COMMERCIAL BANKING

COMMERCIAL BANKING

One unit of currency is as good as another. If I borrow 100 units
from you and repay it later it makes no difference if some of
the notes are a bit dog-eared. Assuming no inflation, the value is
unchanged. Unlike if I use your horse to plough my field and it
comes back exhausted, in the case of money there is no deterioration
in its worth. Why pay interest on a loan, therefore?
Exactly this reasoning used to operate up until the Middle Ages.
To charge interest, to early traders and to many even today, is to
commit the sin of usury.
This argument, while understandable, is at odds with modern
economics. It ignores opportunity cost. Money is LIQUID CAPITAL – it
is capable of productive employment just like any other capital
good – and if it can be invested in some profitable enterprise then
I lose out if I loan that opportunity to you for free.
Modern Islamic banks are prohibited from lending money at
interest so they must instead find other ways to charge for their
services. One common solution is to become part owners, not
creditors, of an enterprise that they finance and so be entitled to a
share in any profits. That is, they thus receive DIVIDENDS on funds
invested, not interest on a loan.
Commercial banking for profit in the Christian world first started
in the Northern Italian states of Lombardy and Florence, where
certain families with wealth at their disposal held court for potential
entrepreneurs. People sat at benches (Italian bancos) to arrange
the loaning of monies and shrewd deals soon led to increases in
investment, production, trade and economic growth of all parties.
Northern Italy, therefore, prospered – fuelling the Renaissance, early
advances in science and the progress of European civilisation.
© 2004 Tony Cleaver
What banking then and now demonstrates is that by mobilising
idle funds – lending on the savings of some for the use of others –
society gains by employing all its resources. As demonstrated in
Chapter 4, capital that just accumulates in unproductive bank vaults
acts as a leakage from the society’s circular flow of incomes and
employment. The most important function of any banking system
is thus to circulate these funds from savers to investors and thus
stimulate increased production and exchange. For this reason all
banks and money lenders are known in aggregate as FINANCIAL
INTERMEDIARIES – mediating between those who have funds surplus
to their needs and those who have insufficient (Box 5.3).
Box 5.3 Banking for the poor
Banks are in business to lend money for profit. Their transaction
costs are reduced if they lend large sums to big, recognised, lowrisk
customers rather than making lots of small loans to poorer
individuals who might struggle to provide evidence of their trustworthiness.
In fact, of course, poor people who can offer little or
no COLLATERAL, or security, do not get loans.
In low-income countries in particular, only a small fraction of
the population holds bank accounts. If people in such countries
want to raise capital they typically go to informal moneylenders
or pawnbrokers. The rates of interest on loans that such agents
charge can be punitive – 50 per cent or more. In this way, creditors
can sometimes claim what few resources poor peasants
possess: a large share of the output of whatever is produced, for
example. Excluded from the formal banking sector, the poorest
stay poor.
How can these problems be avoided? Financing development
is so essential, yet how can poor communities ever raise capital
and fund economic growth if banks will not serve their needs?
One encouraging development is illustrated by the Grameen
Bank, or Village bank, in Bangladesh. This is a MICRO-CREDIT
scheme that its founder, Muhammad Yunus, set it up in 1983 on
the principle that a small amount of money would be loaned out
to a nominated individual in a group of rural poor. No collateral
© 2004 Tony Cleaver
THE CREATION OF MONEY
Financiers from Italy set up in London (in Lombard Street!) and
oversaw the next stage in the development of banking. By issuing
paper promises to return your gold to you whenever you so
demand, banks change the form of money that is used in everyday
transactions. Instead of gold exchanging hands in trade, promissory
notes do. The gold never leaves the bank, therefore – it is just transferred
from one person’s account to another’s. (Note, with several
competing banks it may be that after thousands of exchanges at the
end of a given trading period, the customers of bank A may owe
more to the customers of bank B than vice versa. This net sum is
thus transferred – there is no need to transfer gold from one bank
to another on each and every transaction.)
As the form of money circulating in the economy changes from
gold to paper this leaves banks with stockpiles of gold that are, in
effect, idle. This is too good an opportunity to miss! Consider that
there will always be a certain percentage of customers who will
return to their bank, cash in their promissory notes and claim their
gold. But so long as confidence in banks is maintained, relatively
is required but all members of the group sign up as witnesses to
the deal and have an incentive to ensure that the individual
sticks to the terms of the agreement and repays on time since
others then may become eligible for future loans. This banking
strategy turned out to be incredibly successful. Repayment rates
of 98 per cent were far better than those achieved in the regular
commercial bank sector.
Yunus reports (2003) that more than half a million houses
have been built with loans from the Grameen Bank. Five per cent
of borrowers come out of poverty each year. Housing conditions,
nutrition, health and education have all improved. As a result,
this initiative has been promoted by the World Bank and now
nearly 100 countries have introduced Grameen type micro-credit
programmes. By building on the one asset that poor people do
have – community spirit – there is hope that this ingenious
innovation can liberate the lives of millions from poverty.
© 2004 Tony Cleaver
few will do this. (After all, it is safer to hold your money in the
bank than to store it under your mattress at home.)
Suppose on an average day only 5 per cent of paper promises are
ever cashed in. This means that 95 per cent of banks’ gold holdings
are performing no economic purpose. Why not create more paper
promises therefore? People are always coming into banks asking for
loans. If they can be given bank notes, then the money supply can
be greatly expanded and more investment, production and trade
financed. Providing that banks are responsible and fund genuine
enterprise that increases the flow of goods and services in the
economy, then the growth in money circulating will be matched by
an increase in outputs. Inflation will not result.
In the previous example, a prudent bank might work on keeping a
safe ratio of 10 per cent gold in reserve. If it has 100 units of gold in its
vaults this means it can safely create up to 1000 units of banknotes.
Money creation is thus ten times the gold supply! You should see that
a more nervous, less confident banking system would need to keep
a higher RESERVE ASSETS RATIO and thus be able to create less money.
A more financially sophisticated, trusting society may have a much
smaller reserve and thus be able to create much more money.
The practice of modern FRACTIONAL RESERVE BANKING follows
from this observation. The difference today is that, again, the form
of money has changed. Now it is cash that banks hold in reserve
and loans/credit, exchanged by cheques or plastic cards, that forms
the bulk of the money supply.
What exchanges as money and thus becomes prudent to practice
in banking depends entirely on what society is willing to accept.
Over time, as a financial community gains a reputation for responsibility
and caution, so the smaller the reserve asset ratio it can
retain and thus the higher the MONEY MULTIPLIER it can employ. (In
the UK at the turn of the millennium, total money circulating in
the economy was 27 times official reserves, implying a reserve
assets ratio of 1 : 27 or 3.7 per cent.) At the same time, however,
banks have learnt the hard way when they have got it wrong –
when, for example, they have issued too many notes and kept
insufficient in reserve. If ever customers sense that a bank has made
more promises than it can keep then there follows an inevitable run
on the bank – everybody rushing to try and cash in their accounts
and, of course, in such circumstances very few can ever be saved.
© 2004 Tony Cleaver
CENTRAL BANKS AND THE MONEY SUPPLY
Individual bank collapses are relatively rare these days (though
financial panics are not! See later.) Central banks – such as the US
Federal Reserve, the Bank of England, The European Central Bank –
have grown up in all modern economies to regulate the practices of
private, commercial banks and moneylenders and in some countries
they still insist on a statutory minimum reserve assets ratio to try
and prevent over-lending. In fact central banks will offer to bail out
reputable financial institutions if ever they are caught short of
money. This is known as acting as the LENDER OF LAST RESORT.
Central banks control the issue of cash that forms the MONETARY
BASE of society. They also hold accounts of all recognised financial
intermediaries so that, for example, if bank A needs to transfer
money to bank B (as explained earlier) the easiest form of so doing
is to adjust their respective accounts in the country’s central bank
(Box 5.4).
In performing all these functions, the central bank at the heart of
a financial system is thus in a position to control, or rather to
attempt to control, the national money supply. The mechanisms