Monday, September 14, 2015

Banks and the Stock Market, IV: The Types of Banks


As we saw last week, there are many different kinds of money.  There is currency — what most people think of as money — and then there are the things that currency stands for: 1) existing wealth, and 2) future wealth.  As we also saw last week, there can be intermediate steps between currency and what currency ultimately stands for.

Henry Thornton, "Father of Central Banking"
More than that, Henry Thornton, “the Father of Central Banking” (which is odd, as he was born several decades after the invention of central banking. . . ) explained that, as long as the chain between the wealth represented by currency and the currency was unbroken and in a single strand, the chain could be as long as necessary and have as many links as necessary, without compromising the integrity of the currency.  Thornton explained it somewhat differently in elaborate eighteenth century phrasing in his book, An Enquiry into the Paper Credit of Great Britain (1802), but the chain concept conveys the idea.

Our point today is that whether you’re dealing in existing “money savings,” mortgages, or bills of exchange makes a great deal of difference to the type of bank you use.  One of the problems with explaining banking theory, however, is that there are three basic types of banks, whereas most people think there is only one.

Carter Glass of Lynchburg, Virginia
Further (especially with the conglomeration of the financial services industry following the repeal of Glass-Steagall), most banking institutions combine the different types of banks under one roof, often unaware that they are wearing multiple hats at the same time, so to speak.  That leads to massive confusion as people assume that the proper functioning of one type of bank is a crime because it is different from the way another type of bank operates.

The three types of banks are 1) Banks of Deposit, 2) Banks of Issue (also called Banks of Circulation), and 3) Banks of Discount.  Causing confusion right from the start is that a commercial or mercantile bank is a combination of discount and issue banking, to which is usually added deposit banking features.

Banks of Deposit.  A bank of deposit is defined as a financial institution that takes deposits and makes loans.  This is what most people think of as a bank.  A bank of deposit does not have the power to create money.  It merely serves as an intermediary between savers and borrowers.  The most common banks of deposit are credit unions, savings and loans, and investment banks.

Banks of Issue.  A bank of issue is defined as a financial institution that takes deposits, makes loans, and issues promissory notes intended for use in the community as a medium of exchange.  Strictly speaking, a bank of issue does not create money.  It only accepts deposits of existing wealth and issues promissory notes backed by the deposited wealth or the bank’s capitalization.

Banks of Discount.  A bank of discount is defined as a financial institution that accepts bills and notes at a discount and issues promissory notes backed by the present value of the bills and notes accepted.

Those are the types of banks.  These are, however, applied in practical ways.  We already noted that banks of deposit are common in the form of credit unions, savings and loans, and investment banks.  What about banks of issue and banks of discount?

Not a pure discount bank, but a holding company.
Commercial or Mercantile Banks.  We are not aware of any examples today of “pure” banks of issue or banks of discount, i.e., that perform only that function.  Commercial or mercantile banks combine the functions of banks of issue and banks of discount.  Many usually add personal banking services for consumers, which (while convenient) helps confuse the roles of the different types of banks to the public and the politicians.

Commercial or mercantile banks combine the features of discount and issue banking because otherwise a business seeking a loan based on its creditworthiness would have to take its bill of exchange and offer it to a bank of discount.  If the bank of discount accepted the bill and issued a promissory note, the business would then take the promissory note issued by the bank of discount and take it to a bank of issue to convert it into the promissory note(s) of the bank of issue that the business could then use as money.

It simply makes more sense for a single institution to accept a bill of exchange and issue a promissory note, and then use that promissory note to back a new issue of banknotes (very rare these days) or create a new demand deposit (almost always), on which the borrower can draw.

"The Old Lady of Threadneedle Street": The Bank of England.
Central Banks.  Contrary to popular and political thought, central banks were not invented to finance government.  The fact that they have developed as the primary source of government funding today is the result of an accident of history and political expedience.  Most simply put, a central bank is a commercial bank for commercial banks.  A central bank is sort of a reinsurance company for bills and notes accepted by commercial banks that are then rediscounted at the central bank.

At the same time, a central bank has the power to initiate transactions by going to the open market and buying and selling qualified private sector bills and notes issued by commercial banks, businesses, and individuals.  Again, today’s almost exclusive use of open market operations to deal in secondary government securities is an accident of history combined with political expedience, and was never intended as a function of a central bank.

That covers the different types of bank.  Tomorrow we’ll look at the baffling puzzle of fractional reserve banking.

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