Money, Credit, and Crises: Understanding the Modern Banking System

By Nektarios Michail

While paramount to the modern economy, understanding how the banking system works has been usually cast aside from overall economic education. Even in the aftermath of the recent financial crisis, which has underlined the vital importance of banking in the economy, the workings of the sector remain a black box. To this end, this book provides a comprehensive and easy to read review of the banking sector, covering all issues related to commercial and investment banking and providing experienced as well as non-expert readers the opportunity to expand their knowledge on these topics. After going through the book, readers have the opportunity to gain a deeper knowledge regarding the commercial and investment functions of the banking sector and the ability to evaluate the potential outcome of policy actions.

• Language: English
• Publisher: Palgrave Macmillan
• Release date: Jan 25, 2021
• ISBN: 9783030643843

Book preview

Part IA History of Banking

© The Author(s), under exclusive license to Springer Nature Switzerland AG 2021

N. MichailMoney, Credit, and Criseshttps://doi.org/10.1007/978-3-030-64384-3_1

1. A Brief History of Money and Credit

Nektarios Michail¹  

(1)

Central Bank of Cyprus, Nicosia, Cyprus

Nektarios Michail

Email: [e-mail]

What is money? Despite our daily use of it, it is not often that we ponder what makes something money, especially in the modern era where we take the prevalence of paper or digital money as granted. Throughout history, there have been different uses of various forms of money, and in each step in money’s advance, people have reshaped the way they do their commercial transactions and have introduced new distinctions.¹

In the broadest sense, in order for something to be considered as money, it needs to serve four functions: (a) being a medium of exchange, (b) an overall standard, (c) a measure of value, and (d) a store of wealth.² Being a medium of exchange means that money has the ability of facilitating transactions, so long as it is accepted by all the parties involved. In this sense, practically everything can be used as money: pieces of paper with a stamp on it, cigarettes, iron, copper, and as has been the norm until the early twentieth century, gold.

This brings up interesting complications: suppose John owes Paul 5 chickens, then John can potentially repay his debt by providing 20 pieces of fruit. This simple example suggests that even intangibles like trust and creditworthiness can be employed as a means of transaction; in fact, they have been, and still are in use throughout the world.

The above example also introduces the idea of credit: it could be the case that Paul’s chickens have not hatched yet, or that John’s trees did not bear any fruits at that time of the year. As such, what would matter is that both parties in this transaction believe that the other is trustworthy to repay them back at some future period of time. While unexpected situations beyond their control may prevent the repayment of this debt (e.g. bad weather for the trees, or a pack of foxes attacking the chickens), the idea in the back of head of the person initiating the transaction is that the receiver of the goods can be trusted to repay the favour at some future period of time.

In this case, money is essentially synonymous to credit: John agrees to repay Paul at some future period of time, with this agreement being equivalent to the means of transaction. Thus, credit, appears to have been the first type of money, with the obvious benefit of requiring little, if any, proof for the transaction. As anthropological evidence has also shown, in periods when reading and writing was not something the broader public used, a promise to repay was as good a proof as any other.³

However, the exchange of goods simply on credit terms has plenty of drawbacks, with the most important one laying in the lack of guarantee that what we have exchanged will be compensated for. It is one thing to assume that people from a small village or a small society, whom we have known for all of our lives, will be good in their promise to repay us for what we have provided, and a totally different thing to assume the same for a complete stranger. As you may have guessed, this presents serious impediments on trade, especially with foreigners or even out-of-towners. Thus, as inter-city and inter-nation trade increased, the need for something other than just a promise was required.

This made bartering, i.e. the exchange of one type of good with another take the place of credit. Bartering persisted for centuries. As Adam Smith notes back in 1776, "The armour of Diomede, says Homer, cost only nine oxen; but that of Glaucus cost a hundred oxen. Salt is said to be the common instrument of commerce and exchanges in Abyssinia; a species of shells in some parts of the coast of India; dried cod at Newfoundland; tobacco in Virginia; sugar in some of our West India colonies; hides or dressed leather in some other countries; and there is at this day a village in Scotland, where it is not uncommon, I am told, for a workman to carry nails instead of money to the baker’s shop or the ale-house".⁴

Barter also allows us to understand what the second function of money suggests: money has to serve as a standard of (deferred)⁵ payment of debt. Simply put, this function suggests that if Paul agrees to receive 20 pieces of fruit in a month’s time then the value of this agreement cannot change through time—20 oranges will always be 20 oranges. The third function of money also holds in this case: anything can be expressed in terms of oranges, be it a house, a chicken, or anything else one would wish to trade.

Bartering also comes with its own inconveniences. First and foremost, there is the inconvenience of searching for someone who will both accept what you have and you will also be able to use his production. A builder may build a house for Paul and may not need chickens as he also has his own production of poultry. In order to get the builder to build him a house, Paul would have to enter another agreement with John to exchange chicken for fruit and then provide the fruit to the builder. This would mean a combination of the two types of money (credit and barter), and it would also imply an extension of the trustworthiness required between the two parties (Paul and the builder). This would be necessary as the transaction requires the inclusion of an additional party (i.e. John), who needs to be accepted by the original parties (Paul and the builder).

This is not the only limitation when it comes to credit and bartering. The man who wants to purchase fruit may have nothing but cattle to exchange for it, but the sale of the whole ox may be required as it cannot be broken down to pieces.⁶ The fact that fruits are perishable while an ox can live for a longer period of time makes the potential of such a transaction more difficult for the ox owner. Naturally, a way around this would be to exchange the ox for a number of fruits which could be spread out through time (i.e. two pieces of fruit per day for a year), if both the buyer and the seller were located close to each other. Still, this would have been very difficult in the case of a wandering merchant and a local fruit producer.

To avoid the above issues, a type of money which would also meet the fourth function, i.e. being a store of wealth (value), needed to be introduced, while the other three functions are also met. For something to be used as a store of wealth means that it can last for a significant amount of time, an ability that, e.g. fruit or cattle does not have. Furthermore, this would also imply that it would need to maintain its ability to be exchanged with other things, with at least some degree of certainty, which implies that people would be willing to accept it.

This can happen in two ways: first, by having a sovereign guarantee it, and second, by it being universally accepted as a means of transaction, without requiring state approval. The two characteristics can, naturally be interconnected: for example, a sovereign guarantee almost always makes the item a universally accepted means of transaction, at least within the jurisdiction of that specific nation. Printed (or minted) money is the most suitable example: a country’s government and banks are obliged by law to accept the country’s sovereign currency, a subject we will delve into soon.

The second characteristic can exist without the first being fulfilled, though. For example, gold serves as a universal holder of value irrespective of the fact that most governments do not guarantee transactions with it (more on that in Chapter 6). Other precious metals (or in some cases, precious rocks) also fulfil this requirement, however, for the sake of illustration, will stick to gold for the rest of this analysis.

Gold has a distinct characteristic that makes it quite the exemplary means of transaction: it serves practically no other purpose. To illustrate the significance of this consider an alternative scenario in which copper was employed both as a means of transaction as well as for industrial purposes. This means that the value of copper would be different depending on the person willing to obtain it: it would be worth X to an industrialist who could convert it to electricity cables, Y to the person seeking to mix it with other metals to get a better alloy, and Z to someone who simply employs it as a means of transaction. If the value of, say X was greater than Y and Z, then most likely all values of copper would converge to that, hence depriving industrialists of its use in an alloy. Even worse, if Z was greater, for some reason, then both industrialists would not be able to manufacture.⁷

Hence, the absence of any use for gold (other than for purely cosmetic purposes and currently for some minor industrial applications) is sufficient to make it an excellent means of exchange. This ability has made gold the ultimate means of transaction since very early in the history of mankind. Furthermore, gold and other precious metals have the natural advantage of not being oxidized and are thus able to be also used as a store of wealth. Finally, Gold and other metals can be broken down to smaller pieces, hence facilitating even the tiniest of transactions.

In Babylonia, around 2300 BCE, when trade for citizens outside the city was finally allowed,⁸ the need for a more standardized form of money emerged, making gold and silver rise to prominence. Gold and silver bullion was not particularly easy to transfer though, mostly out of fear of having them stolen. This made home storage of precious metals undesirable. Thus, around 2000 BCE,⁹ Babylonians placed their savings with trusted men, to whom they paid as much as one-sixtieth of the amount for the provision of that service. The famous statutes of Hammurabi addressed this topic, stating that contracts should be arranged before making the deposit.

This early form of banking was further enhanced by the provision of loans from the palace and the temple, out of the wealth they already possessed. Usually, loans involved issuing seed-grain and payment was made after the harvest. Loan contracts were drawn on clay tablets, which included an agreement on interest. The House of Egibi, a family of wealthy Babylonians, was famous for its banking operations which included accepting deposits for safekeeping and financing international trade. At this point, it appears that depositors began asking for interest given that their funds were used productively and allowed the bankers to make a gain for the accrued interest.¹⁰

Introducing Coins

Up until this point in history, when someone referred to the use of money, they talked about the use of gold and silver bullion for transactions and storage. In other words, gold was in unprocessed form, as it was naturally encountered in the ground, or maybe with some minor modifications in order to be suitable for use. To further facilitate trade and perhaps most importantly to gain from the sale of Gold and fund other activities (e.g. wars, roads, bridges), states began to mint coins mostly made by gold and silver. The first state to introduce gold and silver coins was Lydia, around 650–600 BC,¹¹ made by electrum, an alloy of gold and silver.¹² Coin minting made that money the official legal tender of the country or city, i.e. the only currency which was allowed to be used in that specific region.

Standardized money in the form of coins did not have much effect on the nascent banking industry, which was mainly limited to safekeeping, usually by the temple.¹³ Some lending out of these deposits also took place, with the philosopher Demosthenes commenting that more than 20% of funding for a banker’s loans came from deposits. Similarly, he also notes that a court judgement against another banker would result in losses to depositors in his bank. Furthermore, it was confirmed that bankers during that era offered a direct return to induce them to save their money with them or some sort of other services (participation in maritime loans or banking services).¹⁴

Despite the wider use of banking services, banks provided only a small fraction of the total amount of loans, with the majority of these taking place in the city of Athens.¹⁵ However, Athenian bankers were also known to keep their transactions confidential, known only to the banker and the depositor or borrower, which could have potentially undermined the importance of banks. In addition, given the lack of records on which the deposit of funds could be found meant that bankers faced no financial risk, given that the court would have to rely only on the banker’s records. Furthermore, using a banker as an intermediary to borrow money from, unlike direct lending from another person, meant that the transaction did not have to be disclosed to the public.¹⁶

The practice of deposit-taking continued in ancient Rome, while bankers were also allowed to convert foreign currency to the only legal tender in Rome thus becoming the first currency exchangers. As these people conducted their business on a long bench called bancu, they were soon called for the first time, bankers.¹⁷ During the Roman era, a type of public bankers were also appointed by the state to address the problem of citizens’ indebtedness by providing public funds to them.¹⁸ As in Athens, in order for a banking service, such as the transfer of ownership to take place, both parties needed to be physically present.

The next major disruption to the money and banking status quo came with the realization that even metals (precious or not) come with their disadvantages. Using Gold necessitates that the parties involved in the transaction are able to measure the exact weight of the bullion, so that neither buyer nor seller could be cheated. This is especially true for Gold whose value is so large that even the smallest difference in weight could have a strong effect on its value.

Furthermore, assaying the quality of the bullion offered is an even more tedious task: if the content of the bar is 90% and not 100% gold it would make a tremendous difference in the value. This is also why counterfeiting was relatively easy: changing the composition of a gold coin by just 5% would mean huge profits to counterfeiters, while even the smallest change to the weight would also allow them to profit by cheating both the buyer and seller.

Banking in the Middle Ages

As with all previous periods in the history of money, international trade played the predominant role in the move from specie (bullion) to representative (paper) money. Paper money was introduced in China during the tenth century AD, with its roots in the merchant receipts of deposit around 600–900 AD. These were later used in Europe, after their introduction by Marco Polo in the thirteenth century.¹⁹ The idea was similar to the previous development of promissory notes, i.e. that merchants did not want to carry the heavy copper coinage with them in large transactions and thus issued credit notes, often for a limited duration.²⁰ Similar promissory notes often inscribed on leather, were also prominent in ancient Rome and Carthage but without any backing of the amount.²¹ In contrast, paper money (banknotes) were to be used widely as a means of payment, secured by the deposit in either gold or silver.

While there was still no intention to move away from gold and silver, trusting that someone’s coins were not counterfeit was a difficult thing to do. Depositary institutions played an important role when it came to facilitating transactions between individuals, especially in medieval Italy. It is easy to see how paper money has important advantages, as it is easy to create and carry and many denominations can be easily crafted. Furthermore, the presence of an intermediary (the bank) removed any fears of counterfeit coins. Hence, representative (paper) money came to dominate the markets, as the need for larger transactions emerged. In essence, representative money was a certificate, usually in paper form, which reflected a claim to the bank for a particular amount of gold or silver.²²

It was during the Middle Ages that the previous functions of a bank, namely storage and the transfer of ownership to avoid the need for counting and transferring coins from one person to another (still with physical presence required), expanded giving rise to the majority of functions still used today. Medieval bankers had developed a system which allowed them to immobilize the actual coin and allowing the transfer of their ownership on their books, very similar to how bank accounts operate today. It was during this period that the first written order of payment, something resembling a modern-day cheque, although at the time not transferable to a third party, appeared. Italian banks, namely in Venice, charged fees for transfer services with an additional fee charged for cash withdrawals.²³

Despite this immobilization it was still customary that both parties involved in a transaction would have to present at the bank for the change in ownership to take place at a bank.²⁴ After the transaction was completed, customers could withdraw the coins, transfer them to another bank in which they had an account with and even receive an overdraft and some transitory accounts to facilitate the collection of receivables.

Deposit banking alleviated many of the issues associated with the issuance of gold coins: most commercial transactions in the country involved credit and deferred payment, but, with banks as an intermediary, the risk of non-payment or the risk that the payment was counterfeit was essentially zero. Through this, banks alleviated much of the transaction risk, which was the major concern of the credit-and-trust-to-repay systems prior to the introduction of depositary institutions. Furthermore, deposit banks also removed much of the risk of storage and counterfeiting further allowing trade to flourish.

An additional problem depositary banks helped to ease was the scarcity of money. Gold was not easily found, especially before the European escapades into Latin America and the plummeting of local wealth. This, in the absence of banking, could limit the amount of transactions that could take place in an economy. Using depositary banks did not necessitate the use of coins, as ownership could move from one person to another without the need for a physical exchange of coins.

Depositary banks did not usually extend credit in the form of a loan but instead chose to usually take the form of equity participation. In many occasions, banks were forced to act as an investing partner due to the ban on usury: due to religious purposes, Christians were at the time strictly forbidden from charging any kind of interest on loans. ²⁵ Bankers usually invested their own personal funds, as well as those of the bank in commercial ventures, and were not reluctant in investing the bank’s funds in their own ventures as well. As such, the distinction between the bank and the banker was vague.²⁶

Bankers of the era were also involved in non-commercial lending, namely to princes, nobles, municipalities, etc. This captured the largest portion of the banker’s investments, given that non-commercial lending was usually secured. The way this worked was similar to a modern-day pawn shop, as bankers retained jewellery or plates as collateral. Also similar to modern-day developments, a number of failed banks during the 1500s banking crisis in Venice was found to be in possession of vast treasures of jewellery.²⁷

Another practice which is still predominant today was first used during the medieval era: in the case that borrowers did not have collateral, they provided a promissory note co-signed by one or more substantial guarantors. If the borrower failed, the guarantors were then summoned to assume the debt burden. Forward contracts were also indirectly introduced in order to avoid the usury problem: lending to farmers was often in the form of agreeing on a price to purchase the upcoming crops.

Italian banks were also heavily involved in state financing. As it was reported, around 10% to 20% of bank assets in Venice consisted of loans to the government. This was favourable for the government as well, since it enhanced its ability to command resources during crises, given that suppliers were more willing to accept payment from banks than to accept a government note for deferred payment. A similar role was assumed by the Ricci bank in Florence which operated as the de facto official bank of the Grand Duchy, setting the tone for the creation of central banks in the mid-1600s.²⁸ States usually did not have to pay any interest given that the loan was secured by the tax or customs revenue, further supporting local governments and underlining the rapidly increasing power of banks.

Medieval banks also engaged in discounting, i.e. purchasing receivables at a lower price before their due date and benefiting from the proceeds. In addition, banks also provided guarantees, in the sense that they promised to pay if their customer failed to do so. This practice was common for shipbuilders in Genoa, while banks reached the point of guaranteeing the payments of customs duties by importers in Venice. At a more extreme level, banks bought and sold the option to buy claims on public debt at an agreed rate within a pre-specified period, sometimes extending as long as eight months in advance.²⁹

Banks of the era faced pretty much the same problems as their modern-day descendants: liquidity and risk. In essence, banks had to have enough coins available to meet any withdrawal demands, as well as to prepare themselves for potential losses. The situation was much more difficult though. In Burges, a dozen depositors accounted for two-thirds of all deposits, making the bank prone to liquidity issues if one of them suddenly decided to withdraw his funds.³⁰ To address such potential sudden withdrawals, banks were usually forced to keep about 30% of their deposits as reserves and not lend them out. This was (probably) the first time fractional reserve banking was recorded, meaning that banks did not keep all of their liquidity at hand, but only held a percentage of customer deposits while investing the rest. Smaller banks also used to keep their money deposited in larger banks, paying a fee for that service.

Given that coins were not readily at hand when needed, banks resorted to all sorts of trickery in order to avoid giving back the full amount in times of monetary tightness: working shorter hours, giving the money back in low denomination coins which took longer to count, reduce the number of transactions, and even suspend convertibility of the deposits to coins. This naturally induced what later came to be known as bank runs, i.e. that people rushed to banks in order to get their money before the bank was out of liquidity.

Banks were also faced with issues not related to their operations. In the unstable middle ages, war was a common phenomenon and a major cause of instability in both their operations as well as the well-being of their investments. The monetary environment was also unstable given that shortages of coins were common, forcing the public to increase withdrawals and banks to run out liquidity. Given the emphasis on agricultural products, banks were also prone to weather conditions, as well as in specific times of the year, e.g. when coin was needed to purchase grain from the countryside in Florence from September to January.

Deposit banks were heavily regulated by governments, mainly as they played an important role in the management of currency. As mints were usually under the control of the crown, deposit banks were unofficially acting as agents of the mint, by accepting and giving out bullion. There was also a dark side for the need for regulation, as they were suspected of purchasing bullion and selling it abroad. As gold and silver bullion was the predominant measure of the value of money, facing an outflow of bullion would mean that a state would see its currency drop in value. Note that gold coins could easily be melted and then reshaped into the currency of another state, leaving zero traces behind them. To avoid this, governments had to both closely monitor deposit banks as well as manipulate interest rates in order to offer higher deposit returns and convince depositors to keep their money within the state.

There was also another reason for deposit banks’ regulation: the use of deposit banks as a facilitator of trade made them essential to the commercial expansion of a state. Thus, when banks failed, commerce came to a standstill. As always, bank failures brought more regulation even though their enforcement was much more difficult.³¹

Access to banking was restricted in most states, requiring a municipal licence or being a member of an appropriate gild. In other states, banking licences were auctioned to the highest bidder, while in other cases a council examined whether those wishing to establish a bank were suitable for the profession. In most states, bankers had to provide some sort of surety as a guarantee, usually in the form of real estate or through third-party guarantees. If the bank failed, the guarantors were accountable for its debts up to a predetermined amount. In Venice, after a series of bank failures, the required guarantee of 3,000 ducats was later raised to 20,000.³²

The same state had a long history of asset restrictions, aiming to limit the risk exposure of deposit banks. Venice banned investment in most commodities and especially bullion, a restriction Flanders also imposed later on, while it limited investments in commercial ventures to 1.5 times the personal wealth of the banker.³³ Banks in Venice were also forced to pay in cash on demand, something that bankers usually avoided due to liquidity fears.³⁴

Despite the regulation, bank failures were often. When a bank failed, payments were immediately suspended and records seized (if the banker hadn’t already fled the city!), while the sureties were required to pay up. The banker’s personal property was placed in receivership and had to be sold to cover the bank’s debts, including the sureties. As in every other sole proprietary business, the owner’s (banker’s) liability was unlimited.³⁵ In case the depositors could not be repaid in full, the banker could end up in jail, while in Barcelona a banker who failed to pay up within a year was liable to execution. In general, a failed