The History of Banking, Simplified

Banking

History of Banking, Simplified

The History of Banking, Simplified

Modern banks are supposed to have originated with goldsmiths, whose primary business was making jewelry but who developed a profitable sideline as keepers of other people's coin: since goldsmiths' shops had good safes, they provided more secure places for the wealthy to stash their cash than, say, a strongbox under the bed. (Think of Silas Marner.)

At some point goldsmiths discovered that they could make their sideline as keepers of coin even more profitable by taking some of the coin deposited in their care and lending it out at interest. You might think this would get them in trouble: what if the owners of the coin showed up and demanded it right away? But what the goldsmiths realized was that the law of averages made this unlikely: on any given day some of their depositors would show up and demand their coin back, but most would not. So it was enough to keep a fraction of the coin in reserve; the rest could be put to work. And thus banking was born.

Every once in a while, however, things would go spectacularly wrong. There would be a rumor—maybe true, maybe false—that a bank's investments had gone bad, that it no longer had enough assets to repay its depositors. The rumor would cause a rush by depositors to get their money out before it was all gone—what we call "a run on the bank." And often such a run would break the bank even if the original rumor was false: in order to raise cash quickly, the bank would have to sell off assets at fire-sale prices, and sure enough, at those prices it wouldn't have enough assets to pay what it owed. Since runs based even on false rumors could break healthy institutions, bank runs became self-fulfilling prophecies: a bank might collapse, not because there was a rumor about its investments having gone bad, but simply because there was a rumor that it was about to suffer from a run.

And one thing that could cause such a rumor is the fact that other banks had already suffered from bank runs. The history of the U.S. financial system before the Great Depression is punctuated by "panics": the Panic of 1873, the Panic of 1907, and so on. These panics were, for the most part, series of contagious bank runs in which each bank's collapse undermined confidence in other banks, and financial institutions fell like a row of dominoes.

By the way, any resemblance between this description of pre-Depression panics and the financial contagion that swept Asia in the late 1990s is not at all coincidental. All financial crises tend to bear a family resemblance to one another.

The problem of banking panics led to a search for solutions. Between the Civil War and World War I the United States did not have a central bank—the Federal Reserve was created in 1913 - but it did have a system of "national banks" that were subject to a modest degree of regulation. Also, in some locations bankers pooled their resources to create local clearinghouses that would jointly guarantee a member's liabilities in the event of a panic, and some state governments began offering deposit insurance on their banks' deposits.

Source: 62248925-Krugman-Paul-The-Return-of-Depression-Economics-and-
the-Crisis-of-2008-2e-Norton-2009

Banking

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