Banking is the name given to the activities of banks. The word bank is derived from the Italian banca, which means bench. Moneylenders in Northern Italy originally did business in open rooms or areas, with each lender working from his own bench or table. In the modern era banks are financial firms that simultaneously issue deposits, make loans, and create money.
A deposit is issued when a household or a business brings cash or currency to a bank in exchange for an equivalent amount of stored value, which can either be used to meet payment obligations or saved for future expenditure needs. Loan making is a form of credit. Credit comes into being when one economic unit (the creditor) authorizes another (the debtor) to acquire goods prior to paying for the goods received. A bank makes a loan when it authorizes a borrower to make expenditures on the bank’s account up to a contractually agreed maximum level, in exchange for repayment of these advances later in time. Loans are usually made for expenditure purposes that are agreed on in advance (for example, the purchase of housing or of education services). Borrowers are normally authorized to use loan funds for a certain period of time and are required to repay the amount of the loan plus some amount of interest, which reflects the cost of the loaned funds. Common types of loans are working-capital loans, used by businesses primarily for buying supplies and making wage payments, and mortgage loans, which provide long-term funds (often for a duration of thirty years) for purchasing residences.
There are two principal types of bank deposits. Demand deposits are used primarily to handle transaction needs. They are completely liquid, as they can be withdrawn at will and without notice by the deposit holder. Time deposits are used primarily to store savings. They are less liquid than demand deposits, as they are normally contracted for fixed time periods (often six months or one year). In compensation for this loss of liquidity, those holding time deposits receive compensation in the form of (higher) interest payments.
The process of making loans may create money. A financial institution creates money in making loans when it creates demand deposits that can be spent by its borrowers. These borrowers did not possess these deposits before receiving loans, nor were these deposits taken from any of the bank’s deposit customers. The ability to create money by making loans makes banks’ behavior procyclical: Their loan making tends to expand when the economy is growing, further accelerating growth, and to slow when the economy does.
Banking is heavily regulated for two reasons. First, maintaining an orderly economy requires maintaining reliable transaction processes and financial markets, and banks are at the heart of these processes and markets. Second, banks are a source of instability within the economy. The default risks inherent in loan making interact with banks’ ability to expand the money supply through loan making. In a worst-case scenario, unsound bank loan making (or choices of other assets) can weaken an economy and subject it to bank or currency runs, and/or expose an economy to stagnation, deflation, and even recession.
Banking has always been a heavily regulated field of activity. For one, banks typically require a bank charter issued by regulators. Moreover, every economy normally has a central bank, which attempts to control money and credit growth and which is responsible for rescuing the banking system in times of acute crisis. Regulation is especially important at the beginning of the twenty-first century, because banks’ behavior in loan making has changed so much over time. From the 1930s to the 1960s, banks were relatively cautious. They made loans up the amount of their excess reserves, that is, the amount of currency on hand beyond that needed to meet its deposit customers’ normal withdrawal demands. Over time, banks became more aggressive in finding funds to lend. Banks evolved the practice of liability management, in which they set targets for asset and loan growth and reach those targets by borrowing reserves, primarily from other banks in the interbank market.
Banks have also become more aggressive in loan making, as a result in part of their deepening links to financial centers such as Fleet Street and Wall Street. Since the late 1970s, banks have competed to make loans in hot markets, including overseas borrowers. This has led to severe crises of loan repayment and refinancing, the most spectacular cases being the Latin American debt crisis of the 1980s and the East Asian financial crisis of 1997-1998 (Stiglitz 2003). Despite these recurring crises, banks continually push into new areas of loan making, searching for new ways to earn revenue. In the 1990s and 2000s, banks have increasingly extended personal credit (often via credit cards), and have gotten involved in such nonbank-ing activities as derivatives and options, mutual funds and insurance.
The recurring problems in loan markets have made banking behavior a central topic in economic research. One key question is why lending booms and busts occur; another is why borrowers default (that is, are unable to repay loans according to their contractual obligations). Economists focusing on the first question have emphasized that banks are driven by competition to overlend in boom periods, leading to rising financial fragility (more debt obligations relative to available income), which eventually triggers a downturn (Minsky 1982). Economists addressing the second question focus on the distribution of information in credit markets; they emphasize that borrowers may seek to cheat lenders, and that banks may not accurately determine which potential borrowers are competent and which are not (Freixas and Rochet 1997). Banks can avoid default by extracting timely information about borrowers, their competence, and their intentions. Yet the social neutrality of the criteria that banks use to decide which borrowers are creditworthy has been called into question. Economic studies have generated substantial evidence that banks sometimes treat racial minorities, residents of minority and lower-income communities, and even disadvantaged regions unfairly in their credit-market decisions (Austin Turner and Skidmore 1999).
