Category: Your Money

Today we’ll talk a little about the history of banking…how modern banks as we know them came about. We shall also cover the important types of banks and the role of a central banking authority. As with last week, the source of a lot of this information is the book ‘An Introduction to Global Financial Markets’ by Stephen Valdez.

Background

In a lot of ways, modern banking owes its origins to the Italian merchants of the 13^th, 14^th and 15^th centuries. The merchants would sit in open air benches, called ‘banco’ in Italian, to do their money lending business, hence giving us the word ‘bank’. If the business went into liquidation, the bench would be officially broken, giving us the word ‘bancorupto’ or bankrupt! These  bankers were very advanced for their times, they used to do business with traders as far away as London, experimented with marine insurance, had book entry for money instead of physically transporting it and even double entry book keeping systems. Banknotes were invented in the UK by goldsmiths. Goldsmiths has secure vaults of gold and silver coins and would give out receipts for deposits and borrowings backed by gold coins. In fact, for a period of about 150 years goldsmiths were synonymous with bankers in the UK!

Types of banks

Commercial banks

These banks are involved in classic banking activities – taking deposits from investors in return for interest payments and lending money to individuals/businesses. Some commercial banks are into retail banking i.e. catering to the general public and small businesses. Some are into wholesale banking catering to large businesses and institutional investors. Wholesale banking usually involves lesser volumes of transactions than retail banking but the transactions are generally of much higher value.

Merchant and Investment banks

Merchant or Investment banking is the business of ‘helping people raise money’. These banks advice their clients on issues related to merging with or acquiring other companies, issuing new bonds or equity and deciding on the best way to raise capital. If the clients want to raise capital by issuing bonds or equity, these banks help them zero in on the right price, assist in selling the issue to investors and sometimes also underwrite the issue – i.e. buy the securities issued if investors do not.

In the UK, the terms Merchant banking and Investment banking are used interchangeably and mean the same. However, in the US, Merchant banking is used to the practice of applying the banks own capital in takeover/merger activities.

We will talk in more detail about Investment banking activities like Merger and Acquisitions (M&A), Initial Public Offerings (IPO) and underwriting in the coming weeks.

A bank’s balance sheet

A bank’s liabilities would include the shareholders equity plus any retained profits, customer deposits (the largest figure) and other borrowings (for e.g. bonds issued). The liabilities are money borrowed from others that the bank needs to repay at some point. Assets represent how this borrowed money has been utilized. The money may be held as cash reserves, invested in short term securities like money market funds (available at short notice), invested in other securities like Treasury bills, or may be in the form of property or equipment that cannot be easily liquidated. The balance sheet shows what the bank is worth at a particular point in time as the difference between the assets and liabilities will give the profit or loss for that period.

The role of the Central bank

In many countries, though not all, there is a central bank which oversees all the other banks and also serves as the market maker for the country’s economy and manages the government’s money. In some countries there is a separate authority other than the central bank for regulation. In general, the central bank plays the following roles –

1. Serves as a supervisor of the banking system
2. Maintains the economic health of the country
3. Issues bank notes
4. Serves as a banker to the government
5. Acts as a ‘lender of last resort’

The Central bank often mandates that all banks report their profit/losses, liquidity and any large exposures to it at regular intervals. It also has rules pertaining to the minimum amount of cash reserves that banks should maintain, called the liquidity ratio. Often, the Central bank requires banks to deposit a ‘balance of reserves’ with it. The idea behind this is that the banks should be able to repay investors even if a certain percentage of borrowers default on their loans. Thus, the banks should maintain a healthy capital ratio i.e. the ratio between its borrowing (capital) and lending.

Central banks maintain the economic health of the country by regulating interest rates. The concept is – as interest rates are raised, loan payments go up and so does the cost of borrowing money. Therefore, people have less money to spend and the price of goods has to be lowered to attract buyers. This leads to a recession like scenario.  Conversely, when interest rates are lowered, loan payments come down and the cost of borrowing is reduced. So, people go out and spend more. This boosts the economy and stimulates growth.

Central banks help governments raise money by handling government issues like bonds. The cumulative sum of money owed by governments by borrowing is called the national debt. Economists compare the national debt to the national income as a ratio to measure the country’s economic situation. For this purpose, the figure for Gross Domestic Product (GDP) is used as equivalent to the national income.

Finally, Central banks also help other banks temporarily when they meet problems with their liquidity. Though, given the current global economic problems, the term ‘lender of last resort’ has come to mean simply, the rescuer of banks in big trouble who are too big to fail!

Related articles

• EL-ERIAN: It’s Official – The World Needs To Worry About The Damage Caused By QE
• Volcker: Central banks are too aggressive
• Are Central Banks Putting Their Independence at Risk?
• UK economy: The radical options

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