“Without the well-developed capital markets of the US, European companies are reliant on bank lending.” (Financial Times, 2016)
Allyn Young, an American economist, wrote a very interesting and well-written paper about the mystery of money and credit. He argues that we not only need money for trading more easily but also to store value.
Why did banks emerge in the first place?
That is why money should keep its value. The value of money is determined by the purchasing power, which means it is determined by how much you can actually buy with it. Furthermore, it is a liability of the government. Look at the notes in your wallet, there is a stamp from the government on it. The material of your note is not worth 20$, but with the stamp from the government, you can buy goods worth 20$.
Back in the days when we had the gold standard, which means that the currency was backed up by gold, the government-owned gold and printed notes that had the same value as their gold reserves. They issued it, so people could trade notes with each other instead of exchanging gold. The notes had been a promise from the government to pay in gold. So if you had a 20$ note, the government promised to exchange it into gold. Nowadays, we don’t have the gold standard anymore. It is a promise from the government/central bank to pay you in currency. Thus, if you go to the Fed with a 20$ note you can exchange it into another 20$ note, not into gold anymore.
But why do we need banks? Everyone in this country takes my money! The problem back in the days was that there were no central banks or banks that would issue notes that everyone would accept. Today I can do many different things with my money: I can pay for the club, I can go in a restaurant or I can give it to my friend.
Everybody accepts the value of the 10$ bill and is willing to give me something that has the value of 10$ in return.
Back in history merchants did not have banknotes that other merchants or banks would accept, so they needed gold or banks to issue notes and discount notes as well. Discounting notes means that if I have a note from another merchant I can bring it to my bank and they give me currency for it or add it to my deposit account. That is the reason why the checking system evolved and how it worked. Especially in America und England people ran around with small checkbooks, which was not that popular in Germany. It is easy to have a piece of paper with you. You could easily exchange your cheque into cash. Everybody would take it because they can use it to pay someone else or deposit into their bank account.
Banks store your money and work with it
We need banks to give away loans. The merchants did not really trust each other, so no one wanted to lend money to another merchant.
We know the economy needs credit and investments to grow. Therefore we need someone in between the merchants that would be willing to lend them money. So the banking system evolved. People needed places to put their currency/bank notes or gold, so the bank offered that service as well. Banks were looking for a way to make a profit and realized that they had so much money in the cellar that takes away space and does not pay any interests. The people didn’t seem to need all of their money all the time, so the banks decided to keep a certain percentage as reserves and lend the rest to merchants earn interest and make a profit. So they help to distribute the money and wealth, so the economy could grow and expand. John Hicks, another American economist, writes about the most important tasks of a bank:
- Accepting deposits (we don't want to store our money under our beds)
- Discounting bills and (especially back in the days we needed the assurance of being able to alway exchange bank notes into currency or gold)
- Making advances to the customer (most people and especially the economy needs credit to grow, develop and expand and banks have the task not to hoard all the money and wealth but to distribute it)
Financial Times Quote: "So even though we have well-developed capital markets, the companies still need banks to lend money to them, so they can grow and fire up the economy."
The first article: The hierarchy of money
The third article: Why we need a central bank?
The fourth article: How can banks create money out of thin air?
The fifth article: Why do we need central banks especially in a crisis?
The sixth article: What are clearing houses?
The seventh article: What are Fed Funds?
The eighth article: What are dealers, brokers and repos?
The ninth article: Quantitative easing and open market operation
The tenth article: Eurodollars
The eleventh article: Discounts, Discounts, Discounts
The twelfth article: Why dealers provide liquidity
The thirteenth article: Rates and the Treynor Model
The fourteenth article: Brexit
Written by: Philine Paschen