Banking; House Of Cards?

 In this blog I will discuss:

·       Origins of banks and how they became rich (Part 1)

·       The economics of banking and why is it still being used (Part 2)

Part 1:

Banks have been in existence for centuries to do a few basic purposes:

1.        To hold people’s money, so they can withdraw and use it whenever they want

2.       To Give out loans, to people who want to start a business or purchase expensive things like houses or cars

3.       To make a currency like modern day central banks do, so that the society doesn’t have to barter to get their desired products.

However, it was not always like this. The system’s foundations began with humble beginnings, in the shops of individual goldsmiths. This is due to gold being a universally accepted currency as it is value dense as small coins could pay for large sums, the coins didn’t corrode, they were easy to mint (turn to currency), and they were in a limited supply. Therefore, gold became the standard currency of the world and took over from bartering systems and other forms of payment.

Nevertheless, it had its flaws, firstly, being difficult to prove whether it was true gold. Secondly, it was difficult to make exact change as a fraction of a lump of gold was impossible to give, and lastly, it was difficult to keep safe. However, there was a solution to the first two problems- goldsmiths, through a good reputation, they could cast coins with guaranteed purity and weight; and if the seal of the coin was kept well, people could judge the purity and weight of the coin. This entire system was based solely on the trust people had for the smiths; and due to this, people relied on them to keep their gold safe.  This method was also lucrative for the smiths as this was passive income which they received interest for the safety of the money. This also takes place today through negative interest deposits which allow people to assure safety of their wealth.

This was only capitalised on after the smiths started to commodify their trust. They did this through writing receipts for the gold and giving them to depositors to claim their gold whenever they desired. However, people found it easier to exchange these receipts as they were not nearly as heavy as gold, and they were much easier to pay large sums of wealth to another person. The bankers lent out some of their gold directly to depositors, but most of their fortune came from writing out receipts and giving them out as people began to trust these receipts as a method of currency. This meant that they could write out more gold than they had which allowed the goldsmiths to give out receipts when anyone asked them for a loan. The borrower could use these to make any purchase they needed to, the goldsmith would get interest on money that never existed, and the trust people had on goldsmiths never wavered.

This is a win-win, but is it? There was one fatal flaw in the system that would lead into the goldsmith to become bankrupt. It is known as a bank run. Imagine a scenario where too many receipts are handed out and people try to withdraw gold from a bank based on the receipts. If one of these people cant withdraw their promised gold and finds out that it never existed, it would cause all the people to lose faith in the bank.  Everyone would attempt to withdraw as much gold as they possibly could before all of it ran out. And before the bank has enough time for them to regain all the gold, they would lose all their wealth that they accumulated, and go bankrupt. Therefore, this whole system is centred around people rarely withdrawing the gold. Thus, to combat this ever taking place, there was a solution- central banks.

Part 2:

Central banks are the by-product of the banks realising that their success was very much dependent on the success of surrounding competition. If one bank faced a bank run, all banks in the region would face one, due to the widespread panic it would cause the customers of all the banks. Therefore, a central banking system was engineered, as a bank to other banks. If one bank faced too many withdrawals, the central bank would relocate assets from one gold-rich bank to the bank that required it. This was a means to safeguard against the chance of a bank run. This meant that the central bank would control the currency of all the banks under its jurisdiction. However, if the public lost faith in this currency, the whole system would be made redundant- all the country’s savings would be nullified and there would be no back up options unlike if the banks were to be independent.

This also posed a political issue. Would an entity, outside of the government, controlling the complete monetary system not be destabilising to a nation? This is true to a certain extent as banks in general are very powerful, very complicated, and very opaque. However, while the role of modern-day banks is to predominantly serve as financial intermediaries, they are also tasked with the job of making up money. Money used to be backed by gold, but that is no longer the case after the 1970s as the USD, the world reserve currency and the last currency in the world which used gold-based money, moved away from gold, and caused every currency on the world to be worth only as much as somebody is willing to trade for it, allowing financial institutions to create more wealth.

Banks, to this day use traditional schemes to give out money, just like the goldsmiths, by handing out loans without any shifting of assets (creating money). This can work as the dollars no longer have any real value attached to them, thus the loan that is given out to someone is real as it contains a repayment of dollars which is required to be paid. And the currency is artificially told to have value - thus making the bank money, allowing the debtor to gain money.

The bank gives value to their currency in 2 separate methods- first, by demanding the repayment of debts to be done in the local currency: and second, by asking the government to collect taxes in the currency. Society functions on this very well as bank loans will continue to increase in real value if they are not repaid in the currency and the punishment for tax evasion is imprisonment therefore currency has value.

This makes banks originators of wealth which gives them their immense power. However, originating wealth for long durations of time creates a different type of bank run. If too many people try to repay their debts too quickly, bank notes will not be able to make up enough value to repay the debt that has been accumulated. As of July 2021, the public debt of the United States was around 28.43 trillion U.S. dollars. On the other hand, there is approximately US $37 trillion in circulation: this includes all the physical money and the money deposited in savings and checking accounts in the entire world. For perspective, for every 1 dollar there is in circulation there is 7.81 dollars’ worth of debt across the world. All this sounds bad as banks only operate on the knowledge of ever-increasing debt but in truth, this system isn’t all that bad, the system works fantastically to allocate capital and increase peoples’ willingness to spend. If productive output increases more than debt figures by a small margin, only positive things would happen such as price reductions as businesses would be forced to compete for a relatively smaller cash supply.

All in all these banks aren’t any different to normal businesses, they have their own share-holders to keep happy and are profit minded.