Thursday, January 2, 2014

A Brief Course in Banking Theory, I: Banks of Deposit

As 2014 is the centennial of the first year of operation of the Federal Reserve System, we thought it appropriate to start off the New Year with a brief dissertation on commercial and central banking, and how they are supposed to be used — as opposed to how such banks are being used or, more properly, misused these days.

To understand banking, we have to understand money.  Most simply put, money is anything that can be accepted in settlement of a debt.  It can take any form, and consists of anything that somebody will take in exchange for something else.

In other words, all money is a contract, just as (in a sense) all contracts are money.  As such, money consists of offer, acceptance, and consideration — “consideration” being the inducement to enter into a contract, the thing or things of value being exchanged.

What has value?  Obviously, accumulated wealth — “past savings” — has value.  Everybody understands that.  Promises also have value, even if they involve wealth that doesn’t even exist yet.

People can enter into contracts promising to deliver something in the future, and that promise has a present value, even if what is promised doesn’t exist.  It only has to exist when the promise falls due.  These promises — “future savings” — can be used as money.

Thus, all money consists of either past savings or future savings.

Now that we know everything there is to know about money, we can understand banks.

There are two basic types of banks.  These are 1) banks of deposit, and 2) banks of issue.  There is also a (sort of) third type of bank, central banks, which are banks of issue for banks of issue, a bank for banks.

We will look at banks of deposit today.

A bank of deposit is just what it sounds like.  Someone (or a lot of someones) deposit money in a bank.  The bank lends it out to other someones, charging a fee (interest) for this service.  The bank takes interest on the loans it makes, and pays interest on the deposits it takes.

That’s pretty much it.  We’ll look at banks of issue in the next posting in this series.



Frank Rauscher said...

You might want to mention that the deposit bank does have a limit on the loans it can make as a percent of its capital because this forms a basic limit on the "deposits et al" that it should take.

Michael D. Greaney said...

That is correct. While in theory a bank of deposit can lend out every cent of its deposits and capitalization, a banker would be insane to do so. Nobody would be able to cash a check or withdraw savings without causing a "run" on the bank.

To be safe, then, a bank always keeps a certain percentage back and does not loan it out. This, however, starts to get into the area of "practice", especially when you get into just how much to hold back.