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.
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| 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.
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| 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?
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| 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.
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| "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.
