A Primer On Banking And Financial Systems

Most of the individuals in this world understand very little about banks, banking, and financial systems.  Of course if one were to ask a primary or secondary teacher about the matter that teacher would not have given it much thought.  Those in the educational establishment are extremely ignorant of such practical matters that affect the lives of most everyone.  The average individual thinks a bank is where you deposit your paycheck, now often done electronically, and where one might have a debit card and perhaps a credit card in addition to the other credit cards that are issued to them.  And some may have a savings account that currently pays almost no interest.  Banks used to be where one went to obtain a mortgage to buy a house or an automobile.  One even could buy US Savings Bonds there, but alas, if you went to the teller and ask to buy one they might look at you funny.  For the most part, our conception of banks and banking is that it is a necessary evil.  And of course, there are many who do not have banking services because of income or location.

There are three classes of banks, or used to be until Congress and politicians decided to muddy the waters beyond belief.  I think we may do well to return to that system in the very near future.  The retail bank was the bank that served the local community.  One of the primary reasons for the existence of a bank in a community is that it became the distributor of the local currency.  Now currency is that exchange medium that has an official worth set by the prevailing government.  It is money or the medium of exchange, but do not confuse the two terms.  The idea of a storage and clearing house for currency was convenience.  Later on came the creation of credit other than currency.  This is important since the value of a currency is declared by a government in the exchange of goods and services.  With me so far?  Credit is actually something like that check many individuals used to write when purchasing goods and services.  Cash is immediate but not always practical.  A check was an IOU, a letter of credit, a promise to pay at a later date.  Why?  Because the check took time to “clear”, that is, there was a delay in the exchange of currency from the account of the check writer to the account of the check holder.  That delay was known as the float.  If all the accounts were held in one local bank the float was overnight at best.

Banks were established in modern times through the use of capital.  One started a bank by issuing stock certificates that would raise the necessary capital to establish a bank.  Banking laws have changed considerably over the centuries but this is still that basic process.  Why is it necessary to have initial capital?  Because banking is a business, a service for a fee.  The retail bank attracts customers through the promise of services such as savings accounts and checking accounts and credit in the form of various types of loans.  Banks also provide other services such a managing trusts (a sort of guardianship over the money contain therein – couldn’t resist the bit of legalese), origination of local government bond issues, the storage of currency, payroll services for larger companies, and the like.  Banks were the financial life blood of the local community.  The capital raised by the bank was then used to create credit.  That is, the bank made investments of a credit nature.  What are those investments?  Loans, pure and simple.  A local couple wants to buy a house but does not have the cash on hand to do so.  Where do they get that cash?  From the bank in the form of a mortgage, a lien on the property.  That loan is secured by the value of the property less the costs of default and resale.  That is why for so many decades the banks required a twenty percent payment by the buyer and only financed eighty percent of the purchase of the property.  The other requirement is that the couple have a sufficient cash stream (good job with prospects for continuation for several decades) to repay that mortgage.  With me so far?

A business wants to expand it operations.  Perhaps it manufactures goods and the demand for its goods is greater than what it can supply.  Rather than lose market share and allow competition to diminish its business, the answer is to enlarge the physical production through additions to buildings and capital equipment (capital equipment means that the equipment costs a lot and has a long life).  So the business wants to borrow money to pay for all these improvements.  Credit is the choice of financial means to expand.  True, it could issue stock or more stock if it is corporation.  But that would take far more time, as much as a year, depending on the capital markets.  Again, credit is based of the ability to repay the debt issued and the valuation of the assets (buildings, property, capital equipment, inventory, accounts receivable, etc).  Credit accelerates the business exchange of goods and services.  Of course credit comes at a cost, a claim on a portion of future income.  One of the first lessons taught to students in finance courses is the time value of money.  A dollar is worth more today that it is tomorrow, hence the delay is the use of that dollar has a cost.  Well, so far, so good.

The other service that a bank provides is the supply of ready cash or currency.  until such time as cash is outlawed and only the electric transfer of “electric” money or currency is allowed, individuals will always use cash in some transactions.  Imagine a beggar trying to obtain a donation from you when the only transaction is electronic.  One wonders how the local drug pushers would conduct business without the use of cash.  The old banking system provided other functions.  The bankers knew the community and who was more or less trustworthy and who wasn’t.  Just as the local priest know many of the sins of those in his parish the banker knows the financial sins of those who do business with his bank.  Not that all bankers were upright, honest, and moral.  Same for priests.  But as communities change, grow larger and individuals move away, so the same goes for banks.  What we see in the history of “economic development” is what economists call economies of scale.  The steel industry is a case in point.  Very small facilities such as the local blacksmith could turn out a little steel that was often of poor quality.  The amount of heat or energy component was high in ratio to the output of the product.  When someone discovered how to make better steel than the blacksmith by making the furnaces larger and controlling the process process better, not only did the product output increase but the unit cost decreased.  Steel making has been a history of continuous improvement in the quality, the increase in production percentage, and the concentration of production.  It is the great example of economy of scale.  Of course it is also the example of uncontrolled pollution (in the early days), labor strife, and monopolistic practices.  Every business have its evils.  Onward to the larger picuture.

There use to be a difference between commercial banks and investment banks.  Commercial banks, as the name implies, provides services to larger business and governments.  Investment banks were more concerned with investment opportunities such as brokerage services, foreign exchange services, and even international banking services.  Commercial banks served big business and big government.  If a big city wanted to issue bonds, they went to the commercial banker.  If the state government wanted to finance the building of a dam or bridge, they went to the commercial bank.  The investment bank also handled the issuance of corporate stock, bonds, debentures, and so forth.  But the significant difference was investment.  Now all banks, retail, commercial, and investment make most of their profits off investments.  That is, when on issues a mortgage the profit is the interest paid (rent on the money loaned, if you like).  That is where the paid-in capital comes in, that is the stock of money used to make a profit.  Bet the customer deposits are also used for the purposes of making a profit.  One can’t pay interest on the savings account unless that money in the account is making a larger profit for the bank.  One would usually use the 80/20 rule on these accounts.  Only 20 percent of the money in such accounts is actually withdrawn and 80 percent stays in the account.  For checking accounts the ratio is much different.  But any and all such accounts are used to make a profit by way of investment.  And such investments are spread over a wide range of risks.  You may have a thousand dollars in your savings that is used to finance property mortgages.  But you may have only one penny per mortgage at risk for any one mortgage.  This is the service that banks can provide, spreading the risk over a very large number of depositors.  Do you see how that is done?

So all banks will hold portfolios of mortgages, stocks that pay dividends, bonds that pay yearly fixed interest payments, and so forth.  They charge fees for bring to the stock market new issues of stocks.  They charge fees for bringing new bond issues to the markets, they charge fees to originate loans, they charge a lot of fees.  And in one way or another they expand the money supply by issuing credit or helping to issue it.  You see, credit is money.  It spends like money.  Don’t believe me?  Pull out your credit card.  What can you buy with it?  Just about anything.  Only the bum on the corner looking for pocket change can’t take your card as payment, he doesn’t have a card reader nor the services to use one.  That mortgage is credit and it buys the house, same as cash.  The difference is that credit, when used becomes a promise to pay using future earnings.  That is what debt is all about.

The problem we have with banks today is that we have exercised little control over their ability to create debt.  In fact, by changing the banking laws we have encourages the ever expanding credit creation to a point of no return.  You see, if one restricted banks to allowing no more that one dollar of capital to one dollar of risk (credit, for credit is risk), then there would be a limit on the amount of debt issues.  That’s like demanding that Congress be only allowed to pass budgets that spend dollar for dollar tax revenues.  Make deficit spending at all government levels illegal and we would not have a quarter of the problems we have today with finances and banking.  You see, that is what banks do, they encourage deficit spending at all levels.  Buying a house using a mortgage is deficit spending for the individual or couple or family.  The issuance of stock in a corporation is not deficit spending per se, one is buying the right to participate in the distribution of profits, if any.  But one is protected from loss by the corporation to the extent of the price paid by the individual per share of stock.  Yes, it is still risk, but so is life.  A corporate or municipal bond is credit and means that the entity is attempting to live beyond its means.  These are claims against future earnings.  The only earnings that cities have are taxes and grants from their individual state and from the federal government.  And the only income the federal government has is tax revenues (well, a few other very small streams on income such as fees and such).  I will stop here for the word weary.  Next chapter will be on the Federal Reserve System.


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