The Evolution of Banking


We all are deeply entrenched the the banking system and its services but many of us don’t have a clue on how the modern day system began, or what it’s evolving into.

With the exception of the extremely wealthy, very few people buy their homes in all-cash transactions. Most of us need a mortgage, or some form of credit, to make such a large purchase. In fact, many people use credit in the form of credit cards to pay for everyday items. The world as we know it wouldn’t run smoothly without credit and banks to issue it. In this article Investopedia contributor Andrew Beattie, explore the birth of these two now-flourishing industries.

Divine Deposits
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 on 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 in the place of fragile, impermanent paper bills. 

Flipping a Coin
These coins, however, needed to be kept in a safe place. Ancient homes didn’t have the benefit of a steel safe, therefore, most wealthy people held accounts at their temples. Numerous people, like priests or temple workers whom one hoped were both devout and honest, always occupied the temples, adding a sense of security. There are records from Greece, Rome, Egypt and Ancient Babylon that suggest temples loaned money out, in addition to keeping it safe. The fact that most temples were also the financial centers of their cities, is the major reason that they were ransacked during wars.

Coins could be hoarded more easily than other commodities, such as 300-pound pigs, so there emerged a class of wealthy merchants that took to lending these coins, with interest, to people in need. Temples generally handled large loans, as well as loans to various sovereigns, and these new money lenders took up the rest.

The First Bank
The Romans, great builders and administrators in their own right, took banking out of the temples and formalized it within distinct buildings. During this time moneylenders still profited, as loan sharks do today, but most legitimate commerce, and almost all governmental spending, involved the use of an institutional bank. Julius Caesar, in one of the edicts changing Roman law after his takeover, gives the first example of allowing bankers to confiscate land in lieu of loan payments. This was a monumental shift of power in the relationship of creditor and debtor, as landed noblemen were untouchable through most of history, passing debts off to descendants until either the creditor’s or debtor’s lineage died out.

The Roman Empire eventually crumbled, but some of its banking institutions lived on in the form of the papal bankers that emerged in the Holy Roman Empire, and with the Knights Of The Temple during the Crusades. Small-time moneylenders that competed with the church, were often denounced for usury.

Visa Royal
Eventually, the various monarchs that reigned over Europe noted the strengths of banking institutions. As banks existed by the grace, and occasionally explicit charters and contracts, of the ruling sovereign, the royal powers began to take loans to make up for hard times at the royal treasury, often on the king’s terms. This easy finance led kings into unnecessary extravagances, costly wars and an arms race with neighboring kingdoms that lead to crushing debt. In 1557, Phillip II of Spain managed to burden his kingdom with so much debt, as the result of several pointless wars, that he caused the world’s first national bankruptcy, as well as the second, third and fourth, in rapid succession. This occurred because 40% of the country’s gross national product (GNP) was going toward servicing the debt. The trend of turning a blind eye to the creditworthiness of big customers, continues to haunt banks up into this day and age.

Adam Smith and Modern Banking
Banking was already well established in the British Empire when Adam Smith came along in 1776 with his “invisible hand” theory. Empowered by his views of a self-regulated economy, moneylenders and bankers managed to limit the state’s involvement in the banking sector and the economy as a whole. This free market capitalism and competitive banking found fertile ground in the New World, where the United States of America was getting ready to emerge.

In the beginning, Smith’s ideas did not benefit the American banking industry. The average life for an American bank was five years, after which most banknotes from the defaulted banks became worthless. These state-chartered banks could, after all, only issue bank notes against gold and silver coins they had in reserve. A bank robbery meant a lot more before, than it does now, in the age of deposit insurance and the Federal Deposit Insurance Corporation – FDIC. Compounding these risks was the cyclical cash crunch in America.

Alexander Hamilton, the secretary of the Treasury, established a national bank that would accept member bank notes at par, thus floating banks through difficult times. This national bank, after a few stops, starts, cancellations and resurrections, created a uniform national currency and set up a system by which national banks backed their notes by purchasing Treasury securities, thus creating a liquid market. Through the imposition of taxes on the relatively lawless state banks, the national banks pushed out the competition.

The damage had been done already, however, as average Americans had already grown to distrust banks and bankers in general. This feeling would lead the state of Texas to actually outlaw bankers, law that stood until 1904.

Merchant Banks
Most of the economic duties that would have been handled by the national banking system, addition to regular banking business like loans and corporate finance, fell into the hands of large merchant banks, because the national banking system was so sporadic. During this period of unrest that lasted until the 1920s, these merchant banks parlayed their international connections into both political and financial power. These banks included Goldman and Sachs, Kuhn, Loeb, and J.P. Morgan and Company. Originally, they relied heavily on commissions from foreign bond sales from Europe, with a small backflow of American bonds trading in Europe. This allowed them to build up their capital.

At that time, a bank was under no legal obligation to disclose its capital reserve amount, an indication of its ability to survive large, above-average loan losses. This mysterious practice meant that a bank’s reputation and history mattered more than anything. While upstart banks came and went, these family-held merchant banks had long histories of successful transactions. As large industry emerged and created the need for corporate finance, the amounts of capital required could not be provided by any one bank, so IPOs and bond offerings to the public became the only way to raise the needed capital.

The public in the U.S. and foreign investors in Europe knew very little about investing, due to the fact that disclosure was not legally enforced. Therefore, these issues were largely ignored, according to the public’s perception of the underwriting banks. Consequently, successful offerings increased a bank’s reputation and put it in a position to ask for more to underwrite an offer. By the late 1800s, many banks demanded a position on the boards of the companies seeking capital, and, if the management proved lacking, they ran the companies themselves.

Morgan and Monopoly
J.P. Morgan and Company emerged at the head of the merchant banks during the late 1800s. It was connected directly to London, then the financial center of the world and had considerable political clout in the United States. Morgan and Co. created U.S. Steel, AT&T and International Harvester, as well as duopolies and near-monopolies in the railroad and shipping industries, through the revolutionary use of trusts and a disdain for the Sherman Anti-Trust Act. 

Although the dawn of the 1900s had well-established merchant banks, it was difficult for the average American to get loans from them. These banks didn’t advertise and they rarely extended credit to the “common” people. Raci

sm was also widespread and, even though the Jewish and Anglo-American bankers had to work together on large issues, their customers were split along clear class and race lines. These banks left consumer loans to the lesser banks that were still failing at an alarming rate.

The Panic of 1907
The collapse in shares of a copper trust set off a panic that had people rushing to pull their money out of banks and investments, which caused shares to plummet. Without the Federal Reserve Bank to take action to calm people down, the task fell to J.P. Morgan to stop the panic, by using his considerable clout to gather all the major players on Wall Street to maneuver the credit and capital they controlled, just as the Fed would do today. 

The End of an Era
Ironically, this show of supreme power in saving the U.S. economy ensured that no private banker would ever again wield that power. The fact that it took J.P. Morgan, a banker who was disliked by much of America for being one of the robber barons with Carnegie and Rockefeller, to do the job, prompted the government to form the Federal Reserve Bank, commonly referred to today as the Fed, in 1913. Although the merchant banks influenced the structure of the Fed, they were also pushed into the background by it. 

Even with the establishment of the Federal Reserve, financial power, and residual political power, was concentrated in Wall Street. When the First World War broke out, America became a global lender and replaced London as the center of the financial world by the end of the war. Unfortunately, a Republican administration put some unconventional handcuffs on the banking sector. The government insisted that all debtor nations must pay back their war loans which traditionally were forgiven, especially in the case of allies, before any American institution would extend them further credit.

This slowed down world trade and caused many countries to become hostile toward American goods. When the stock market crashed in on Black Tuesday in 1929, the already sluggish world economy was knocked out. The Federal Reserve couldn’t contain the crash and refused to stop the depression; the aftermath had immediate consequences for all banks. A clear line was drawn between being a bank and being an investor. In 1933, banks were no longer allowed to speculate with deposits and the FDIC regulations were enacted, to convince the public it was safe to come back. No one was fooled and the depression continued. 

World War II Saves the Day
World War II may have saved the banking industry from complete destruction. WWII, and the industriousness it generated, lifted the American and world economy back out of the downward spiral.

For the banks and the Federal Reserve, the war required financial maneuvers using billions of dollars. This massive financing operation created companies with huge credit needs that in turn spurred banks into mergers to meet the new needs. These huge banks spanned global markets. More importantly, domestic banking in the United States had finally settled to the point where, with the advent of deposit insurance and mortgages, an individual would have reasonable access to credit. 

The Bottom Line
Banks have come a long way from the temples of the ancient world, but their basic business practices have not changed. Banks issue credit to people who need it, but demand interest on top of the repayment of the loan. Although history has altered the fine points of the business model, a bank’s purpose is to make loans and protect depositors’ money. Even if the future takes banks completely off your street corner and onto the internet, or has you shopping for loans across the globe, the banks will still exist to perform this primary function.

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