To begin, we start with the realization that there are two kinds of banks. These are the "bank of deposit," and the "bank of issue" (also called the "bank of circulation").
The bank of deposit is pretty much what it sounds like, and what most people tend to think of as a bank . . . whether or not they are looking at an actual bank of deposit. A bank of deposit takes deposits (obviously), then lends out the deposits to borrowers. The bank charges interest on such loans, some of which is passed through to the depositors. The bank of deposit retains the rest of the interest as its revenue, from which it meets its costs and generates profit for the owners.
Assuming that a country is on the gold standard, the bank of deposit can either lend out the gold that was deposited, or it can keep the gold safe in its vaults and issue a banknote to substitute for the gold. These banknotes circulate as currency, or "current money." If a customer presents a banknote to the bank, the bank will either use the banknote to cancel a debt owed by the customer, or exchange the note for gold.
The bank of issue is a different creature altogether. The most common type of bank of issue is the commercial bank, that is, a bank intended to facilitate commerce. A bank of issue converts non-monetary wealth into money. If something has value, it can (in theory, anyway) be converted into money.
A bank of issue (again, in theory) does not need a customer to make a deposit before making a loan. Instead, a borrower comes to the bank and pledges something of value in exchange for a loan. Technically, if the pledge involves real property (i.e., land), the pledge is called a "mortgage." If the pledge involves anything other than land (that is, personal property), it is called a "pawn." The latter term is nowadays usually restricted to small loans made on "portable security," that is, items of relatively high value that can be transported easily.
The bank of issue creates the money, either in the form of a banknote that circulates as currency, or in the form of a demand deposit on which the borrower issues checks. A check, while it is money, does not usually circulate as currency, but is returned immediately (more or less) to the bank of issue for redemption after a single transaction. Usually the recipient of a check does not take it to the bank on which it was drawn and demand cash, but deposits it in his or her own bank, taking the banknotes issued by that bank or issuing checks.
The recipient's bank presents the check to the bank on which it was drawn in order to settle the account and complete the transaction. Since the original bank and the receiving bank often have thousands, if not millions of such transactions back and forth, very little cash changes hands — or needs to, as the accounts eventually "zero out" (again, in theory). This "zeroing out" is usually done through a clearinghouse, a financial institution designed to facilitate transactions between banks and minimize the movement of actual cash, which can be both unwieldy and unsafe.
In practice, however, there is a role for reserves of currency even with a "pure" bank of issue. Assuming a gold standard, a bank of issue may need gold on hand to reassure the public as to the value of its banknotes and demand deposits. A bank of issue does this by converting its banknotes and demand deposits into gold coin on demand (or into banknotes of the central bank that can be converted into gold) instead of using them to settle debts.
A bank of issue thereby assumes the character of a bank of deposit, at least in part. The bank has to maintain deposits — reserves — of whatever serves as the currency in order to insure its banknotes and demand deposits. It thereby backs its banknotes and demand deposits both with the loans it made to create the money (which might go bad), and a percentage of its total loans in gold, which is presumed always to be good, despite what history has shown.
In our next posting we will look at the "Bullion Controversy," which provided the fertile seedbed out of which grew the three schools of money, credit, and banking.