Unraveling the Complexities of the International Banking System
Table of Contents
- The Origins of Banking in 11th Century Italy
- How Banks Work Today
- The 2008 Financial Crisis and Its Aftermath
- The Future of Banking and Alternative Models
- Conclusion
The Origins of Banking in 11th Century Italy
11th century Italy was the center of European trading. Merchants from all over the continent met to trade their goods, but there was one problem: too many currencies in circulation. In Pisa, merchants had to deal with seven different types of coins and had to exchange their money constantly.
This exchange business, which commonly took place outdoors on benches, is where we get the word "bank" from; from the word "banco", Italian for "bench". The dangers of travelling, counterfeit money and the difficulty of getting a loan got people thinking. It was time for a new business model: home brokers started to give credit to businessmen, while Genevese merchants developed cashless payments.
The Problem of Multiple Currencies
In Pisa during the 11th century, merchants had to deal with seven different types of coins when conducting business. This required constantly exchanging currencies, which was inconvenient, risky, and costly. The exchange business typically took place outdoors on benches, which is how we get the word "bank" from the Italian word "banco" meaning bench. The multitude of currencies circulating through Europe's trading hubs created significant friction for conducting business.
The Birth of Modern Banking
In response to the currency exchange challenges, new banking models emerged in Italy. Home brokers started providing credit to traveling businessmen, enabling them to avoid carrying large amounts of cash. Additionally, Genevese merchants developed systems for cashless payments between merchant accounts, creating some of the earliest forms of modern banking networks.
How Banks Work Today
In a nutshell, banks are in the risk management business. Banks take unused funds from savers through deposits and lend that money out at higher interest rates to generate revenue. This process turns unused capital into productive funds that society can use to finance houses, businesses, and more.
Banks generate income through interest on loans, custodial services for assets, trading currencies, and more. However, some banks have shifted focus to short-term profits over serving client needs, leading to excessive risk-taking.
Risk Management at the Core
Modern banks make money by taking in deposits from savers and lending that money out to others at higher interest rates. This generates revenue for the banks but also introduces risk, as some borrowers will inevitably default on loans. Thus banks must carefully assess and manage risks across their lending and investing activities. How well a bank manages risks is core to its long-term profitability and survival.
Creating Liquidity for the Economy
A key function of banks is turning unused funds provided by savers into active capital that can be deployed across the economy. This expands access to financing for activities like starting businesses, buying homes, and enabling economic growth. Banks create liquidity out of dormant funds, allowing money to move to more productive uses. However, they must balance this liquidity creation with responsible risk management.
The 2008 Financial Crisis and Its Aftermath
In the early 2000s, major banks shifted away from prudent risk management in pursuit of short-term profits. This excessive risk taking, especially in mortgage lending, contributed to the 2008 financial crisis and Great Recession.
With the crisis threatening collapse of large banks, governments were forced to approve bailouts while implementing new regulations to govern banking behavior and risk management.
The Collapse of Major Banks
Banks like Lehman Brothers took dangerous risks prior to 2008, such as lending extensively to subprime mortgage borrowers. When housing prices started to decline, it caused a wave of defaults and major losses for overexposed banks. Investor confidence plunged as banks wrote down billions in bad loans. Stock prices plummeted and intimate connections between large banks caused the crisis to spread rapidly through the global financial system.
Government Bailouts and New Regulations
With major banks on the brink of failure, governments had to take dramatic interventions to stop complete collapse. Hundreds of billions were spent on bailouts and purchasing bad bank assets. New banking regulations were also enacted to curtail excessive risks. However the banking lobby successfully blocked some of the most aggressive proposed regulations in subsequent years.
The Future of Banking and Alternative Models
While traditional banks will continue playing a key economic role, new banking models are emerging as alternatives. These range from investment banks to credit unions to crowdfunding and microfinance platforms.
Each alternative banking model has different incentives, governance structures, and risk profiles. But collectively they are increasing access to financing while reducing systemic risk.
Investment Banks and Credit Unions
Investment banks avoid conflicts of interest through fee-based income instead of trading commissions, with some providing considerable transparency around fees and advisor incentives. Credit unions are member-owned cooperatives providing financial services just like traditional banks, but with shared, democratically governed ownership.
Crowdfunding and Microcredits
New crowdfunding platforms enable raising funds from large pools of small investors, avoiding traditional financial gatekeepers while spreading risks widely. Microlending platforms extend very small loans, often to disadvantaged groups unable to qualify at banks, helping finance entry into self-employment.
Conclusion
While recent history highlights deep problems with large banks taking excessive risks, entirely replacing them would create significant economic challenges.
However, emerging alternative banking models are forcing change while expanding access to capital across society. Hybrid approaches may develop that retain the strengths of traditional models while integrating aspects of new innovations.
FAQ
Q: How did banking first emerge in history?
A: Banking first emerged in 11th century Italy as merchants sought simpler ways to exchange currencies and obtain credit to facilitate trade across Europe.
Q: What risks do modern banks take today?
A: Banks take risks by lending out money from customer deposits at higher interest rates, calculating that enough borrowers will repay their loans to be profitable.
Q: What caused the 2008 financial crisis?
A: The 2008 crisis was triggered by major banks taking excessive risks with subprime mortgages, causing a housing bubble and stock market crash when borrowers defaulted.
Q: How did governments respond to the 2008 banking crisis?
A: Governments bailed out banks with billions in aid and imposed new regulations to govern risk-taking and require emergency reserves.
Q: What alternative banking models are gaining popularity?
A: Alternative models like investment banks, credit unions, crowdfunding platforms, and microcredit lenders are getting popular.
Q: Why are banks so important for the economy?
A: Banks play a crucial role in providing liquidity for economic growth by lending out unused capital from savers to individuals and businesses.
Q: How did the traditional role of banks change over time?
A: Many banks abandoned prudent long-term lending to chase short-term profits through risky trading and complex instruments.
Q: What protects customers if a bank fails today?
A: Regulations like deposit insurance and emergency reserves aim to prevent bank failures and protect customers if they still occur.
Q: Are crowdfunding platforms a viable alternative model?
A: Yes, crowdfunding spreads investment risks widely while enabling people to fund ideas they believe in.
Q: How do microcredits help people escape poverty?
A: Small microcredit loans help entrepreneurs in developing countries start businesses and gain economic opportunities.