Modern Banking System and the Obsolete Concept of Banking: Explain and Illustrate in the World Wide aspect

  1. Introduction

1.1 Definition of Banks

A bank is a financial institution and a financial intermediary that accepts deposits and channels those deposits into lending activities, either directly or through capital markets. A bank connects customers that have capital deficits to customers with capital surpluses. [1]

Banks act as payment agents by conducting checking or current accounts for customers, paying checks drawn by customers on the bank, and collecting checks deposited to customer’s current accounts. Banks also enable customer payments via other payment methods such as Automated Clearing House (ACH), Wire transfers or telegraphic transfer, EFTPOS, and automated teller machine (ATM). [2]

Banks borrow money by accepting funds deposited on current accounts, by accepting term deposits, and by issuing debt securities such as banknotes and bonds. Banks lend money by making advances to customers on current accounts, by making installment loans, and by investing in marketable debt securities and other forms of money lending.

Banks provide different payment services, and a bank account is considered indispensable by most businesses and individuals. Non-banks that provide payment services such as remittance companies are normally not considered as an adequate substitute for a bank account.

1.2 History of Banking System

1.2.1 Banking in Ancient Times

The History of Banking begins with the first prototype banks of merchants of the ancient world, which made grain loans to farmers and traders who carried goods between cities. This began around 2000 BC in Assyria and Babylonia. [3]

Later, in ancient Greece and during the Roman Empire, lenders based in temples made loans and added two important innovations: they accepted deposits and changed money. Archaeology from this period in ancient China and India, also shows evidence of money lending activity. Banking activities in Greece are more varied and sophisticated than in any previous society. Private entrepreneurs, as well as temples and public bodies, now undertake financial transactions. They took deposits, made loans,changed money from one currency to another and tested coins for weight and purity. [4] They even engaged in book transactions. Moneylenders could be found who would accept payment in one Greek city and arrange for credit in another, avoiding the need for the customer to transport or transfer large numbers of coins. Rome, with its genius for administration, adopted and regularized the banking practices of Greece. By the 2nd century AD, a debt can officially be discharged by paying the appropriate sum into a bank, and public notaries are appointed to register such transactions. The collapse of trade after the fall of the Roman Empire made bankers less necessary than before, and their demise was hastened by the hostility of the Christian church to the charging of interest. Usury comes to seem morally offensive. [5]

1.2.2 Banking in Medieval Times

During the 13th century bankers from north Italy, collectively known as Lombards, gradually replaced the Jews in their traditional role as money-lenders to the rich and powerful. The business skills of the Italians were enhanced by their invention of double-entry book-keeping. Creative accountancy enabled them to avoid the Christian sin of usury; interest on a loan was presented in the accounts either as a voluntary gift from the borrower or as a reward for the risk taken. [6]

Banking, in the modern sense of the word, can be traced to medieval and early Renaissance Italy, to the rich cities in the north such as Florence, Venice and Genoa. The Bardi and Peruzzi families dominated banking in 14th century Florence, establishing branches in many other parts of Europe. Perhaps the most famous Italian bank was the Medici bank, established by Giovanni Medici in 1397. [7]

The main developers of banking in London were the goldsmiths, who transformed from simple artisans to becoming depositories of gold and silver holdings. Events such as the appropriation of £200,000 of private money by King Charles I from the royal mint, in 1640 caused merchants to lose trust in the existing institutions and drive them to find more trusted alternatives such as the goldsmiths. [8]

Goldsmiths soon found themselves with money they had no immediate use for, and they began to lend it out at interest to merchants and the government. Finding substantial profit in this business, they began to solicit deposits and pay interest on them. The goldsmiths eventually discovered that the deposit receipts they provided were passing from person to person in lieu of payment in coin. This prompted them to begin lending paper receipts rather than coins. By promoting acceptance of the receipts as a means of payment, the goldsmiths discovered they could lend more than the gold and silver coin they had on hand, a practice that became known as fractional-reserve banking. [9]

The development of banking spread from northern Italy through Europe and a number of important innovations took place in Amsterdam during the Dutch Republic in the 16th century, and in London in the 17th century. During the 20th century, developments in telecommunications and computing caused major changes to banks operations and let banks dramatically increase in size and geographic spread.

1.3 Modern Banking System

1.3.1 Unit Banking

Unit banking means a system of banking under which banking services are provided by a single banking organization. Such a bank has a single office or place of work. It has its own governing body or board of directors. It functions independently and is not controlled by any other individual, firm or body corporate. It also does not control any other bank. [10]

One of the most important advantages of unit banking system is that it can be managed efficiently because of its size and work. Co-ordination and control becomes effective. There is no communication gap between the persons making decisions and those executing such decisions. Unit banking is localized banking. The unit bank has the specialized knowledge of the local problems and serves the requirement of the local people in a better manner than branch banking. The funds of the locality are utilized for the local development and are not transferred to other areas. [11]

Under unit banking system, there is no transfer of resources from rural and backward areas to the big industrial and commercial centers. This tends to reduce regional imbalance.

Since the size of a unit bank is small, it cannot reap the advantages of large scale, division of labor and specialization. In unit banking system there will be large number of banks in operation. There will be lack of control and therefore their rates of interest would differ widely from place to place. Moreover, transfer of funds will be difficult and costly. [12]

1.3.2 Branch Banking

Branch Banking is a system of banking in which a banking organization works at more than one place. The main place of business is called head office and the other places of business are called branches. The head office controls and co-ordinates the work at branches. The day-to-day operations are performed by the branch manager as per the policies and directions issued from time to time by the head office. This system of banking is prevalent throughout the world. [13]

Such banks, because of their large size can enjoy the economies of large scale, division of work and specialization. These banks can also afford to have the specialized services of bank personnel which the unit banks can hardly afford. Branch banking can provide extensive service to cover large area. They can open their branches throughout the country and even in foreign countries.

Under branch banking, the bank maintains continual contacts with all parts of the country. This helps it to acquire correct and reliable knowledge about economic conditions in various parts of the country. This knowledge enables the bank to make a proper and profitable investment of its surplus funds. [14]

When some branches suffer losses due to certain reasons, this has its repercussions on other branches of the bank. Thus branch banking system as well as unit banking system suffers from defects and drawbacks. But the branch banking system is, on the whole, better than the unit banking system. In fact, the branch banking system has proved more suitable for backward and developing countries. Branch banking is very popular and successful. A comparison between unit banking and branch banking is essentially a comparison between small-scale and large-scale operations. [15]

                                      2. Importance of Modern Banking System

2.1 Importance of Banking System in the Economy

The role of banking system can be compared to the circulatory system within the human body. Just like blood vessels carry the essential nutrients to all parts of the human body, the banking system is expected to supply the “money capital” to the all the individuals and the institutions.

Formation of capital is very important, especially for all the under developed and the developing nations. This is because since poverty is a key concern, it is but obvious that the rate of saving would be extremely low. Here, an effective system of banking for commercial purposes is of utmost importance to make the current savings available for the entrepreneurs to invest and produce which would in turn contribute to the growth of the economy. [16]

For effective monetization of money, opening of banks in different parts of the country is very important. This is especially true for all the rural and other under developed areas where everything remains dormant. [17] Mobilization of resources would only be possible if new branches of banks are opened in these areas. This would also open doors to the external world which means development in all aspects.

Banks offer credit facilities which are the driving force for any business project to be put into action. In a developing nation where in agriculture is main livelihood for the major part of the population, investing in such sectors is of high importance. So, apart from trade and commerce, banks are a must to venture into the unknown.

Banks are a source for loans and advance installments of money. They are a source of money for setting up any new or spreading an existing business establishment.

2.2 Importance of Banking in Global Trade

All payments in an international trade are made through bank either by way of wire transfer or check with the latter not being preferred for not being the quickest. The following are some of the common ways of payment modes in international trade.

Letter of Credit is an international trade instrument that is mutually convenient for both the parties. [18] The exporter gets paid once he produces the copy of BoL (bill of lading) which he receives from the shipping company and the LoC, to the bank, regardless of whether the consignment as arrived at destination or not.

Wire transfer is by far the fastest and the cheapest option in which the importer will instruct his bank to transfer the amount to the exporter’s bank account. The first time, the transfer happens in about 10-15 days depending on the destination country and the routing bank. International wire transfers are made through intermediary banks/correspondent banks.

Foreign exchange market is another area where international commercial banks play vital role.            Foreign exchange market serves two main functions, convert the currency of one country into the currency of another and provide some insurance against foreign exchange risk.[19] International businesses receive payments in foreign currencies for their export, the income it receives from foreign investments and income received from licensing agreements with foreign firms.

                                      3. Problems with Modern Banking System

3.1 Creation of Money

Under fractional-reserve banking, the type of banking currently used in most countries, banks retains only a fraction of their demand deposits as cash. Fractional-reserve banking is a form of banking where banks maintain reserves (of cash and coin or deposits at the central bank) that are only a fraction of the customer’s deposits. Funds deposited at a bank are mostly lent out; the bank keeps only a fraction (called the reserve ratio) of those funds as assets or “reserves”. [20] Some of the funds lent out are subsequently deposited with another bank, increasing the fund assets and deposit liabilities at that second bank, and allowing further lending. As most bank deposits are treated as money in their own right, fractional reserve banking increases the money supply, and banks are said to create money.

As a simple example of how the fractional reserve system works, consider a scenario of only one bank, a reserve fraction of 10%, and an initial money supply of $1000 cash that is initially deposited at the bank. This can effectively be turned into $9954 through 50 successive loans and redeposits. This is achieved as follows. Only 10% of the original $1000 is required to be held as reserve for the deposit, and so the remaining $900 can be loaned out to a customer who will most likely exchange it with another person for some goods or services. That person will most likely in turn redeposit it in another account within the bank. As only 10% of this new deposit must be held in reserve, the remaining $810 may then be loaned out again and subsequently redeposited, and so on and so forth. If we end the series after 50 iterations, we find that we have $9954 now in existence within the money supply against original deposit of $1000.

However, if many depositors withdraw all at once, the bank itself (as opposed to individual investors) may run short of liquidity, and depositors will rush to withdraw their money, forcing the bank to liquidate many of its assets at a loss, and eventually to fail. [21] If such a bank were to attempt to call in its loans early, businesses might be forced to disrupt their production while individuals might need to sell their homes and/or vehicles, causing further losses to the larger economy

3.2 Financial Crisis

The 2007–2012 financial crisis, also known as the Global Financial Crisis and the 2008 financial crisis, is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s. It resulted in the collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. In many areas, the housing market also suffered, resulting in evictions, foreclosures and prolonged unemployment. [22] The crisis played a significant role in the failure of key businesses, declines in consumer wealth estimated in trillions of US dollars, and a downturn in economic activity leading to the 2008–2012 global recession.

The financial crisis caused significant stress on banks around the world. The failure of a large number of major banks resulted in government bail-outs. The collapse and fire sale of Bear Stearns to JP Morgan Chase in March 2008 and the collapse of Lehman Brothers in September that same year led to a credit crunch and global banking crises. [23]

4. Banking Law

Currently commercial banks are regulated in most jurisdictions by government entities and require a special bank license to operate. Usually the definition of the business of banking for the purposes of regulation is extended to include acceptance of deposits, even if they are not repayable to the customer’s order—although money lending, by itself, is generally not included in the definition. [24]

Unlike most other regulated industries, the regulator is typically also a participant in the market, being either a publicly or privately governed central bank. Central banks also typically have a monopoly on the business of issuing banknotes. Banking law is based on a contractual analysis of the relationship between the bank (defined above) and the customer—defined as any entity for which the bank agrees to conduct an account.  These implied contractual terms may be modified by express agreement between the customer and the bank. The statutes and regulations in force within a particular jurisdiction may also modify the above terms and/or create new rights, obligations or limitations relevant to the bank-customer relationship.

5. Conclusion

The role of banking system can be compared to the circulatory system within the human body. Just like blood vessels carry the essential nutrients to all parts of the human body, the banking system is expected to supply the “money capital” to the all the individuals and the institutions. All payments in an international trade are made through bank either by way of wire transfer or check with the latter not being preferred for not being the quickest.

The banking system is not without problems. Banks were in many responsible for the recent financial crisis. However the banking system is one of the most important aspects of modern life. And it is an indispensible part of modern life.

 

  • Bank, retrieved 15 July 2012 from http://en.wikipedia.org/wiki/Bank

6.Bibliography

  • Banking – Standard Activities, retrieved 15 July 2012 from http://en.wikipedia.org/wiki/Bank
  • Martin A. Armstrong, The Origins of Money, Retrieved 15 July 2012 from http://en.wikipedia.org/wiki/History_of_banking
  • History of Banking, Retrieved 15 July 2012 from http://www.historyworld.net/wrldhis/PlainTextHistories.asp?historyid=ac19
  • History of Money, Retrieved 15 July from http://www.historyworld.net/wrldhis/PlainTextHistories.asp?historyid=ab14
  • Lombard Banking, Retrieved 15 July 2012 from http://en.wikipedia.org/wiki/Lombard_banking
  •   Banking in the Middle Ages, Retrieved 15 July 2012 from http://www.ucalgary.ca/applied_history/tutor/endmiddle/bluedot/banking.html
  •   Banking Origin and Development, Retrieved 15 July 2012 from
  • http://www.investmentsandincome.com/banks-banking/banking_origin.html
  •   A History of English Clearing Banks, Retrieved 15 July 2012 from http://www.banking-history.co.uk/history.html
  •   Unit Banking, Retrieved on 15 July 2012 from http://financial-dictionary.thefreedictionary.com/Unit+Banking
  •     Disadvantages of Unit Banking, Retrieved on 15 July 2012 from
  • http://macsnote.blogspot.com/2011/04/disadvantages-of-unit-banking.html
  •   Branch Banking, Retrieved on 15 July 2012 from www.investopedia.com/terms/b/branch-banking.asp
  •   What are the various advantages of Branch Banking ?, Retrieved on 15 July 2012 from http://www.preservearticles.com/201012281859/advantages-of-branch-banking.html
  •   What are the main disadvantages of Branch Banking ?, Retrieved on 15 July 2012 from http://www.preservearticles.com/201012281860/disadvantages-of-branch-banking.html
  •   Role of Banks and Financial Institutions in Economy, Retrieved on 15 July 2012 from http://www.competitionmaster.com/ArticleDetail.aspx?ID=41e9ef66-3271-418d-b344-09f76d6f59a1
  •   Importance of Banks in an Economy, Retrieved on 15 July 2012 from  www.slideshare.net/RChengeta/importance-of-banks-in-an-economy
  •   Role of Banks is International Trade, Retrieved on 15 July 2012 from
  • http://bizcovering.com/international-business-and-trade/role-of-banks-in-worldwide-trade/
  •   Letter of Credit, Retrieved on 15 July 2012 from http://www.investopedia.com/terms/l/letterofcredit.asp
  •   Financial Services, Retrieved on 15 July 2012 from http://en.wikipedia.org/wiki/Financial_services
  •   Fractional Reserve Banking, Retrieved on 15 July 2012 from http://www.investopedia.com/terms/f/fractionalreservebanking.asp
  •   Bank Run, Retrieved on 15 July 2012 from http://www.investopedia.com/terms/b/bankrun.asp
  •   The 2007-08 Financial Crisis In Review, Retrieved on 15 July 2012 from http://www.investopedia.com/articles/economics/09/financial-crisis-review.asp#axzz21FJJSMap
  •   Global Financial Crisis – What caused it and how the world responded, Retrieved on 15 July 2012 from http://www.canstar.com.au/global-financial-crisis


[1] Bank, retrieved 15 July 2012 from http://en.wikipedia.org/wiki/Bank

[2] Banking – Standard Activities, retrieved 15 July 2012 from http://en.wikipedia.org/wiki/Bank

[3] Martin A. Armstrong, The Origins of Money, Retrieved 15 July 2012 from http://en.wikipedia.org/wiki/History_of_banking

[4] History of Banking, Retrieved 15 July 2012 from http://www.historyworld.net/wrldhis/PlainTextHistories.asp?historyid=ac19

[5] History of Money, Retrieved 15 July from http://www.historyworld.net/wrldhis/PlainTextHistories.asp?historyid=ab14

[6] Lombard Banking, Retrieved 15 July 2012 from http://en.wikipedia.org/wiki/Lombard_banking

[7] Banking in the Middle Ages, Retrieved 15 July 2012 from http://www.ucalgary.ca/applied_history/tutor/endmiddle/bluedot/banking.html

[8] Banking Origin and Development, Retrieved 15 July 2012 from

http://www.investmentsandincome.com/banks-banking/banking_origin.html

[9] A History of English Clearing Banks, Retrieved 15 July 2012 from http://www.banking-history.co.uk/history.html

[10] Unit Banking, Retrieved on 15 July 2012 from http://financial-dictionary.thefreedictionary.com/Unit+Banking

[11] Unit and Branch Banking System, Retrieved on 15 July 2012 from

http://vidyagyan.blogspot.com/2007/09/unit-and-branch-banking-system.html

[12] Disadvantages of Unit Banking, Retrieved on 15 July 2012 from

http://macsnote.blogspot.com/2011/04/disadvantages-of-unit-banking.html

[13] Branch Banking, Retrieved on 15 July 2012 from www.investopedia.com/terms/b/branch-banking.asp

[14] What are the various advantages of Branch Banking ?, Retrieved on 15 July 2012 from http://www.preservearticles.com/201012281859/advantages-of-branch-banking.html

[15] What are the main disadvantages of Branch Banking ?, Retrieved on 15 July 2012 from http://www.preservearticles.com/201012281860/disadvantages-of-branch-banking.html

[16] Role of Banks and Financial Institutions in Economy, Retrieved on 15 July 2012 from http://www.competitionmaster.com/ArticleDetail.aspx?ID=41e9ef66-3271-418d-b344-09f76d6f59a1

[17] Importance of Banks in an Economy, Retrieved on 15 July 2012 from  www.slideshare.net/RChengeta/importance-of-banks-in-an-economy

[18] Letter of Credit, Retrieved on 15 July 2012 from http://www.investopedia.com/terms/l/letterofcredit.asp

[19] Financial Services, Retrieved on 15 July 2012 from http://en.wikipedia.org/wiki/Financial_services

[20] Fractional Reserve Banking, Retrieved on 15 July 2012 from http://www.investopedia.com/terms/f/fractionalreservebanking.asp

[21] Bank Run, Retrieved on 15 July 2012 from http://www.investopedia.com/terms/b/bankrun.asp

[22] The 2007-08 Financial Crisis In Review, Retrieved on 15 July 2012 from http://www.investopedia.com/articles/economics/09/financial-crisis-review.asp#axzz21FJJSMap

[23] Global Financial Crisis – What caused it and how the world responded, Retrieved on 15 July 2012 from http://www.canstar.com.au/global-financial-crisis/

[24] Bank, retrieved 15 July 2012 from http://en.wikipedia.org/wiki/Bank