exchange ra te (the rate at which one nationscurrency can be exchanged for another nations). To achieve itsmonetary policy objectives, central bankers use a combination ofpolicy tools. For example, the central bank may increase ordecrease the amount of money (coin and currency) in circulation bybuying or selling government debt instruments, such as bonds, onthe open market. This policy tool is known as open marketoperations. Since interest rates are usually related to how muchmoney and credit are available in the economy, the central bank canusually lower interest rates by buying bonds from the public withmoney. This increases the amount of money in the economy andlowers interest rates. To raise rates, the authority would sell bonds,thereby reducing the amount of money available to the public. Thecentral bank could also cause a lowering or raising of interest ratesby increasing or decreasing the amount of money banks must holdas a reserve against their deposits. By increasing reserves, thecentral bank forces banks to hold more money in their vaults, whichmeans they can lend less money. Less money available for loansmakes loans harder to get which, in turn, causes banks and otherlenders to raise interest rates on loans.Central banks can be either privately owned or owned by thegovernment. In Europe, central banks are owned and operated bythe government. In the United States, commercial banks own thecentral bank, which is called the Federal Reserve. The FederalReserve, established in 1913, consists of a seven-person Board ofGovernors located in Washington, D.C., and the presidents of 12regional Federal Reserve Banks. Each member of the Board ofGovernors is appointed by the U.S. president and confirmed by theU.S. Senate for staggered 14-year terms. From among the sevengovernors, the president also designates and the Senate confirms achairman of the board for a four-year term. The Federal Reservesprimary policy group is called the Federal Open Market Committee(FOMC). It consists of the seven governors plus five regional FederalReserve Bank presidents. The FOMC is responsible for controllingthe money supply and interest rates in the United States.Because central banks control the money supply, there is alwaysthe danger that central banks will simply create more money andthen lend it to the government to finance its expenditures. Thisoften leads to excessive money creation and i n f la t ion (a continuous


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increase in the prices of goods), which can be caused by having toomuch money available to purchase goods. Inflation occurred in theUnited States when the government printed Continental dollars topay for the Revolutionary War. So many were printed that theybecame worthless, and a popular slogan of the day was Its notworth a Continental. The danger of inflation is particularly acute incountries where the government owns the central bank. Governmentownership of the central bank is illegal in the United States, exceptin national emergencies. European countries agreed in theMaastricht Treaty of 1992 not to allow central banks to lend moneyto their governments.VII BANKING IN OTHER COUNTRIES

A CanadaBecause of Canadas close historical relationship with the UnitedStates and the United Kingdom, development of the Canadianbanking system has been influenced by both countries. Unlike theUnited States, however, Canada always had a branch-bankingsystem. Until 1994 banks in the United States were restricted toopening branches only in the city or state where they wereincorporated. One of the first laws passed by Canadas Parliamentafter confederation, in 1867, allowed any Canadian-chartered bankto operate in any part of the dominion. This law encouraged thegrowth of Canadas branch-banking system, in which a few largebanks operate all the countrys banking offices. In 2000 there wereonly 13 domestic banks in Canada, and the six largest controlledmore than 90 percent of all bank assets in Canada. The remainingseven domestic banks accounted for about 2 percent of bankassets, and foreign banks accounted for about 7 percent of bankassets.The largest commercial banks of Canada operate extensively inforeign countries, particularly in the West Indies, Asia, and theUnited States. In addition to the usual business of commercialloans, Canadian banks operating in foreign countries havespecialized in investment banking and wealth-managementactivities.The regulator of federally chartered Canadian banks and financialinstitutions is the Office of the Superintendent of FinancialInstitutions (OSFI), which was established in 1987. Since 1967deposit insurance has been provided by the Canada DepositInsurance Corporation (CBIC), which insures up to $60,000 Canadian


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per depositor per institution. Both the OSFI and the CBIC are CrownCorporations 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 forCanadian monetary policy. Unlike the U.S. Federal Reserve, theBank of Canada is also responsible for issuing and managing thenational debt. In the United States, this function is performed bythe Department of the Treasury. The primary policy group of theBank of Canada is called the Governing Council. This group consistsof the governor of the Bank of Canada, the senior deputy governor,and four deputy governors. The Bank of Canada is less independentof the government than is the U.S. Federal Reserve because it mustconsult with the minister of finance on policy matters.B The European ContinentUntil recently, European banking was very different from banking inthe United States. European banks were frequently owned by thegovernment and could engage in activities that were prohibited tobanks in the United States. Most of these prohibited activitiesinvolved investment banking such as secu r i t y unde rwr i t ing (sellinga firms stock or bonds at a guaranteed price) or secu r i t y p l acem ent(finding buyers for a firms stock or bonds). These services areimportant to businesses and being able to provide them gaveEuropean banks an advantage over U.S. banks. These differencesare rapidly disappearing. Most European banks are now privatelyowned and recent U.S. legislation has allowed U.S. banks to engagein investment-banking activities through the bank holding companyform of organization.Two differences remain between U.S. and European banking. Thefirst is that many European banks can own nonbank commercial andindustrial businesses. Such ownership is still prohibited, for themost part, for U.S. banks and holding companies. As a result, banksin Europe tend to be more business oriented and much moreinvolved with corporate governance (corporate decision-making)than their U.S. counterparts. This also explains why most Europeancompanies rely more heavily on bank loans to finance theiractivities than do U.S. companies which rely more on funds raisedby selling stocks and bonds in financial markets.The second difference is that banking is much more concentrated inEurope. In other words, banking markets are dominated by a fewlarge banks whereas in the United States many banks compete for acustomers deposits and loans. This stems from the fact thatEuropean countries have had very liberal branching laws allowing


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banks to have extensive deposit-gathering networks in their homecountry and also from the fact that most European countries are notas concerned about monopolies as are U.S. regulators. It is notclear how long this difference will last, however, as legislation inthe United States in 1994 allowed banks to establish banks andbranches in other states.The establishment of the Economic and Monetary Union (EMU) in1992 created a new banking system in Europe that parallels that ofthe United States in many ways. The EMU created a new EuropeanCentral Bank (ECB) that will coordinate monetary policy throughoutmost of continental Europe. It also established a uniform currencyin Europe called the euro that beginning in 2002 was the currencyused throughout Western Europe, except in Denmark, Sweden, andthe United Kingdom. The EMU also allowed banks to branchthroughout Europe and not just in their home country.C United KingdomSince the 17th century Britain has been known for its prominence inbanking. The capital, London, still remains a major financial center,and virtually all the worlds leading commercial banks arerepresented there.Aside from the central Bank of England, which was incorporated,early English banks were privately owned rather than stock-issuingfirms. Bank failures were common; so in the early 19th century,stock-issuing banks, with a larger capital base, were encouraged asa means of stabilizing the industry. By 1833 these corporate bankswere permitted to accept and transfer deposits in London, althoughthey were prohibited from issuing money, a prerogative monopolizedby the Bank of England. Corporate banking flourished afterlegislation in 1858 approved limited liability for stock-issuingbanks. The banking system, however, failed to preserve the largenumber of institutions typical of U.S. banking. At the turn of the20th century, a wave of bank mergers reduced both the number ofprivate and stock-issuing banks.The present structure of British commercial banking wassubstantially in place by the 1930s, with the Bank of England, thenprivately owned, at the apex, and 11 London c l ea r ing banks rankedbelow the Bank of England. Clearing banks sort and then forwardchecks to the bank from which they were originally drawn forpayment. Two changes have occurred since then: The Bank ofEngland was nat iona l i zed (became government-owned) in 1946 bythe postwar Labour government; and in 1968 a merger among thelargest five clearing banks left the industry in the hands of four:


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Barclays, Lloyds (now Lloyds TSB Group), Midland (now part ofHSBC Holdings), and National Westminster (taken over by the RoyalBank of Scotland in 2000).The larger clearing banks, with their national branch networks,dominate British banking. They are the key links in the transfer ofbusiness payments through the checking system, as well as theprimary source of short-term business finance. Moreover, throughtheir ownership and control over subsidiaries, the big British banksinfluence other financial markets such as consumer and housingfinance and merchant banking. The dominance of the clearing bankswas 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 UnitedStates), and other financial concerns, as well as local governmentauthorities. The major banks responded to this competition byoffering 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 overthe British banking system, which was previously supervised on aninformal basis. Only institutions approved by the Bank of England asrecognized banks or licensed deposit-taking institutions arepermitted to accept deposits from the public. The act also extendedBank of England control over the new financial intermediaries thathave flourished since 1960.D Developing CountriesThe type of national economic system that characterizes developingcountries plays a crucial role in determining the nature of thebanking system in those countries. In capitalist countries a systemof private enterprise in banking prevails. In state-managedeconomies, banks have been nationalized. Other countries havepatterned themselves after the social-democracies of Europe; inEgypt, Peru, and Kenya, for instance, government-owned andprivately owned banks coexist. In many countries, the bankingsystem developed under colonialism, with banks owned byinstitutions in the parent country. In some, such as Zambia andCameroon, this heritage continued, although modified, afterdecolonization. In other nations, such as Nigeria and Saudi Arabia,the rise of nationalism led to mandates for majority ownership bythe indigenous population.Banks in developing countries are similar to their counterparts indeveloped nations. Commercial banks accept and transfer depositsand are active lenders, especially for short-term purposes. Other


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financial intermediaries, particularly government-owneddevelopment banks, arrange long-term loans. Banks are often usedto finance government expenditures. The banking system may alsoplay a major role in financing exports.VIII INTERNATIONAL BANKINGThe expansion of trade in recent decades has been paralleled by thegrowth of multinational banking. Banks have historically financedinternational trade, but a notable recent development has been theexpansion of branches and subsidiaries that are physically locatedabroad, as well as the increased volume of loans to foreignborrowers. In 1960 only eight U.S. banks had foreign offices with atotal of 131 branches. By 1998 about 82 U.S. banks had about 935foreign branches.Similarly, the number of foreign banks with offices in the UnitedStates has increased dramatically. In 1975, 79 foreign banks werechartered in the United States, accounting for 5 percent of U.S.bank assets. In 1998, 243 foreign banks had U.S. offices, accountingfor 23 percent of U.S. bank assets. Most of these banks arebusiness-oriented banks, but some have also engaged in retailbanking. In 1978 the U.S. Congress passed the InternationalBanking Act, which imposed constraints on the activities of foreignbanks in the United States, removing some of the advantages theyhad acquired in relation to U.S. banks.As banks make more international loans, many experts believe thatthere must be greater international cooperation regarding standardsand regulations to lower the risk of bank failure and internationalfinancial collapse. In 1988 the Basel Committee on BankingSupervision, an international organization of bank regulators basedin Basel, Switzerland, took the first steps in this direction with theBasel Capital Accord. The accord established a global standard forassessing the financial soundness of banks and required banks tomaintain a minimum ratio of capital to risky assets. Many bankingexperts believe this accord became the primary tool forstrengthening the safety of international banking. The accord waseventually adopted by 100 countries. In 2001 the Basel Committeerecommended a new set of regulations known as the New BaselCapital Accord to replace the 1988 agreement.IX HISTORY OF BANKING

A Origins of Banking


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Many of todays banking services were first practiced in ancientLydia, Phoenicia, China, and Greece, where trade and commerceflourished. The temples in Babylonia made loans from theirtreasuries as early as 2000 bc. The temples of ancient Greeceserved as safe-deposit vaults for the valuables of worshipers. TheGreeks also coined money and developed a system of credit. TheRoman Empire had a highly developed banking system, and itsbankers accepted deposits of money, made loans, and purchasedmortgages. Shortly after the fall of Rome in ad 476, bankingdeclined in Europe.The increase of trade in 13th-century Italy prompted the revival ofbanking. The moneychangers of the Italian states developedfacilities for exchanging local and foreign currency. Soon merchantsdemanded other services, such as lending money, and graduallybank services were expanded.The first bank to offer most of the basic banking functions knowntoday was the Bank of Barcelona in Spain. Founded by merchants in1401, this bank held deposits, exchanged currency, and carried outlending operations. It also is believed to have introduced the bankcheck. Three other early banks, each managed by a committee ofcity officials, were the Bank of Amsterdam (1609), the Bank ofVenice (1587), and the Bank of Hamburg (1619). These institutionslaid the foundation for modern banks of deposit and transaction.For more than 300 years, banking on the European continent was inthe hands of powerful statesmen and wealthy private bankers, suchas the Medici family in Florence and the Fuggers in Germany. Duringthe 19th century, members of the Rothschild family became themost influential bankers in all Europe and probably in the world.This international banking family was founded by German financierMayer Amschel Rothschild (1743-1812), but it soon spread to all themajor European financial capitals.The Bank of France was organized in 1800 by Napoleon. The bankhad become the dominant financial institution in France by the mid-1800s. In Germany, banking experienced a rapid development aboutthe middle of the 19th century with the establishment of severalstrong stock-issuing, or publicly owned, banks.Banking in the British Isles originated with the London goldsmithsof the 16th century. These men made loans and held valuables forsafekeeping. By the 17th century English goldsmiths created themodel for todays modern fractional reserve bankingthat is, thepractice of keeping a fraction of depositors money in reserve whileextending the remainder to borrowers in the form of loans.


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Customers deposited gold and silver with the goldsmiths forsafekeeping and were given deposit receipts verifying theirownership of the gold deposited with the goldsmith. These receiptscould be used as money because they were backed by gold. But thegoldsmiths soon discovered that they could take a chance and issueadditional receipts against the gold to other people who needed toborrow money. This worked as long as the original depositors didnot withdraw all their gold at one time. Hence, the amount ofreceipts or claims on the gold frequently exceeded the actualamount of the gold, and the idea that bankers could create moneywas born.A1 History of Banking in the United States

A1a Bank of North AmericaThe first important bank in the United States was the Bank of NorthAmerica, established in 1781 by the Second Continental Congress. Itwas the first bank chartered by the U.S. government. Other banksexisted in the colonies prior to this, most notably the Bank ofPennsylvania, but these banks were chartered by individual states.In 1787 the Bank of North America changed to a Pennsylvaniacharter following controversy about the legality of a congressionalcharter. Other large banks were chartered in the early 1780s by thevarious states, primarily to issue paper money called bank notes.These notes supplemented the coins then in circulation andassisted greatly in business expansion. The banks were alsopermitted 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. Mostassets took the form of business loans. The only restraint on abanks ability to extend loans was the publics unwillingness toaccept its notes. Acceptance of a banks notes usually wasdetermined by the banks record in exchanging the notes for coinswhen 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 UnitedStates, commonly referred to as the First Bank of the UnitedStates, to serve both the government and the public. One-fifth of thebanks capital was supplied by the federal government. The bankwas a repository of government funds and a source of loans forindividuals and the federal and state governments. The charter ofthe First Bank of the United States was allowed to lapse in 1811,


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in part because half of its stock was owned by foreigners but alsobecause of opposition to the bank by more than 80 state-charteredbanks. The main reason for the conflict between state banks andthe First Bank of the United States was that the public preferredthe notes of the Bank of the United States because of the banksexcellent reputation. This made it difficult for state banks to attractcustomers.A1b Second Bank of the United StatesDuring the War of 1812, hard currency (coins) became scarce andmany state banks stopped redeeming their notes for coins. Thisbrought into question the underlying value of bank notes and limitedtheir use as money. At the same time, however, banks beganincreasing the amount of notes they issued. This rapid increase inpaper money caused prices to rise and created inflation. Thesedevelopments created a demand for establishing the Second Bankof the United States, which was chartered in 1816. The bank had astormy career. Many local bankers who had to compete with thisgovernment-sponsored bank opposed it, as did President AndrewJackson. As a result of Jacksons opposition, the federalgovernment withdrew its deposits in 1833, and three years later,when the banks charter was not renewed, it went out of existence.A1c Free Banking and the Safety Fund SystemIn 1838 New York State passed a free banking law. Before this dateall incorporated banks had been chartered by states and had beengranted the note-issuing privilege. Under free banking, charterscould be obtained without a special act of the state legislature. Themain requirement for new banks was that they post collateral ofgovernment bonds equal in value to the notes to be issued. Inprinciple, noteholders were protected because, if the bank failed,proceeds from the sale of the collateral would be used to reimbursethem. Free banking was soon adopted by other states. Becausethere was little regulation of new banks, many banks failed andbank fraud occurred. The free-banking years of 1837 to 1863 arealso 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 onlyif they kept on deposit amounts large enough to cover theredemptions. Since Boston was a trade center, the pressure wasgreat on all New England banks to accept this system, known as theSuffolk banking system. Practically all New England banks hadjoined the system by 1825.


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In the early 1800s New York State also developed the safety fundsystem, under which each member bank contributed a smallpercentage of its capital annually to a state-managed fund. Thepurpose of the fund was to protect noteholders in the event of bankfailure. In 1842 Louisiana enacted legislation to limit the number ofbanks and to require them to maintain one-third of their assets incash and two-thirds in short-term obligations.A1d The National Banking Act of 1863The Civil War (1861-1865) brought about the National Banking Act of1863, and with it a fundamental change in the structure ofcommercial banking in the United States. Originally named theNational Currency Act, but later amended and renamed, the NationalBanking Act created the system known as dual banking, in whichbanks could have either a state or federal charter. This system stillexists in the United States. The act established the Office of theComptroller of the Currency in the Department of the Treasury andgave it the power to issue national bank charters to any bank thatmet minimum requirements. The philosophy of relatively freebanking continued until 1935 when Congress made it more difficultto obtain a bank charter. The 1863 act allowed nationally charteredbanks to issue a uniform bank note backed by U.S. governmentbonds. The amount of the notes was not to exceed 90 percent of thevalue of the bonds. Officials hoped that the issuance of uniformbank notes backed by the U.S. government would guarantee thevalue of bank notes and thereby produce a useful nationwidecurrency, while also inducing state banks to take out nationalcharters. However, because the regulations accompanying anational charter were much stricter than state charters, amovement toward federal charters did not happen as planned. In1865 the U.S. Congress enacted a 10 percent tax on any bank orindividual paying out or using state bank notes. As a result of thetax, many banks converted to national charters, but many otherssimply stopped issuing their own notes. Instead, these state banksbegan to issue their customers demand deposit moneythat is,checking accounts, instead of bank notes.By the 1870s, deposits were well established as a substitute forpaper 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 reservesrelative to deposits, and less capital. State-chartered banks hadmore flexible branching opportunities and fewer restrictions on thetypes of loans that could be made.The National Banking Act was successful in correcting some


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failings of the pre-Civil War commercial banking system. It produceda unified national paper currency consisting primarily of nationalbank notes. Bank crises, however, did not disappear. Panicsoccurred in 1873, 1884, 1893, and 1907, although the causes ofthese crises varied. Between 1873 and 1907, demand deposits faroutweighed bank note circulation. At times some banks were unableto make immediate payment of demands on these deposits.Consequently these banks failed, and their depositors sufferedlosses of all or part of the money in their accounts.A1e Federal Reserve Act of 1913The financial panic of 1907 resulted in the Federal Reserve Act of1913. This act went further than any earlier legislation inrecognizing the importance of stable money and credit conditions tothe health of the national economy. Under the Federal Reserve Act,a central bank was reestablished for the United States, the firstsince the Second Bank of the United States. The new bank wascharged with maintaining sound credit conditions. To achieve thisgoal, the Federal Reserve System was given control over theminimum amount of reserves that member banks must hold for eachdollar of deposits. It also obtained the power to lend money tomember 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 membershipis optional. Membership requires a bank to buy stock in the FederalReserve System. Most large banks under state charter have joinedthe system.World War I (1914-1918) brought about inflation and a sharp postwarrecess i on (economic slowdown). Although the banks had boughtlarge quantities of U.S. government bonds during the war, they alsolent large amounts of money to individuals engaged in stock marketspeculation. By investing in bonds, banks helped financegovernment expenditures during the war and the attendantexpansion of American productive resources in the decade followingWorld War I. By lending money to speculators, they became a majorfactor in the climb of stock prices and the wave of speculation thatresulted in the crash of 1929.A1f Banking During the Great DepressionThe Great Depression of the 1930s dealt a severe blow to thecommercial banking industry. Many banks fa i led (went out ofbusiness) when their loans could not be repaid. The number ofcommercial banks declined from 26,000 in 1928 to about 14,000 in1933. Total deposits in these banks declined by about 35 percent.


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Depositors rushed to retrieve their money, a process known as a runon the banks, and the federal government was forced to close allthe banks for four days in 1933 to stem the panic. It becameapparent to observers that the Federal Reserve System had notsolved all the problems of bank stability.Consequently, during the Great Depression, Congress recognizedthe importance of a sound banking system and created a number ofagencies to restore public confidence in the banking system. Amongthe first of these was the Federal Housing Administration, whichwas created in 1934 to insure payment on home loans made byprivate lending institutions. The guarantee helped preserve thevalue of bank loans and enabled banks to continue to lend money tohomebuyers.The Banking Act of 1933, also known as the Glass-Steagall Act,created the Federal Deposit Insurance Corporation (FDIC) to insurebank deposits, increase the confidence of depositors, and thereforeprevent bank runs. Federal Reserve member banks were required tojoin the FDIC. Membership was optional for other banks. The Glass-Steagall Act also set interest rate ceilings on deposits to reducecompetition among banks, which was considered a cause of bankfailures during the Great Depression. It also prevented banks frombecoming too involved in investment-banking activities, such asunderwriting stocks or bonds for companies. Underwriting, whichtypically involves selling stocks or bonds at a guaranteed price, canbe risky and can cause banks to fail. The act also prevented banksfrom buying stock, which is a risky activity if the stock marketcrashes. This prohibition on investment-banking activities lasteduntil the 1980s.The banking system began to recover in 1934. By 1937 deposits hadreached pre-Depression levels. During World War II (1939-1945),deposits increased rapidly and more than doubled from 1941 to1946. For the next 40 years the U.S. banking system went through acontinuous expansion and modernization. In particular, there was anenormous increase in lending to consumers, through installmentloans (loans for a fixed amount repaid in equal monthly payments)and credit card loans (loans for a varied amount repaid moreflexibly).A1g Banking After World War I ISome of the legislation enacted during the Great Depression and inthe immediate postwar period began to have negative repercussionson the banking industry by the 1970s, according to some experts.Interest ceilings on deposits, which were required by the Glass-


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Steagall Act, prevented banks from competing with unregulatedmoney market funds or even bonds issued by the U.S. Treasury. Aspeople withdrew deposits to earn higher interest elsewhere (aprocess known as disintermediation), SLAs found it increasinglydifficult to raise funds to make mortgage loans. Many SLAs went outof business. Disintermediation was not the only problem SLAs faced,however. Many SLAs decided to venture into business lending in theearly 1980s with drastic consequences as commercial real estatemarkets collapsed. Many business loans went bad and forced evenmore SLAs out of business. In 1980, 3,998 SLAs existed in theUnited States. By 1992 the number had dwindled to only 2,039.There were 672 SLA failures from 1989 to 1992 alone and over 1,200overall. The SLA crisis ultimately led to the collapse of the FederalSavings and Loan Insurance Corporation. It necessitated arestructuring of deposit insurance in the United States and agovernment bailout of the SLA industry that cost taxpayers anestimated $200 billion.Restrictions on how banks could expand geographically alsoaffected the industry. The Bank Holding Company Act of 1956prohibited bank holding companies from acquiring banks acrossstate lines. As a result of geographic limitations on expansions,banks were forced to operate primarily in local markets, whichmade 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 tobanking.Legislation enacted in the 1980s and 1990s began to address theseissues. The Depository Deregulation and Monetary Control Act of1980 eliminated ceilings on interest rates. The 1994 Riegle-NealInterstate Banking and Branching Efficiency Act legalized interstatebanking, allowing banks to diversify geographically.The most sweeping legislation, however, took place in 1999 whenCongress 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, andThomas Bliley, Jr. The act also removed some of the restrictions ofthe Bank Holding Company Act of 1956 by permitting bank holdingcompanies to engage in the full range of financial services,including lending, deposit taking, investment advising, insurance,stock and bond underwriting, and other investment bankingservices. The act did not, however, allow bank holding companies toown nonfinancial businesses. Many observers believe that the newlaw will increase the dominance of bank holding companies and


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lead to the establishment of so-called universal banks that offer afull array of financial services, including traditional bankingservices, insurance, investment advice, and stock and bondbrokerage services. Critics of the law, however, caution that thenew law, combined with the provisions of the 1994 act that endedrestrictions on branching and allowed nationwide banking, mayultimately diminish competition for financial services in the UnitedStates.

Reviewed By:James M. JohannesMicrosoft Encarta 2008. 1993-2007 Microsoft Corporation. Allrights reserved.

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