Banking, explained
Where your money is (usually) safe and sound
The inner workings of banking are often enigma-like to the average person. We know they keep our money, do stuff with that money, and in return give us credit cards to use. Other than that, this supposedly crucial institution is hidden under layers of financial jargon. In this article, we’re going to demystify banking.
Where did banking come from?
There isn’t a clear answer, but evidence suggests that the concept may have begun in ancient Assyria and Babylonia (both in the Middle East) with merchants (people who trade commodities, usually with foreign countries). They loaned grain within a barter system, in which people directly traded goods and services rather than money. So instead of purchasing an apple for $2, you’d purchase an apple for say, 2 bananas.
Lenders from ancient Greece, China, and India as well as the Roman Empire added 2 new features to this system: they accepted deposits, meaning they kept people’s money, and they exchanged different currencies. However modern banking has its roots in Renaissance Italy. Here is what historians would generally refer to as the first official banks, with some of the most famous ones such as the Medici Bank or the Banco di San Giovanni, being founded.
The success of Renaissance-era banking led to the practice being spread in England, where merchants stored their gold in private vaults and charged a fee for the service. Goldsmiths eventually began lending money out on behalf of the depositor and banknotes (a legal instrument in which the issuer premises in writing to pay a sum of money to the other) were also introduced.
Why do we need banks?
Banks, at their core, are essentially safe places to store wealth. But the wealth doesn’t just sit there - banks connect savers and borrowers. People keep their money in banks and receive interest for doing so. Think of this interest as a reward for the saver’s trust.
The bank takes this money and lends it out to other people at a much higher interest rate. Some borrowers won't be able to pay back their loan, thus the bank just loses that money. So how does the bank manage their loans and distinguish between good and bad borrowers? Credit is a way of measuring the trust of a borrower. People with good credit ratings (usually over 670 out of 800) will qualify more easily for a loan than people with bad credit ratings (usually below 580).
This ensures that the money (which is technically the saver’s money) isn’t just being thrown around here and there, but it’s instead being invested productively, in projects that will succeed and thus allowing the borrower to pay back the loan along with the interest. This is how banks profit and spur economic growth; through taking unused money and turning it into funds that society can use in a constructive fashion, such as buying a home or expanding business - money is being used productively.
How banks create money
You’re probably familiar with that “money printer go brrrr” meme, which depicts a group of questionable-looking Federal Reserve officials printing cash like there’s no tomorrow. Contrary to popular belief, most money is created when banks accept deposits and make loans.
To understand how, we need to quickly go over a couple of concepts:
Assets: everything the bank owns (the building, loans, etc)
Liabilities: everything the bank owes (deposits, loans from other banks, etc)
Stockholder equity: ownership of the bank represented as shares of stock
With these terms, we get an equation:
Assets = liabilities + stockholder equities.
So if a bank has $100 in assets and $50, this means they have $50 in stockholder equities ($50 in liabilities + $50 in stockholder equities gives us $100 in assets). There are a few other banking terms to know:
Capital requirements: the minimum amount of cash that a bank must set aside by law to ensure that they have something to fall back on in case of an emergency
Excess bank reserves: funds that are available for lending
Required bank reserves: goes hand-in-hand with capital requirements, it’s the cash set aside by law
Reserve ratio: the percentage of deposits that the bank cannot lend. In the United States for example, large banks are subject to a 10% required reserve ratio.
Most money is created when a bank lends its excess reserves. For example, if a person deposits $100 into their account in Bank A, this creates excess reserves of $90 (assuming we’re going with a 10% required reserve ratio). Let’s assume that the bank lends this $90 to person B who uses it to purchase a pair of headphones, in which case the headphone seller deposits this money into Bank B. And just like that, $100 grew to $190. Money has just been “created.”
It initially seems to be just rerouting money, but remember, the $100 that the initial depositor had is still his $100 - it’s just been loaned out. In his bank account, the initial depositor still has $100 in Bank A. Moreover, he can withdraw the $100 since the bank has a reserve. But the $90 loan Bank A loaned to person B increased money supply, so long as the $90 is subsequently deposited into Bank B.
With that $90 Bank B has just received, they now have $81 in excess reserves which is then loaned out and re-diposited. This process continues until all excess reserves are loaned out.
Banks are arguably the most important institution in an economy. Along with holding nearly all of a country’s assets and wealth, they also make sure it’s put to good use. The original concept that the Assyrians and Babylonians first came up with was deceptively simple yet brilliant. Who knew it would centuries later expand into the central cog of the global economy?