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merchant might want a safe place
to store his gold, from where he can
withdraw it quickly if necessary.
Another might want a loan—which
is riskier for the bank and may tie
up money for a longer time. So the
bank came to stand between the
two needs: “borrowing short, and
lending long.” This suited everybody
—the depositor, the borrower, and
of course the bank, which used
customer deposits as borrowed
money (“leverage”), to multiply
profits and make a high return
on its owners’ invested capital.
However, this practice also
makes the bank vulnerable—if a
large number of depositors demand
their money back at the same time
(in “a run on the bank”), the bank
may be unable to provide it
because it will have used the
depositors’ money to make long-
term loans, and it retains only a
small fraction of depositors’ money
in ready cash. This risk is a
calculated one, and the advantage
of the system is that it usefully
connects savers and borrowers.
Financing long-distance trade
was a high-risk business in
14th-century Europe. It involved
time and distance, so it suffered
from what has been called the
“fundamental problem of exchange”
—the danger that someone will run
off with the goods or the money
after a deal has been struck. To
solve this problem, the “bill of
exchange” was developed. This
was a piece of paper witnessing a
buyer’s promise to pay for goods in
a specific currency when the goods
arrived. The seller of the goods could
also sell the bill immediately to raise
money. Italian merchant banks
became particularly skilled at
dealing in these bills, creating an
international market for money.
By buying the bill of exchange,
a bank was taking on the risk that
the buyer of the goods would not
pay up. It was therefore essential
for the bank to know who was
likely to pay up and who was not.
Lending—indeed finance in
general—requires specialized,
skilled knowledge, because
a lack of information (known as
“information asymmetry”) can
result in serious problems. The
borrowers least likely to repay are
the ones most likely to ask for loans;
and once they have received a loan,
there are temptations not to repay.
A bank’s most important functionFINANCIAL SERVICES
is its ability to lend wisely, and
then to monitor borrowers to deter
“moral hazard”—when people
succumb to the temptation not to
repay and default on the loan.Geographical clusters
Banks often cluster together in
the same place to maximize
information and skill. This explainsBills of exchange, such as this one
from 1713, later developed into the
common bank check. All types
promise to pay the bearer a specific
amount of money on a certain date.A 21st-century banking crisis
The global financial crisis, which
began in 2007, has led to rethinking
about the nature of banking.
Leverage, or borrowed money, lay
at the heart of the crisis. In 1900,
about three-quarters of the assets
of a bank might be financed by
borrowed money. In 2007, the
proportion was often 95–99
percent. The banks’ enthusiasm
for placing financial bets on future
movements in the market, known
as derivatives, magnified this
leverage and the risks it carried.Significantly, the crisis followed
a period of banking deregulation.
A variety of financial innovations
seemed lucrative in a rising
market. However, they led to
poor lending standards by two
groups: those providing housing
loans to poor US families, and
bond investors overly reliant on
the advice of credit rating
agencies. These are the issues
faced by all banks since the
Medicis: poor information,
financial incentives, and risk.Granting mortgages to “subprime”
borrowers (people unable to repay)
led to a wave of house repossessions
and the financial crisis of 2007–08.