The term bank refers to an institution that deals in money and its substitutes and provides other financial services. Banks accept deposits, make loans, and derive a profit from the difference in the interest rates paid and charged respectively. Some banks also have the power to create money.

The principal types of banking in the modern industrial world are commercial banking and central banking. A commercial banker is a dealer in money and in substitutes for money, such as checks or bills of exchange. The banker also provides a variety of other financial services. The basis of the banking business is borrowing from individuals, firms, and occasionally governments—i.e., receiving “deposits” from them. With these resources and with the bank's own capital, the banker makes loans or extends credit and invests in securities. The banker makes profit by borrowing at one rate of interest and lending at a higher rate and by charging commissions for services rendered.

A bank must always have cash balances on hand in order to pay its depositors upon demand or when the amounts credited to them become due. It must also keep a proportion of its assets in forms that can readily be converted into cash. Only in this way can confidence in the banking system be maintained. Provided it honors its promises (e.g., to provide cash in exchange for deposit balances), a bank can create credit for use by its customers by issuing additional notes or by making new loans, which in their turn become new deposits. The amount of credit it extends may considerably exceed the sums available to it in cash. However, a bank is able to do this only as long as the public believes the bank can and will honor its obligations, which are then accepted at face value and circulate as money. So long as they remain outstanding, these promises or obligations constitute claims against that bank and can be transferred by means of checks or other negotiable instruments from one party to another. These are the essentials of deposit banking as practiced throughout the world today, with the partial exception of socialist-type institutions.

Another type of banking is carried on by central banks, bankers to governments and “lenders of last resort” to commercial banks and other financial institutions. They are often responsible for formulating and implementing monetary and credit policies, usually in cooperation with the government. In some cases—e.g., the U.S. Federal Reserve System—they have been established specifically to lead or regulate the banking system; in other cases—e.g., the Bank of England—they have come to perform these functions through a process of evolution.

Some institutions often called banks, such as finance companies, savings banks, investment banks, trust companies, and home-loan banks, do not perform the banking functions described above and are best classified as financial intermediaries. Their economic function is that of channeling savings from private individuals into the hands of those who will use them, in the form of loans for building purposes or for the purchase of capital assets. These financial intermediaries cannot, however, create money (i.e., credit) as the commercial banks do; they can lend no more than savers place with them.

The development of banking functions and institutions, the basic principles of modern banking practice, and the structure of a number of important national banking systems are discussed in the following sections.

1.1       The Development of Banking Systems: General Overview

Banking is of ancient origin, though little is known about it prior to the 13th century. Many of the early “banks” dealt primarily in coin and bullion, much of their business being money changing and the supplying of foreign and domestic coin of the correct weight and fineness. Another important early group of banking institutions was the merchant bankers, who dealt both in goods and in bills of exchange, providing for the remittance of money and payment of accounts at a distance but without shipping actual coin. Their business arose from the fact that many of these merchants traded internationally and held assets at different points along trade routes. For a certain consideration, a merchant stood prepared to accept instructions to pay money to a named party through one of his agents elsewhere; the amount of the bill of exchange would be debited by his agent to the account of the merchant banker, who would also hope to make an additional profit from exchanging one currency against another. Because there was a possibility of loss, any profit or gain was not subject to the medieval ban on usury. There were, moreover, techniques for concealing a loan by making foreign exchange available at a distance but deferring payment for it so that the interest charged could be camouflaged as a fluctuation in the exchange rate.

Another form of early banking activity was the acceptance of deposits. These might derive from the deposit of money or valuables for safekeeping or for purposes of transfer to another party; or, more straightforwardly, they might represent the deposit of money in a current account. A balance in a current account could also represent the proceeds of a loan that had been granted by the banker, perhaps based on an oral agreement between the parties (recorded in the banker’s journal) whereby the customer would be allowed to overdraw his account.

English bankers in particular had, by the 17th century, begun to develop a deposit banking business, and the techniques they evolved were to prove influential elsewhere. The London goldsmiths kept money and valuables in safe custody for their customers. In addition, they dealt in bullion and foreign exchange, acquiring and sorting coin for profit. As a means of attracting coin for sorting, they were prepared to pay a rate of interest, and it was largely in this way that they began to supplant as deposit bankers their great rivals, the “money scriveners.” The latter were notaries who had come to specialize in bringing together borrowers and lenders; they also accepted deposits.

It was found that when money was deposited by a number of people with a goldsmith or a scrivener a fund of deposits came to be maintained at a fairly steady level. Over a period of time, deposits and withdrawals tended to balance. In any event, customers preferred to leave their surplus money with the goldsmith, keeping only enough for their everyday needs. The result was a fund of idle cash that could be lent out at interest to other parties.

About the same time, a practice grew up whereby a customer could arrange for the transfer of part of his credit balance to another party by addressing an order to the banker. This was the origin of the modern check. It was only a short step from making a loan in specie or coin to allowing customers to borrow by check: the amount borrowed would be debited to a loan account and credited to a current account against which checks could be drawn; or the customer would be allowed to overdraw his account up to a specified limit. In the first case, interest was charged on the full amount of the debit, and in the second the customer paid interest only on the amount actually borrowed. A check was a claim against the bank, which had a corresponding claim against its customer.

Another way in which a bank could create claims against itself was by issuing bank notes. The amount actually issued depended on the banker’s judgment of the possible demand for specie, and this depended in large part on public confidence in the bank itself. In London, goldsmith bankers were probably developing the use of the bank note about the same time as that of the check. (The first bank notes issued in Europe were by the Bank of Stockholm in 1661.) Some commercial banks are still permitted to issue their own notes, but in most countries, this has become a prerogative of the central bank.

In Britain the check soon proved to be such a convenient means of payment that the public began to use checks for the larger part of their monetary transactions, reserving coin (and, later, notes) for small payments. As a result, banks began to grant their borrowers the right to draw checks much in excess of the amounts of cash actually held, in this way “creating money”—i.e., claims that were generally accepted as means of payment. Such money came to be known as “bank money” or “credit.” Excluding bank notes, this money consisted of no more than figures in bank ledgers; it was acceptable because of the public’s confidence in the ability of the bank to honor its liabilities when called upon to do so.

When a check is drawn and passed into the hands of another party in payment for goods or services, it is usually paid into another bank account. Assuming that the overdraft techniques are employed, if the check has been drawn by a borrower, the mere act of drawing and passing the check will create a loan as soon as the check is paid by the borrower’s banker. Since every loan so made tends to return to the banking system as a deposit, deposits will tend to increase for the system as a whole to about the same extent as loans. On the other hand, if the money lent has been debited to a loan account and the amount of the loan has been credited to the customer’s current account, a deposit will have been created immediately.

One of the most important factors in the development of banking in England was the early legal recognition of the negotiability of credit instruments or bills of exchange. The check was expressly defined as a bill of exchange. In continental Europe, on the other hand, limitations on the negotiability of an order of payment prevented the extension of deposit banking based on the check. Continental countries developed their own system, known as giro payments, whereby transfers were effected on the basis of written instructions to debit the account of the payer and to credit that of the payee.