Banking
Banking
Nonbank financial intermediaries
A bank deals in money and money substitutes; it also provides a range of financial services. In a formal sense, it borrows or receives “deposits” from firms, individuals, and (sometimes) governments and, on the basis of these resources, either makes “loans” to others or purchases securities, which are listed as “investments.” In general, it covers its expenses and earns its profits by borrowing at one rate of interest and lending at a higher rate. In addition, commissions may be charged for services rendered.
A bank is under an obligation to repay its customers’ balances either on demand or whenever the amounts credited to them become due. For this reason, a bank must hold some cash (which for this purpose may include balances at a bankers’ bank, such as a central bank) and keep a further proportion of its assets in forms that can readily be converted into cash. It is only in this way that confidence in the banking system can be maintained. In its turn, confidence is the basis of “credit.” Provided its promises are always honored (for example, to convert notes into gold or deposit balances into cash), a bank can “create credit” for use by its customers—either by issuing additional notes or by making new loans (which in turn become new deposits). A bank is able to do this because the public believes the bank can and will without question honor these promises, which will then be accepted at their face value and circulate as money. As long as they remain outstanding, these promises continue to constitute claims against that bank and can be transferred by means of checks or other instruments from one party to another. In essence, this is what is known as “deposit banking.” With some variations, it is the accepted basis of commercial banking as practiced in the modern world. Indeed, deposit banking cannot be said to exist as long as the assets held by a bank consist only of cash lodged by depositors. Once the accounts of banks begin to show more deposits than cash, part of these deposits must represent loans that have been made by a banker to his customers, that is, deposits created by the banking system.
Origins
Although no adequate documentation exists prior to the thirteenth century, banking is known to have a longer history. However, many of the early “banks” dealt primarily in coin and bullion, much of their business being concerned with money-changing and the supply of lawful foreign and domestic coin of the correct weight and fineness. A second and important group consisted of merchant-bankers who dealt not only in goods but also in bills of exchange, which provided for the remittance of money and the payment of accounts at a distance, without shipping actual coin. This was possible because many of these merchants had an international business and held assets at a number of points on the trading routes of medieval Europe. For a consideration, a merchant would be prepared to accept instructions to pay out money through an agent elsewhere to a named party, the amount of the bill of exchange to be debited by the agent to the merchant-banker’s account. In addition to the consideration paid, the merchantbanker would also hope to make a profit from the exchange of one currency for another. Since there was the possibility of loss, any profit or gain was not regarded as usurious. There were also techniques for making concealed loans by supplying foreign exchange at a distance but deferring payment for it until a later date. The interest charge was camouflaged by fluctuations in the rate of exchange between the date of ordering goods and the date of payment for them.
The acceptance of deposits was another early banking activity. These might relate either to the deposit of money or valuables merely for safekeeping or for purposes of transfer to another party or to the deposit of money in current account. A balance in current account might also represent the proceeds of a loan granted by the banker. Indeed, by oral agreement between the parties, recorded in the banker’s journal, a loan might be granted merely by allowing a customer to overdraw his account. In all these instances, a banker was held liable to meet on demand the claims of his depositors.
Deposit banking
By the seventeenth century English bankers had begun to develop a depositbanking business, and the techniques evolved there and in Scotland were in due course to prove highly influential elsewhere. As men of wealth and reputation, the London goldsmiths already kept money and other valuables in safe custody for customers. They also dealt in bullion and foreign exchange and this led to their acquiring and sorting coin for profit. In order to attract coin for sorting, they offered to pay a rate of interest and, in this way, began to supplant as deposit bankers their great rivals the “money scriveners.” These were notaries who had come to specialize in bringing together borrowers and lenders and had themselves been accepting deposits.
It was soon discovered that when merchants deposited money with a goldsmith or scrivener they tended, as a group, to maintain their deposits at a fairly steady level; the goldsmith was able to “depend upon a course of Trade whereby Money comes in as fast as it is taken out.” In addition, customers preferred to leave their surplus money with the goldsmith and to hold only enough for their everyday needs. Hence, there was likely to be a fund of idle cash that could be lent out at interest to those who could use such money to advantage.
Invention of the check. There had also grown up a practice whereby the customer could arrange for the transfer to another party of part of his credit balance with his banker by addressing to him an order to this effect. This was the origin of the modern check (the earliest known example in England is dated 1670). It was but a short step from making a loan in specie to permitting customers to borrow by issuing checks. One technique was to debit a loan account with the full amount borrowed and immediately to credit an equivalent amount to a current account against which checks could be drawn. Alternatively, the customer might be permitted to overdraw his account. In the former case, interest was charged on the full amount placed to the debit of the loan account; in the latter, interest was charged only on the amount actually borrowed. But, in both cases, the customer was permitted to borrow by issuing checks in payment for goods or services. The checks represented claims against the bank, which had a corresponding claim against its customer.
Bank notes. Another means whereby a bank could create claims against itself was by issuing notes. If the volume of notes so issued exceeded the amount of specie or bullion held, additional money would have been created. The amount that was issued depended on the banker’s calculation of the possible demand from his customers for specie; the public would accept such notes only because of the banker’s known integrity. The evidence suggests that in London the goldsmith bankers were developing the use of the bank note at about the same time as the check, although the first bank notes in Europe were issued in 1661 by the Bank of Stockholm (later to become the Bank of Sweden). Some commercial banks are still permitted to issue their own notes, but most such issues have now been taken over by the central bank.
Bank credit
In Britain the check proved to be such a convenient means of payment that gradually the public came to prefer the use of checks for the larger part of their monetary transactions, using coin (and, later, notes) for the smaller kinds of payments. In consequence of this development, the banks grew bold and accorded their borrowers the right to draw checks far in excess of the amount of cash actually held. In other words, the banks were then creating “money”—claims that were generally accepted as means of payment. This money came to be known as “bank money” or “credit.” If bank notes are excluded, this money consists of figures in bank ledgers and is money only because of confidence in the ability of the banks to honor their liabilities when called upon to do so.
When a check is drawn and passed to another party in payment for goods or services, the check will usually be paid into another bank account, although certain checks may be cashed by direct presentation. If the check has been drawn by a borrower (and assuming that the overdraft technique is employed), 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. Because every loan so made tends to return to the banking system as a deposit, deposits will tend, for the system as a whole, to increase (and to decrease) approximately to the same extent as loans. 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 be created immediately.
Negotiable instruments. In England, where the mercantile courts had greater scope than on the Continent, one of the most important factors in promoting the development of banking was the legal recognition of the negotiability of credit instruments. When orders of payment were first introduced in Europe they were certainly nonnegotiable, but in England many such orders were drawn in terms similar to those of a bill of exchange and, when the doctrine of negotiability had been established and accepted by the Courts of Common Law, the check was explicitly defined as a bill of exchange and recognized as a negotiable instrument. This helps to explain some of the differences between banking arrangements in Continental Europe and in Britain, as well as in countries influenced by British traditions. In particular, Continental limitations on the negotiability of an order of payment stood in the way of the extension of deposit banking based on the check that became such a feature of British development in the eighteenth and early nineteenth centuries. Meanwhile, Continental countries were developing a system of Giro payments, whereby transfers were effected on the basis of written instructions to debit the Giro account of the payer and to credit that of the payee.
Despite the above differences, the various banking systems have many similarities. This may be attributed to the fact that all banks trade in a type of “commodity” (money and money substitutes) that has particular characteristics. Thus, in all banking institutions (with the partial exception of those in the U.S.S.R. and those based on the same system), there is some emphasis on the need for liquidity (or the ease with which assets can be converted into cash without substantial loss) and on margins of safety in lending. Even where certain of the commercial banks are state owned (for example, in Australia, Egypt, France, and India), this has remained true.
Structure of banking systems
It is more interesting, therefore, to establish why banking systems in the several countries do differ from one another, sometimes in quite material respects. The problems that face banks are much the same the world over but there is considerable variety in the solutions that are put forward to resolve them. Hence, it is in the details of organization and technique that one tends to find the differences. Yet there is a tendency for the differences to become less pronounced because of growing efficiency in international communication and the disposition to emulate practices that have proved successful elsewhere. Those differences that survive are largely the result of influences deriving from the economic and sociopolitical environment. These similarities and differences can be discussed in terms of: (a) the structure of commercial banking systems; and (b) the varying emphases in the types of business that are done by banks in different countries.
Although one must be careful not to oversimplify, it is possible to classify banking structures as falling within one or another of certain broad categories. For example, “unit banking” still describes fairly accurately the commercial banking arrangements that obtain over large areas in the United States, which has nearly fourteen thousand banks and not very many more bank branches. In a number of other countries it is more usual to find a small number of commercial banks, each of which operates a highly developed network of bank branches. In England and Wales, for example, only 11 banks (5 much larger than the rest) do nearly all the domestic banking business through more than 11,500 branches and agencies. Between these two extremes, there are many instances of “hybrid” systems, where the services of banks that are national in scope are supplemented by those that restrict their activities to either a region or a locality. Examples of such banking systems would be those of France and India. Although these hybrid systems are slowly changing their character (banks are tending to become fewer in number and individually larger, often with networks of branches), so far they have remained different enough from the two other main types of banking systems to warrant separate classification.
Unit banking—the United States
Over large areas of the United States, bank organization is still passing through a phase of structural development that many other countries went through some decades ago. This is not to deny that there has been much experimentation in the evolution of the American banking system, but its development has been subject to constraints that have certainly influenced the path that was chosen. For example, the United States has a federal form of government with a constitution that permits both federal and state legislatures to pass laws to regulate banking. A bank can, therefore, be subject to the banking laws of its own state as well as to those passed by the federal Congress. Some states permit branch banking (sometimes subject to restrictions); others prohibit it. Of itself, this has cut across any integrating forces operating on a nationwide basis. Thus the constitutional arrangements, reinforced by the political influence of small local bankers, provided the legal framework that encouraged the establishment and retention of a large number of unit banks. It must be emphasized that it was not federalism as such but the division of powers within the federation that constituted the barrier to concentration. In Australia, which also has a federal constitution, the federal government has exclusive power to legislate for all banking except that conducted by banks owned by a state government and operating within the state, and for the most part the laws relating to banks have been applied nationally. As it happens, there have been no legal impediments to the spread of branch banking in Australia, and this system is in fact well developed.
The initial establishment of a large number of banks in the United States was due to the scarcity of capital in relation to profitable opportunities for investment as the frontiers of settlement were pushed rapidly westward by the early pioneers. To satisfy the heavy demand for loans and for a medium of exchange, banks sprang up across the country. At this time, too, communications between the frontiers of settlement and the established centers of commerce and finance were still undeveloped. It was only with the coming of the railroads that east-west traffic expanded at all rapidly. Steady territorial expansion also converted the United States into a country of immense distances; there was an obvious need for a large number of banks to serve the diverse and rapidly expanding demands of a growing and constantly migrating population.
As long as communications remained imperfect, therefore, it is not difficult to explain the existence of large numbers of competing institutions. But why the subsequent failure of bank mergers or amalgamations to produce a concentration of financial resources in the hands of large banking units serving local needs through a network of branches? The retention of a primarily unit-banking system long after the barriers of distance had been broken down can be attributed in part to the federal constitution; disinclination to change was further strengthened by the widespread distrust of monopoly and the deep-rooted fear that a “money trust” might develop. There was wide acceptance of a political philosophy that emphasized the virtues of individualism and free competition. Moreover, restrictions on branching, bank mergers, and holding companies were a feature of both the state and federal banking laws. However, in parts of the United States bank branches are already numerous (especially in California, where branching is statewide; also in New York, although there the area covered by a branch network is restricted) and, despite regulation, a large number of bank mergers have been approved.
Branch banking—Britain
The demand for larger banking units is generally a concomitant of economic growth, with which may often be associated a rapid increase in population and its aggregation in industrial centers. A prior condition not only of growth but also of the integration of an economy and its financial institutions (without which larger units could scarcely emerge) is the development of adequate transport facilities and communications. Without efficient communications, banks could not clear checks drawn on other banks and effect their remittances easily and quickly. Branch banking is not necessarily a function of growth, but in England it was associated with it. Again, good communications were a prerequisite, in order to control branches at a distance. The Scots, for example, who from the establishment of the Bank of Scotland in 1695 favored the establishment of branches, were not initially very successful—primarily because of poor communications and the difficulty of moving adequate supplies of coin. It was not until after the Napoleonic Wars that these banks began to expand their branches with vigor. The banks then sought to overcome their difficulties by appointing as “agents” to take charge of their branches local men of standing and repute, for whom banking was often merely a sideline. Only much later, as communications improved, was responsibility for authorizing advances gradually shifted from the “agent” to the head office.
By the 1830s in England, the stream of industrial progress was running fast and already the size of the business unit was growing. A large number of small private banks were proving inadequate to meet the needs of an industrial structure no longer capable of financing itself. Bigger industrial units required financial units with greater resources, whether for lending or in the form of the more extensive connections essential to the provision of an increasing range of services. Small banks, unable to stand the strain of these enlarged demands, often became overextended and failed. This was the economic basis for the growth in bank size that was encouraged by legislation, beginning in 1826, permitting joint-stock ownership. The more widely spread proprietary, less exposed to the vagaries of human frailty, was a much more important influence on growth than limited liability, which at first—and until after the failure of the City of Glasgow Bank in 1878—was regarded with some suspicion.
Although most of the early joint-stock banks tended for some time to remain localized in their business, joint-stock ownership, latterly with limited liability, furnished the basis for the subsequent growth of the English banks in both resources and geographic coverage. These developments, which assisted in attracting deposits and in spreading the banking risk over a wider range of industries and areas, were undoubtedly encouraged by the competitive spirit and desire for personal power. They were greatly accelerated by the bank amalgamation movement that began during the nineteenth century and came to fruition during the first two decades of the twentieth century, giving Britain substantially the kind of banking system that it has today.
Hybrid banking
Different again from the unit banking of the United States and the primarily branch-banking systems of, for example, Britain, Australia, Canada, New Zealand, and South Africa are the hybrid banking systems. These are characterized by a small number of banks with branches throughout the country that hold the larger part of total deposits; the balance of deposits are lodged in a relatively large number of small banks. Although there are differences of degree and the long-term trend would seem to be toward concentrating bank deposits in fewer institutions, it has been found in many instances (for example, in France, Germany, Italy, the Netherlands, and India) that the number of the small banks decreases rather slowly. In Japan, where there is a small number of large city banks with branch networks and a larger number of local banks, there was a small increase in the total following World War ii and then virtual stability.
It is pertinent to inquire why the decrease should be slow and what obstacles exist to impede integration. Their precise character will vary from country to country; only a few examples can be offered here. These will be drawn from France and India. Frenchmen, for example, are individualists; this is reflected in the large number of small businesses that still exist and in the continuing demand for the small banking unit that can provide a more individual and personal service than the larger bank. Again, particularism is still strong in some parts of France; this manifests itself in support for local institutions. Moreover, the local banker can often attract business simply because of his special knowledge of the local industries and people; this enables him to accept risks that the big banks will decline. Also, in the past, the larger institutions in France preferred to open their own branches in new areas rather than to absorb local and regional banks.
In a less developed country like India, where a relatively large number of small banks still exists, there are other kinds of impediments. India is primarily an agricultural country, with an economic and social structure based largely on villages. These are often separated by both distance and poor communications. Integration of banking, based as it is on the spread of new ideas and institutions, is also impeded by the great barriers of ignorance and illiteracy; some degree of literacy is an obvious prerequisite for operating a bank account. In addition, there are the barriers of language and caste, as well as the difficulties that arise from joint family ownership (for example, when providing security for a bank loan). Again, habits of thrift are not easy to inculcate until incomes can be lifted sufficiently to provide a margin for saving. Hence the still strong preference for the indigenous banker with his flexible methods, and even for the moneylender. Both have existed for centuries. The indigenous banker, who is also a merchant, offers genuine banking services—accepting deposits (when available) and remitting funds; making loans quickly and with a minimum of formality; and, by means of the hundi (an indigenous credit instrument in promissory note form), financing a significant, if decreasing, part of India’s domestic trade and commerce.
It is hoped that the moneylender in India will gradually be displaced, however, by the development of a network of rural credit cooperatives, although in some areas progress has been very slow. In addition, as an act of policy and over a period of years, a progressively larger number of “pioneer” bank branches have been opened in rural areas, initially by the semipublic Imperial Bank of India and more recently by its nationalized successor, the State Bank of India. Meanwhile, many of the smaller banks that tend to serve the persons or concerns that initially sponsored them have begun to disappear.
Norway provides an interesting example of the effects on banking structure of physical geography. Almost everywhere the country is mountainous, and overland transport (especially in winter) is often difficult. Although airlines and telecommunications are beginning to knit the country together more effectively, it will be some time before improved communications can break down the particularisms that favor the continued existence of the local banks.
Yet in all these countries there is already evidence of much integration as a result of the steady growth in the size of branch networks, as well as in the share of total business done by the more important banks. Regional and local banks have been absorbed, a process that has been quickened by the need for larger resources than can be mustered by the smaller banks. In France, regional and some local banks have become associated with an institution in the capital. In India small banks have amalgamated on a regional basis, usually with the active encouragement of the Reserve Bank of India, which has hoped thereby to impart a greater degree of strength and stability to the Indian banking system. India has also encouraged the progressive extension of “pioneer branches,” a technique that has also been employed in Pakistan. In all these countries (as in the United States) there is widespread use of bank correspondents. Indeed, when banking systems are either of a unit or hybrid type, institutions must carry a rather higher proportion of total funds as balances with correspondents than do branch-banking institutions, in order to compensate the correspondent for providing a range of services that otherwise could be supplied only by setting up a local branch.
Types of banking business
It remains to inquire into the degree to which there are variations in the types of business done by commercial banks in different countries and to establish the reasons for such differences. The essential characteristics of banking business can be most readily understood within the framework of a simple balance sheet.
The main liabilities are capital (including reserve accounts) and deposits—domestic and foreign—whether of corporations, firms, private individuals, other banks, or (sometimes) governments; whether repayable on demand (that is, sight or current accounts) or after the lapse of a period of time (time, term, or fixed deposits, but also including on occasion savings deposits).
The most important assets items are: cash, (which may be in the form of credit balances with other banks—for example, with the central bank or with correspondents); liquid assets, such as money at call and short notice, day-to-day money, short-term government paper (for example, Treasury bills and notes), and commercial bills of exchange, all of which may be readily converted into cash without risk of substantial loss; investments or securities (medium-term and long-term government securities, including those of local authorities such as states, provinces, or municipalities; also, in certain countries, participations and shares in industrial concerns); advances and loans to customers of all kinds, but primarily those in trade and industry, including in some countries term and mortgage loans (discounts, that is, discounted commercial bills of exchange, may sometimes be shown here, instead of under liquid assets); and premises, furniture, and fittings (usually written down to quite nominal figures).
A bank balance sheet must also include an item to cover contingent liabilities (for example, on bills of exchange whether “accepted” or endorsed by the bank); this will be exactly balanced by a “contra” item on the other side, representing the customer’s obligation to the bank (for which the bank might also have taken security). Virtually all banks of any size nowadays provide acceptance credits (sometimes called bankers’ acceptances), primarily to finance external trade. As the acceptor of a bill, a bank lends its name and reputation to it and thereby ensures the readier discount of paper that might otherwise have been difficult to place. A bank endorsement may serve a similar purpose.
Bank deposits
Deposit banks, as their name suggests, operate largely on the basis of their deposits. These consist of borrowed money (and therefore liabilities), but insofar as an increase in deposits provides a banker with additional cash (an asset), this increase in cash will supplement his loanable resources. Capital and reserve accounts, which are the other important liability item, now serve primarily as the ultimate cover against losses (for example, on loans and investments). But they usually represent only a small part of the total liabilities of deposit banks. In the United States, the capital accounts are also significant as they provide the statutory basis of a bank’s lending limit to the individual borrower. However, those institutions concerned with investment banking (for example, the French banques d’affaires), a proportion of whose loans and industrial investment is likely to be long-term and therefore less liquid, must necessarily depend to a rather greater extent on their own capital resources.
For the banking system as a whole, an increase in deposits may arise in two ways: (a) if the banks increase their loans they will either transfer the money borrowed to a current account and create a new deposit directly or they will accord the borrower a limit up to which he may draw checks, which when they are deposited by third parties create a new deposit; or (b) the growth in deposits may stem from enlarged government expenditure financed by the central bank—claims on the government equivalent to cash will be paid into the commercial banks as deposits and their ownership thereby transferred from their initial recipients to the banks themselves. In the first case, as bank deposits increase, there is a related increase in the potential liability to pay out cash; in the second, the increase in deposits with the commercial banks will be accompanied by a corresponding increase in bank holdings of money claims equivalent to cash.
For the individual bank, an increase in its loans may result in a direct increase in deposits, either by transfer to a current account (as above) or by transfer to another customer of the same bank. Again, there will be an increase in the potential liability to pay out cash. But an increase in loans by another bank (including central bank loans to the government) may result in increased deposits with the first bank matched by a corresponding claim to cash (or its equivalent). Thus, the individual bank can generally expect that an increase in deposits will result in some net acquisition of cash or in a corresponding claim for receipt of cash from a third party. It is in this sense that an accretion to deposits provides the basis for further bank lending.
Except in countries where banks may still be small and insecure, the banks as a whole can usually depend on current account debits being offset very largely by the related credits, although an individual bank may from time to time experience marked fluctuations in its deposit totals. Further inertia may be added to the deposit structure by accepting money contractually for a fixed term or repayable only subject to notice. Nevertheless, at the banker’s discretion, funds may in fact be withdrawn prior to due date. Alternatively, a bank may lend against the security of such a deposit. Overdependence on foreign deposits, which tend to be more volatile than those of domestic origin, may have the opposite effect, since rumors from a distance are apt to prompt precipitate action.
Indeed, at all times, confidence in the banks is the true basis of stability. This is greatly enhanced where there exists a central bank prepared to act as “lender of last resort.” Deposit insurance (as in the United States and India) is another means of maintaining confidence as it protects the small depositor against loss in the event of a bank failure. This was also the ostensible purpose of the “nationalization” of bank deposits in Argentina from 1946 to 1957. The recipient bank acted merely as the agent of the government-owned and government-controlled central bank, all bank deposits being guaranteed by the state.
Cash and liquidity requirements. The essence of the banker-customer relationship is the banker’s undertaking to provide his customers with cash on demand or after an agreed period of notice. Hence the necessity to hold a cash reserve and to maintain a “safe” ratio of cash to deposits. This ratio may be established by convention (as in England) or by statute (as in the United States and elsewhere). In either case, the choice has been based on experience. However, where a minimum cash ratio is imposed by law a bank’s assets will in fact be impounded and, in the absence of any revision of the required ratio, be unavailable to meet sudden demands for cash by the bank’s customers. Indeed, the necessity to provide some dayto-day flexibility is one reason why required ratios are often based on the averaged cash holdings of an institution over a legally specified period.
One of the first bankers to publicize the importance of maintaining an adequate proportion of deposits in cash (or other liquid form) was George Rae; this was in 1875. Whatever the amount of cash held (short of covering demand deposits 100 per cent), no bank could meet depositors’ claims in their entirety if all customers were to exercise fully their rights to demand cash. If that were a common phenomenon, it would not be possible to base banking on the receipt of deposits. But for the most part the public is prepared to leave its surplus funds on deposit with the banks, confident that their money will be repaid as required. Nevertheless, there are occasions when unexpected demands for cash may exceed what might reasonably have been anticipated. A banker must, in consequence, always hold part of his assets in cash and a proportion of the remainder in assets that without significant loss can be quickly converted into cash. In theory, even his less liquid assets should be self-liquidating within a reasonable time.
While no banker can safely ignore the necessity to maintain adequate reserves of liquid assets, some tend to emphasize instead the desirability of limiting the sum of loans and investments to a certain percentage of deposits (say, to 70 per cent). They would feel “uncomfortable” if their loandeposit ratio were to run for any length of time at too high a level; investments are often regarded as something of a residual. But whichever ratio were adopted as a guide to action would matter little, since the effects would be much the same.
There are three main ways in which a bank’s assets may be mobilized: (a) loans may be “callable” (repayment may be demanded immediately or at short notice); (b) securities may be sold in an organized market; or (c) paper representing investments or loans may be discounted at the central bank or submitted as security for an advance. However, any precipitate calling in of loans would so disrupt the delicate nexus of debtor-creditor relations as to exaggerate the loss of confidence liable to occasion a run on the banks. So would heavy selling of marketable assets, with sharply falling prices and consequent losses. Ready cash may be obtainable only at a high price. Either the banks must maintain cash reserves and liquid assets at a high level, or there must exist a “lender of last resort” (for example, a central bank) able and willing (albeit subject to conditions) to provide the banks with cash, when required, in exchange for or against the security of eligible assets. In either event, liquid assets (including cash) are an essential component of the bank balance sheet, and, indeed, in some countries the commercial banks may be required to maintain a minimum liquid asset ratio. This is common, for example, in western European countries and also applies in effect to the English, Australian, and Canadian banks. In Asia, the requirement is usually limited to cash reserve ratios only, although Malaysia is an exception. A minimum liquid assets ratio has also been prescribed for commercial banks by several of the new African central banks (for example, in Ghana and Nigeria) and in Jamaica. At the same time, a central bank resorts to such requirements nowadays less as a means of maintaining appropriate levels of commercial bank liquidity than as a technique for influencing directly the lending potential of the banks.
Bank investments
The commercial banks rightly regard their investments (often consisting largely of medium-term government securities, but also sometimes including industrial shares and participations) as rather less liquid than money-market assets (such as call money and treasury bills). Nevertheless, by staggering their maturities, they are able to ensure that a portion of their holdings is regularly approaching redemption, thereby constituting a secondary liquid reserve. Following redemption at maturity, the banks usually reinvest all or most of this money by purchasing longerterm securities that in due course themselves become increasingly shorter-term. (In Britain, the average maturity of a bank investment portfolio is about five years; it is usually rather less in the United States.) But selling before maturity is also quite common—in order to vary the spread of maturities, or to restore a bank’s liquidity, or to expand loans. Because market conditions may be variable and longer maturity dates give less opportunity to avoid loss by holding securities to maturity, banks tend for balance-sheet purposes to “write down” the value of their investments (and other assets) and thereby to create “hidden reserves.” The essential difference between money-market assets and bank investments is that as a rule the liquidity of investments depends primarily on marketability (although sometimes it depends on the readiness of the government or its agent to exchange its own securities for cash), whereas the liquidity of money-market assets depends partly on marketability and partly on eligibility at the central bank. For this reason, money-market assets are more liquid.
Long-term finance. Where special investment banks exist (like the French banques d’affaires, although these also undertake a sizable deposit banking business, especially for firms in which they hold shares or any other kind of capital interest), or where the commercial banks are accustomed to finance long-term industrial developments (as in West Germany), it is no more than ordinary business prudence both to operate on the basis of relatively large capital funds (plus long-term deposits) and to value the relevant investments most conservatively. The risk of error and therefore of loss tends to increase with the period of the commitment, which after the initial technical investigation may begin as an interim credit to be converted later into a participation. Since one of the functions of these banks (which frequently organize themselves in consortiums or syndicates) is to “nurse” investments until a venture is well established, it may be necessary to hold such participations for long periods. Then, if in the bank’s judgment market conditions are deemed favorable, the original investment can be converted into marketable securities by arranging an issue of shares to the public. Nevertheless, even assuming the ultimate success of the issue, a bank may on occasion be obliged to hold such shares for long periods before being able to liquidate the bulk of its holdings and begin the process all over again. In fact, a banque d’affaires will often retain a sufficient percentage of a firm’s shares to ensure a degree of continuing control.
In contrast with Continental tradition, the long-term provision of industrial finance is usually referred in the countries of the British Commonwealth (including the United Kingdom) to specialist institutions, with the commercial banks providing part of the necessary capital. Except in the United States, where the banks are active competitors for this business, installment credit (hire-purchase finance) is also provided in most countries largely by specialist houses. In Japan, the long-term financial needs of industry are met partly by special industrial banks (which supplement their capital with the proceeds of debenture issues) and partly by the ordinary commercial banks (on the basis of the large volume of time deposits they attract).
Since World War II, term lending has been systematically developed in the United States, largely for the purpose of financing industrial re-equipment and growth. This policy owes its origin to the poor loan demand of the 1930s, when the banks sought to induce additional borrowing, especially at times when stock markets were unfavorable for new issues, by offering finance for a period of years. These loans, the majority of which have an effective maximum maturity of little more than five years, are subject to a formal agreement between the customer and (usually) a group of lending banks, sometimes in cooperation with other institutions, such as insurance companies. More recently, banks in several other countries (including Britain and Australia) have instituted term loans to finance exports and capital expenditure, both in industry and in agriculture.
Loans and advances. Yet even in countries where commercial banks do lend long-term to industry, it is the self-liquidating loans and advances that constitute the core (and often the most profitable part) of earning assets. Traditionally, much of this accommodation is of the “seed-time to harvest” kind, that is, provision of working capital, although there may be some temporary financing of fixed capital development pending arrangements to raise long-term finance elsewhere. Overdrafts, whereby a borrower may overdraw his account (or go into debit) up to an agreed limit, are the common means of bank lending in the United Kingdom and in a number of other countries. In theory they are temporary but usually renewable annually or repayable after due and reasonable notice has been given; in practice they may run on for long periods, depending on the character of the business being financed. The advance is reduced or repaid when credits are paid into the account, and recreated when new checks are drawn. The “cash credit” employed in India and Pakistan to finance the holding of stocks is similar. Even in countries where the overdraft predominates (for example, in Britain and the Netherlands), the method of debiting a loan account for credit to a current account may sometimes be used; checks are drawn on the current account, with interest payable on the whole amount of the loan (itself usually for a fixed period) instead of only on the amount actually overdrawn.
Elsewhere (for example, on the Continent and in the United States and Japan), bank finance is often made available short-term on the basis of discountable paper—commercial bills or promissory notes, often subject to a line of credit similar to an overdraft limit. This accommodation is also self-liquidating as it matures, although such paper may be renewable at the discretion of the lender. If eligible for rediscount at the central bank, it becomes virtually a liquid asset, unlike a bank advance or loan. Under both systems, finance may be made available with or without formal security, depending on the reputation and financial strength of the borrower. In many countries the customer may seek finance (and other services) from a number of banks (to protect their own interests these institutions will usually freely exchange information about joint credit risks), but in Britain and in the Netherlands the tendency is for all but the largest concerns to use the services of a single institution to meet the bulk of their banking needs.
Nonbank financial intermediaries
Finally, we must consider the relations between the commercial banks and other types of financial intermediary that undertake quasi-banking business. In the days of “cloakroom” banking (lending out mainly such money as had in fact been deposited in cash), banks were not in any important sense “creators of money,” except to the extent of their note issues. In a similar way, installment credit (or hire-purchase) finance companies, mortgage banks, and building societies (or savings and loan associations) in effect lend out only what they receive and, since money deposited with them usually and with little delay finds its way back to the banks themselves, the existence of such intermediaries cannot seriously affect the level of bank deposits. Other institutions, such as local governmental and other authorities, collect savings to spend; these, again, reappear in bank accounts. Yet, although they may not “create money” in the same way as the commercial banks, nonbank financial intermediaries can be the means of activating otherwise idle balances (accumulated from savings in earlier periods) and can thereby add to the intensity of the use made of monetary assets. In large measure what they do is merely gather savings together and direct these (by lending them) into the hands of those who will use them. In this event they lend no more than savers decide to place with them from their current income receipts. Only to the limited extent that these intermediaries invest in government securities may deposits be lost to the banking system, just as when commercial undertakings buy treasury bills. However, during times of credit restriction, when bank lending has been significantly curtailed, the nonbank financial intermediaries have been able to increase their share of the types of loans also made by the banks. In that way they seriously compete with the latter for business that once lost is difficult to regain. In addition, the competition for new loan business has certainly been intensified by the growth of lending institutions other than banks, and in a number of countries banks have been forced either to acquire capital interests in finance companies or themselves to develop installment credit or hire-purchase business.
J. S. G. Wilson
[See alsoBanking, Central; Financial intermediaries; Money.]
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