Banking for most people is a little like pornography. There is something not quite right about it, but a lot of people seem to like it and can’t seem to function without it, and they can’t define it, but they know it when they see it.
We can’t do too much about banking’s reputation or people’s love, hate, or need for it, but we can define it, which is the point of today’s posting. Rather than make too much of the porn-banking analogy, however, we’ll cut straight to the chase.
There are three fundamental categories of banks. We used to say, “types of banks,” but we admit that terminology was misleading. As will be explained below, a “commercial bank” is a type of bank, while a “bank of deposit” is a category of bank.
So, there are three categories of banks:
· Banks of Deposit,
· Banks of Issue or of Circulation, and
· Banks of Discount.
We can take these in order of complexity, the simplest first, the bank of deposit.
Bank 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 the only category of bank, a confusion resulting from the fact that banks of deposit deal exclusively in currency or currency substitutes, such as checks and other negotiable financial instruments representing existing assets.
Since most people limit their understanding of money to currency, it is easy to understand why people regard the other two categories of banks with deep suspicion. Types of banks of deposit are savings banks, credit unions, savings and loans, and investment banks. Deposit banks cannot create money, and do not deal in all kinds of money, but are restricted to dealing with the reserve currency or substitutes for it. A bank of deposit makes a profit by lending money at an interest rate higher than the interest rate paid on deposits.
Bank of Issue or of Circulation. A bank of issue (“bank of circulation” is the older term) is defined as a financial institution that takes deposits, makes loans, and issues promissory notes. A promissory note is a form of money, so in that sense a bank of issue “creates money” — but only in a sense. If we understand money only as currency or currency substitutes such as checks and money orders, then a bank of issue creates money by issuing promissory notes.
If, however, we understand money as “all things transferred in commerce,” then we realize that a bank of issue does not, strictly speaking, create money, but change one form of money for another, taking a fee and making a profit for doing so. This is the type of banker — the “money changers” — that Jesus drove out of the Temple, evidently for overcharging for their services, not for performing them.
A bank of issue takes one form of money and exchanges it for another — and that means anything of value, including currency from another economy or system, such as the Roman or Greek money the Temple money changers exchanged for “sacred money” that would be accepted in the Temple or by other merchants and businessmen who preferred to deal in Shekels of Tyre instead of Roman Denarii or Greek Drachmae.
At one time, banks of issue issued banknotes, and each bank had its own currency backed by the promissory notes it issued, that might or might not pass at par with the official reserve currency. Nowadays, the few institutions that function as pure banks of issue, issue some form of negotiable promissory note that can be sold or exchanged for currency or currency substitutes. Where banks of deposit deal exclusively with existing currency and currency substitutes, banks of issue deal exclusively with existing money (“past savings”), which may be currency or any other form of wealth in the possession of the borrower.
This is the way the “Cheese Banks of Parma” operate. Farmers make cheese that must be aged, but they need to make a profit immediately. They “mortgage” their cheese at a cheese bank, which takes possession of the cheese and deposits it in their vault (caves in which the cheese is aged) and issues the farmer a certificate that can be sold immediately or retained by the farmer when it (and the cheese) matures, paying a fee for the service.
Bank of Discount. Like a bank of issue, a bank of discount is also defined as a financial institution that takes deposits, makes loans, and issues promissory notes. Where a bank of issue deals exclusively with past savings in the possession of the borrower, however, a bank of discount deals exclusively with “future savings” — the present value of something that the borrower reasonably expects to have in his or her possession at some future date. This doesn’t mean that the goods or whatever don’t exist somewhere, but that the borrower does not own them.
When the possibility of the borrower coming into possession of the thing, whether money, a crop, or anything else, can be quantified, e.g., there is a 97% chance that the borrower will come into possession of the thing, so a loan based on a future thing worth $100,000 that the borrower expects to have — future savings — is discounted at 3%. Thus, a borrower who has a 97% chance of coming into a thing worth $100,000 in ninety days can obtain a loan of $97,000 now in exchange for a payment of $100,000 in ninety days. A bank of discount makes its profit out of this differential.
A bank of discount is thus the only category of bank that actually creates money, for the wealth that backs the promissory note the bank of discount issues does not yet exist in the possession of the borrower. Again, it probably exists somewhere, but the borrower does not own it. The money that a discount bank creates out of future savings or wealth to come into the possession of the borrower, is cancelled when it is redeemed with past savings or existing wealth that has come into the possession of the borrower.
To summarize,
· Banks of Deposit deal in existing currency,
· Banks of Issue deal in existing money, and
· Banks of Discount deal in future money.
What baffles many people is that there are few banks of issue and no banks of discount (that we know of) left in the world, and they automatically assume that all banks are banks of deposit, and that they are therefore engaged in illegal activities. They do not understand that commercial or mercantile and central banks are a combination of bank of issue and bank of discount, and can therefore legitimately create money — if it is done correctly, which today generally it is not.
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