Basics of Banking
Table of Contents
1. Introduction to Banking
Banking appears to have originated in Ancient Mesopotamia. Receipts in the form of clay tablets were used to record transfers between parties. It appears that these clay tablets were more in the form of a bank draft or money order issued by the private sector rather than by the state. In effect, these clay tablets were the forerunner of our more modern paper money systems. Among some of the earliest recorded laws was “Code of Hammurabi” pertaining to the regulation of the banking industry in Mesopotamia. The development of banking in Mesopotamia is quite interesting. It illustrates that all the modern practices such as “Deposits”, “Interest”, “Loans” and “Letter of Credit” existed from the time of the first great civilizations on earth.
1.1. Banking and Religious Places
Banking and money appear to have been closely centered on religious places. Often great temples, churches and mosques served as treasuries holding vast sums of wealth donated by its followers. At times, various rulers would borrow from these treasuries at a prescribed rate of interest. Thus, these religious places provided a center around which civilization grew through its interactions. Ancient homes didn't have the benefit of a steel safe, therefore, most wealthy people held accounts at their religious places. Numerous people, like priests or clerics and other workers whom one hoped were both devout and honest, always occupied these religious places, adding a sense of security.
1.2. Banking in Europe
The development of banking spread from northern Italy throughout the Holy Roman Empire, and in the 15th and 16th century to northern Europe. Though the first bank called the ‘Bank of Venice’ was established in Venice, Italy in 1157 to finance the Monarch in his wars, but modern banking began with the English goldsmiths only after 1640. This was followed by a number of important innovations that took place in Amsterdam during the Dutch Republic in the 17th century and in London in the 18th Century. In fact, Merchant banks are the original modern banks. These were invented in the Middle Ages by Italian grain merchants. In France during the 17th and 18th century, a merchant banker or marchand-banquier was not just considered a trader but also received the status of being an entrepreneur par excellence. Merchant banks in the United Kingdom came into existence in the early 19th century; the oldest was Barings Bank.
Banks have been around since the first currencies were minted, perhaps even before that, in some form or another. Currency, particularly the use of coins, grew out of taxation. In the early days of ancient empires, a tax of one healthy pig per year might be reasonable, but as empires expanded, this type of payment became less desirable. Additionally, empires began to need a way to pay for foreign goods and services, with something that could be exchanged more easily. Coins of varying sizes and metals served the purpose. In fact, Bank comes from an Italian word “Banco” whose meaning is ``bench”. Italian merchants in olden days (during Renaissance period) dealt with money between each other beside a bench. They used to place the money on that bench. Slowly the name Banco changed to Bank through the time.
The first bank to begin the permanent issue of banknotes was the Bank of England in 1695. Initially hand-written and issued on deposit or as a loan, they promised to pay the bearer the value of the note on demand. By 1745, standardized printed notes ranging from £20 to £1,000 were being printed. Fully printed notes that didn't require the name of the payee and the cashier's signature first appeared in 1855. Until the mid-nineteenth century, commercial banks were able to issue their own banknotes, and notes issued by provincial banking companies were commonly in circulation.
1.3. Banking in United States
Merchants traveled from Britain to the United States and established the Bank of Pennsylvania in 1780 to fund the American Revolutionary War (1775–1783). During this time, the Thirteen Colonies had not established currency and used informal trade to finance their daily activities. Hence, in 1781, an act of the Congress of the Confederation established the Bank of North America in Philadelphia, where it superseded the state-chartered Bank of Pennsylvania founded in 1780 to help fund the war. The Bank of North America was granted a monopoly on the issue of bills of credit as currency at the national level. In 1791, U.S. Treasury Secretary Alexander Hamilton created the Bank of the United States, a national bank meant to maintain American taxes and pay off foreign debt. President Andrew Jackson vetoed the bank in 1832 as he opposed the concentration of power in the hands of the powerful few. This decision of his was opposed by Henry Clay and Biddle (who was from a prominent Philadelphia family).
Investment banking began in the 1860s with the establishment of Jay Cooke & Company, one of the first issuers of government bonds. In 1863, the National Bank Act was passed to create a national currency, a federal banking system, and make public loans. During the period from 1890 to 1925, the investment banking industry was highly concentrated and dominated by JP Morgan & Co.; Kuhn, Loeb & Co.; Brown Brothers; and Kidder, Peabody & Co. The Federal Reserve System also known Fed is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of financial panics (particularly the panic of 1907) led to the desire for central control of the monetary system in order to alleviate financial crises. The Great Depression in (1929-1939) saw to the separation between investment and commercial banking known as the "Glass-Steagall Act" (a 1933 Law), but the Act was repealed in 1991 leading to the 2008 financial crisis. The Federal Deposit Insurance Corporation (FDIC) was created by the 1933 Banking Act, enacted during the Great Depression to restore trust in the American banking system. More than one-third of banks failed in the years before the FDIC's creation, and bank runs were common. On September 2, 1969, Chemical Bank installed the first ATM in the U.S. at its branch in Rockville Centre, New York. The first ATMs were designed to dispense a fixed amount of cash when a user inserted a specially coded card.
The late-2000s financial crisis is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s. It was triggered by a liquidity shortfall in the United States banking system and has resulted in the collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world.
The collapse of the U.S. housing bubble, which peaked in 2006, caused the values of securities tied to U.S. real estate pricing to drop, damaging financial institutions globally. Questions regarding bank solvency, declines in credit availability and damaged investor confidence affected global stock markets, where securities suffered large losses during 2008 and early 2009. Due to the 2008 financial crisis, and to encourage businesses and high-net-worth individuals to keep their cash in the largest banks (rather than spreading it out), Congress temporarily increased the insurance limit to $250,000. With the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, this increase became permanent as of July 21, 2010.
A very long history of banking at U.S. …
1.4. Central Banks
The onset of the worldwide depression in 1929 was a disaster for the banking system. In the last quarter of 1931 alone, more than 1,000 U.S. banks failed, as borrowers defaulted and bank assets declined in value. This led to scenes of panic throughout the country, with long lines of customers queuing up before dawn in hopes of withdrawing cash before the bank had no more to pay out.
As the banks were not regulated, the needs of creation of Central Banks came into picture in the 19th Century. Many Central banks were established in European countries during the 19th century. The US Federal Reserve was created by the U.S. Congress through the passing of The Federal Reserve Act in 1913. Australia established its first central bank in 1920, Colombia in 1923, Mexico and Chile in 1925 and Canada and New Zealand in the aftermath of the Great Depression in 1934. By 1935, the only significant independent nation that did not possess a central bank was Brazil, which subsequently developed a precursor thereto in 1945 and the present central bank twenty years later. Having gained independence, African and Asian countries also established central banks or monetary unions.
2. The Ways Banks Make Money
The fundamental question: Why does a bank needs to make money?
After all banking is a business and banks too have myriad of expenses to bear such as salaries to staff, managing their varied businesses, meeting regulatory requirements, R&D (mostly for new products and investments), expansion etc., for its effective functioning. It is, therefore, very important to understand how banks make money? The marketplace is full of various types of products and services and the bank is like a shop that buys and sells money in various forms like loans, deposits, and other financial products.
Let us check on the source of funds for banks:
2.1 Source of Funds for Banks
Interest Rate on Loans: With rising aspiration levels, consumers are trying to look at unique ways of realizing their dream car, house and many such materialistic ambitions. One of the easiest and non-complicated ways of receiving this dream is a bank loan. There are a wide range of loans that are on offer from home loans to car loans, personal loans, travel loans and loans for investing in securities. The bank levies varying degrees of interest rates on different types of loans depending on the duration of the loan and the amount of loan involved.
Service Charges: Banks offers various services and charges nominal fees for these services rendered. When standalone these fees feel nominal to its customers but, when accumulated the service charges become a contribution to a bank's source of funds.
Inter-bank Lending: Another very popular mode of earning money for a bank is through the rate of interest earned via inter-bank lending. Most of this lending is for the short-term (e.g., 3 Months), and sometimes just overnight. These loans are essentially for addressing a bank’s daily liquidity needs and day to day expenses and pay-outs that might be lined up on a daily basis. The benefit of an inter-bank lending for the borrower bank is the fact that rate of interest at which it takes the loans from another bank is always at the best possible rates compared to any loan from other sources. This helps the bank save crucial interest outgo that might otherwise have drained its balance sheet. Hence, a win-win situation for both banks.
Auction of Assets: Many times, when an individual or a company defaults on a specific loan, the bank impounds on the collateral that was given in exchange of the loan amount and puts it up for sale. These can involve a wide range of products ranging from houses, cars and other personal belongings including jewellery. The bank has to otherwise bear additional cost for asset maintenance and upkeep of all these properties if not disposed. Hence, auctioning these properties is an easy way for the bank to recover the defaulted loan amount as well as profit. Also, Auction is a low expense affair to the bank.
Trading in Securities: Many banks, especially the investment banks are active in equity, forex and commodity markets for their clients. The commission and fees are the main sources of funds for the banks.
Charges for Financial Advices: This is another interesting and hugely beneficial services specially offered by investment banks. Many big companies which are not publicly listed and planning for initial public offerings cannot make it alone as they do not have market knowledge. Here's where investment banks help these companies for initial IPO's and make money through advisory fees. Also, investment banks help these big companies for the follow-on public offerings too. The crucial advices given by banks are in terms of "What rate the issue should be priced", "The total number of shares to be issued" etc. Banks also makes money in advices it gives while negotiating crucial acquisition and mergers of companies. The logic is when a big investment bank is involved; the chances of good deal are always higher with limited scope for foul play. Fair pricing is also another great motivation for involving an investment bank to negotiate M&A deals. Some modern banks also make money through advices given for tax planning and succession (or Estate) planning too.
Charges for Vaults: Many of us are scared to keep our precious jewellery, important documents at home. The threat of theft makes them nervous, and the bank comes to the aid of all such customers. They have vaults of various sizes and dimension to suit the needs of many different types of customers who require these vault services. The bank charges annual fees for the maintenance, upkeep and also monthly rental in return for these services. While customers are happy that their precious documents and jewellery are in safe hands, the banks use this unique opportunity for enhancing its profit base. Maintaining a vault does not require a huge manpower either. In that way, it is yet another low expense formula to enhance the bank’s earnings.
Underwriting Income: Investment banks help private companies go public. This means that they help sell the shares of these private companies on the open market. While doing so, they underwrite all the shares. This means that they take the risk that if these shares are not sold to the common public, then they will buy the shares themselves. Public issues generally run into millions of dollars. Investment banks charge a hefty commission on the issue size.
Advisory fees: Investment banks earn advisory fee for raising capitals (even for governments), advising on investments, Fixed income trading, derivatives trading, commodities trading etc.
Fee for securitization: Securitization is the process of converting assets (like loans) into saleable securities (like Bonds). During this conversion for the client, investment banks take appropriate fees and commission in every step of securitization process.
Research Fees: Investment banks does a lot of research jobs for its clients for example, the profitability analysis for any Merger or Acquisition deal. This is done to ensure that they provide the most up to date reports to their clients. Also, Money managers often purchase research materials from Investment banks, to make better investment decisions.
Swaps: Investment banks make money through swaps. Swaps create profit opportunities through a complicated form of arbitrage, where the investment bank brokers a deal between two parties that are trading their respective cash flows.
Payments Fees: Banks charges various Payment processing fees say for wire transfers or ACH or fees charged to merchants for processing credit card payments etc.
Bank Charges: Banks also earn through various charges for delays say delays in payment by the customer towards credit card, withdrawal charges for ATM (for utilizing ATM a greater number of time than the prescribed withdrawals), Overdraft interest charges, Charges for bank drafts, Charges for being an Advising bank in letter of credit, correspondent banking charges etc.
Overdraft Fee: An overdraft fee is charged when a payment or withdrawal of a banking customer account exceeds the available balance and the bank covers the transaction for the customer (only up to a certain limit decided during provision of overdraft facility).
Line of Credit: Bank earns interest fee through a line of credit (LOC) it offers to its customers. It is an arrangement between a bank and a customer where customer can borrow up to a certain amount from bank without applying for a loan (which is a cumbersome process) to a certain limit that can be drawn on repeatedly.