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the development of financial
districts in large cities. Economists
call this phenomenon “network
externalities,” which refers to the
fact that, as a cluster starts to form,
all the banks benefit from the
network of deepening skills and
information. Florence was one such
cluster. The City of London, with its
goldsmiths and shipping experts,
became another. In the early
1800s the remote northern inland
province of Shanxi became
China’s leading financial center.
Today, the internet creates new
ways of clustering online.
The benefit of specialization
explains why there are so many
different types of banks—covering
savings, mortgages, car loans, and
so on. The form a bank takes can
also address information problems.
Mutual societies and credit unions,
for instance, which are effectively
owned by their customers, first arose
in the 19th century to increase
trust between the bank and its
customers at a time of social
change. Because the members of
these organizations checked up on
each other, and the managers had
good local knowledge, they could
provide the long-term loans that
their customers needed. In some
countries, such as Germany, they
thrived. The Dutch bank Rabobank
is an example of a cooperative
model, as is India’s “micro-finance”
Grameen Bank, which makes many
loans of small amounts.
However, clustering can also
lead to risky competition and
crowdlike behavior. It is especially
important for banks to have a good
reputation because they have an
asset transformation role—they
transform deposits into loans—and
their loan-assets are riskier, longer,
and less easy to turn into cash (less
“liquid”) than their deposit-liabilities.
Bad news can lead to panics.
Bank failures can have severe
consequences for other banks, and
for government and society, as
witnessed in the failure of
Creditanstalt Bank in Austria in
1931, which led to a run on the
German mark, UK sterling, and then
the US dollar, triggering further bank
runs and contributing to the GreatLET TRADING BEGIN
Depression. As a result banks need
to be regulated, and most countries
have strict rules about who can
form a bank, the information they
must disclose, and the scope of
their business activities.Finance broadly
Banking is just the largest part of
finance, but all finance is about
connecting people who have more
money than they need with people
who need more money than they
have—and will use it productively.
Stock exchanges connect these
needs directly, through equities
(shares conferring ownership of a
company), bonds (lending that can
be traded), or other instruments.
These exchanges are either
physical places, such as the New
York Stock Exchange, or regulated
markets where trading takes place
through phone calls and computers,
like the international bond market.
The clustering created by exchanges
makes these long-term investments
more liquid: they can easily be sold
and turned into money. Savings can
also be pooled to lower transaction
costs and diversify risks. Mutual
funds, pension funds, and insurance
companies all perform this role. ■The City of London is home to a
dense cluster of banks built over
medieval streets. Today it is the world’s
largest center for foreign-exchange
trading and cross-border bank lending.
A banker is a fellow
who lends you his umbrella
when the sun is shining,
but wants it back the
minute it begins to rain.
Mark Twain
US author (1835–1910)