Introduction:
Modern economic and financial heritage begins with the coming of democratic capitalism, around the time of Adam Smith (1776). Under this system, the state does not interfere in economic affairs unnecessarily, removes barriers to competition, and in general, does not prevent and discourage any one willing to work hard enough –and who also has access to capital—from becoming a capitalist.
Some hundred years after Adam Smith, England was at the peak of its power. Politically, it ruled 25% of the earth’s surface and population, the British economy was by far the strongest and most developed in the world. The rest of Europe was not all that important. There was, however, some competition from America that fancied itself as rising economic power. Otherwise, the horizon was comparatively free of competition. British industry and British Finance were very secure in their respective positions [Smith and Walter, 2003]
English financial markets had made it all possible according to Walter Bagehot. England’s economic glory was based on the supply and accessibility of capital. In poor countries there were no financial resources any way, and in most European countries money stuck to the aristocrats and land owners and was unavailable to the market .But in England, there was a place in the city of London--- called Lombard Street--- where money could be obtained upon good security or upon good prospects of probable gain [Bagehot, 1873].
By the early 1900s, New Work was beginning to emerge as world’s leading financial centre. During this time Wall Street became an important financial centre. After World War 1, American Prosperity continued, While Europe’s did not. Banks Had a busy time, raising money for corporations, foreign governments and investment companies and making large loans to investors buying securities. Banks were then ‘Universal’, i.e, they were free to participate in commercial banking (lending) and investment banking, which at the time meant the underwriting, Distribution and trading of securities in financial markets. Many of the large banks were also involved in substantial amount of investment business. There was trade to finance all over the world, especially in such mineral-rich areas as Latin America and Australia. There were securities new issues (underwritings) to perform for foreign clients which in the years prior to 1929 crashed. The stock market crash 1992 was a global event --- markets crashed everywhere--- all at the same time, and the volume of foreign selling orders was very high. The Great Depression followed. There were three prominent results from these events.
First were Deposit Insurance System and the glass –Stegall Provision of the Act, Which completely separated commercial banking from securities activities. Second was the depression itself which led to a 30-year period of banking being confirmed to basic, slow-growing deposit-taking and loan making with a limited local market only. Third was the Rising Importance of government in deciding financial matters, especially during the post-year recovery period. There was little for banks or securities firms to do until the late 1950s and early 1960s.
By then, international business had resumed its rigorous expansion and US banks also increased their activities abroad. The Euro-dollar market and Euro-bond market followed this expansion process. Also, the banks and investment banks were also re- attracted to international capital market transactions. Most large businesses are now effectively global, especially financial businesses. Banking and capital market services have proliferated, and numerous new competitors have emerged on the scene many of which are not banks at all. New regulations are constantly being introduced and old ones changed. Telecommunications provides an easy of access to information.
Operational Definition of a Bank:
A simple operational definition of a bank is that: A bank is an institution whose current operations consist in granting loans and receiving deposits from the public. This is the definition regulators use when they decide whether a financial intermediary has to submit to the prevailing prudential regulations for banks. This definition has the merit of insisting on the core activities of banks, namely deposits and loans. It may be noted that many words of this definition are important.
--- The word current is important because most industrial or commercial firms occasionally lend money to their customers (or borrow from their suppliers). Even if it is recurrent, this lending activity called “trade credit” is only complementary to the core activity of these firms.
---The fact that both loans and Deposits are offered is important because it is the combination of lending and borrowing that is typical of commercial banks. Banks finance a significant proportion to their loans through the deposits of public. This is the main explanation of the fragility of banking system and the justification of banking regulation.
--- Finally, the term “public” emphasizes that banks provide unique services( liquidity ansd means of payment) to the general public. However, the public is not, in contrast with professional investors, armed to assess the safety and soundness of financial institutions, to assess whether individuals’ interests are well preserved by banks. Moreover, in the current situation a public good (access to a safe and efficient payment system) is provided by private institutions (commercial banks). These two reasons: protection of depositors and the safety and efficiency of the payment system have traditionally justified public intervention in banking activities [Freixas and Rocket,1999]
The existence of banks is justified by the role they play in the process of resource allocation, and more specially in the allocation of capital. As merton (1993) states “A well developed smoothly functioning financial system facilitates the efficient life-cycle allocation of household consumption and the efficient allocation of physical capital to its most productive use in the business performed by banks alone. These functions are sufficiently stable to apply generically, from Italy’s Renaissance to today’s world sufficiently stable to apply generically, form Italy’s Renaissance to today’s world [freixas and Rochet, 1999]. Nevertheless, financial market has evolved and financial innovations have emerged at a spectacular rate in the last two decades. In addition, the development of security markets has led to a functional differentiation, with financial markets providing some of the services financial intermediaries used to offer exclusively. Thus, for example, it is as simple today for a firm involved in international trade to hedge exchange rate risk through a future market as through a bank contract. prior to the development of futures markets, one would have tended to think that this was a functional characteristic of bank’s activity.
Today, some economists and bankers draw attention to developmental role of commercial banks. But the “developmental role” might not, prima facie, be seen as a characteristic of purely commercial banks which are historically involved in collection of deposits and provision of working capital. Nevertheless, it is felt that even in the case of such traditional commercial banks the attitude and philosophy of bank management has changed to great extent. The commercial banks are considered an essential instrument of national endeavor. The nature of their lending practices and the channelization of working funds would in themselves influence the pattern of national development. In many developing countries, there is a talk of social obligations of commercial banks.
Commercial banking is changing rapidly. Both the nature of business and the structure of the industry have changed dramatically in the last quarter century. While the economic role of commercial banks have varied little over time, the nature of commercial banks and competing financial institutions is constantly changing. Savings and loans and credit unions, brokerage firms, insurance companies and general stores now offer products and services traditionally associated with commercial banks. Commercial banks, in turn offer a variety of insurance, real estate and investment banking services they were once denied. The term bank today refers as much to the range of services traditionally offered by depository institutions as to the specific type of institution. However, although commercial banks remain the single most important intermediary in most countries, the business they do and the structure of industry is not the same in all countries.
Business of Banking:
According to paget’s Law of Banking, There is no exhaustive definition of ‘ Bank’ as par common Law. However, the usual characteristics are:
A. The conduct of current accounts;
B. The payment of cheques drawn on banks;
C. The Collection of cheques for customer.
These characteristics, however, are not equivalent to a definition, and these are also not the only characteristics. A ‘bank’ may be better described with reference to its permitted business. Although, Traditionally, the main business of banks is acceptance of deposits and lending, the banks have now spread their wings far and wide in to
many allied and even unrelated activities. These are summarized below: [IIBF, 2005]
A
• Borrowing, raising or taking up of money;
• Drawing, making, accepting, discounting, buying, selling, controlling and dealing in bills of exchange, Hundis, promissory notes, coupons, draft, bills of lading, railway receipts, warrants debentures, certificates, scripts and other instruments and securities whether transferable or negotiable or not;
• Granting and issuing of letters of credit, ‘Traveler’s cheques and circular notes;
• Buying and selling dealing in bullion and specie;
• Buying and selling of foreign exchange;
• Acquiring, holding, issuing on commission, underwriting and dealing in stocks, funds, shares, debentures, debenture stocks bonds and securities and investment of all kinds;
• Purchasing and selling of bonds, scrips and other forms of securities on behalf of constituents or others;
• Negotiation on loans or advances;
• Receiving of all kinds of bonds, scrips or valuables on deposits or for safe custody or otherwise;
• Providing of safe deposit vaults;
• Collecting and Transmitting of money and securities.
B
1. Acting as agent of government, local authority or any other person and carry on agency business;
2. Contracting for public or private loans and monitoring and issuing the same;
3. Insure, guarantee, underwrite, participating in managing and carrying out of any issue of state, municipal or other loans or of shares, Stock, debentures or debenture stock of companies and lending money for any such purpose of any such issue;
4. Carry out and transact every kind of guarantee and indemnity business;
5. Manage sell and realize any property which may come in its possession in satisfaction of any of its claims;
6. Acquire, hold and deal with any property or any right, title or interest in any such property which may form the security for any loan or advance;
7. Undertake and execute trusts, undertake the administration of estates as executor, trustee or otherwise;
8. Establish, support and aid associations, institutions etc for the benefit of its present employees and may grant money for charitable purpose;
9. Acquire, construct and maintain any building for its own purpose;
10 Do all such things which are incidental or conducive to the promotion or advancement of its business.
11. Do any such business specified by the government as the lawful business of a banking company.
The origin of Development banking:
The evaluation of banking exhibits some fairly clean patterns. Commercial banks, combining payments functions and financial intermediation, have developed from five main types of institution—payment processors (Examples, Medieval money changers English goldsmiths, public banks of deposits); merchant banks ( examples, Florentine banks, English country banks, U.S. private banks); Securities firms (examples Scriveners, industrial and universal banks); near Banks ( examples, Saving banks, Credit unions; and chartered banks.
Payment Processors and merchant banks began with payments functions. But economies of scope led into intermediation. Customers naturally held their liquid reserves with their payments processors and merchant banks as deposits.
Second evolutionary path began with intermediation and added payment functions. This was the case with securities firms and near banks. Part of business of securities fund is to find investment for the customers. Customers keep funds with them waiting rto be invested. Offering Payment Services out of these deposits is a natural extension of their business. Merril Lynch’s CMA is a classic example of this process. Customers keep Funds with them in non- transaction deposits; it is natural to offer these customers transaction services. Recent deregulation, in the United States and elsewhere, has removed the regulatory obstacles to their doing so.
In contrast to this stories of evolution, chartered banks were set up from the very beginning as full fledged fractional reserve banks. Government set them up initially as an instrument of public finance. They used them both to finance direct government expenditure…..often on wars….and to finance government projects and programs. Commercial banks remain to this day important purchasers of government debt.
Referring to historical development of depository institutions we notice that banking institutions existed since the days of the earliest human civilization. Consequently, there evolution has spanned the time that organized societies have inhabited the earth. We are making a very brief reference to this development.
Historical Development of commercial Banks: Goldsmith Banks:
Inconveniences associated with barter ultimately led people to use commodities, particularly gold and silver, as money. Both metals were relatively scarce and highly valued. Both were easy to divide in to units of various sizes so that people could make change.
In the earliest times, people used un-coined gold and silver, known as bullion, to make transactions. But by using bullion people exposed themselves to asymmetric information problems. Such problems arise when one party to a transaction processes information that the other party does not have. On the other hand an adverse selection problem was associated with using gold and silver bullion as money: the individual with the greatest incentive to offer bullion in exchange for goods and services were hazard problem also existed when people used billion in exchange for goods and services were those whose bullion coined the least pure gold or silver. On the other hand moral hazards problem also excited when people used bullion as money. Once two parties to an exchange had reached an agreement on how much bullion will be paid for a good or bad service, the tender offering the bullion had an incentive to reduce the level of purity of the gold or silver before the exchange took place.
Goldsmiths specialized in reducing the extant of these asymmetric information problems. Parts to a transaction would pay a goldsmiths would issue the holder of bullion a certificate attesting to the bullion’s weight and gold or silver content. Other goldsmiths went a step further. To provided standardized weights of gold or silver that they imprinted with a scale of authenticity. These standardized unites were the earliest coins.
Bullion Deposits and Fractional-Reserve Banking:
Eventually, some goldsmiths simplified the process further by issuing Paper notes including that the bearer held gold or silver of given weights and pictures on deposits with goldsmiths. Then the bearers of these notes could transfer the notes of others in exchange for goods and services. These notes were the first paper money. The gold and silver held on deposits with goldsmiths became the first bank deposit.
Once goldsmiths became depository institutions, it was only a matter of time before they took the final step towards modern banking by becoming lends. Goldsmiths began to notice that withdrawal of bullions relative to new bullion deposit where fairly predictable. Therefore as long as the goldsmiths held reserves of gold and silver to cover unexpected bullion withdrawal, they could lend paper notes in express of amounts of bullions that they kept at hand .They could charge interest on the loans by requiring repayment in bullion excess of value of notes that they issued.
By lending funds in excess of the reserves the reserves money (gold and silver bullion) that they actually possessed, these goldsmith banks developed the earliest form of fractional reserve banking. As long as the economic conditions were stable and the goldsmiths managed their accounts wisely, those who held the goldsmith’s notes would be satisfied with this arrangement. But in bad times or in instances when a few goldsmiths overextended themselves, many note holders might show up at the same time demanding the gold or silver bullion lending to bank-runs. These were the earliest bank-runs.
To be continued.................
