Banking: An Overview

1
Contents
Evolution of Banking ............................................................................................................................... 3

1.1 What is banking? ............................................................................................................................... 3

1.2 History of Banking ............................................................................................................................. 3

1.3 Services Offered by Banks ................................................................................................................. 5

1.3.1 Traditional Services Offered by Banks ........................................................................................... 5

1.3.2 New Services Offered by Banks ..................................................................................................... 5

1.4 Trends in Banking Services ................................................................................................................ 6

1.5 Classification of Banking Systems ..................................................................................................... 6

1.5.1 Central Banking System ................................................................................................................. 6

1.5.2 Commercial Banking System ........................................................................................................ 10

1.5.3 Classification of Commercial Banking Services ............................................................................ 11

1.6 Structure of Financial System ......................................................................................................... 11

2
In this chapter, the reader will learn the process of evolution of banking and its contribution to the
growth of world commerce. The chapter will provide the rationale for banking and its supervision. A
brief mention has been made of the high level segmentation of banking, which will be explored
further in the next chapters. The chapter ends with the description of typical financial statements in a
bank. The description of the terms in a financial statement has been kept to a level suitable for an
introductory course.

Evolution of Banking
1.1 What is banking?
Traditionally banking is defined as the process of accepting deposits from surplus units in
the economic system (lenders) with the objective of lending these funds to the deficit units
in the economic system (borrowers).

A simple form of banking was practiced by the ancient temples of Egypt, Babylonia, and
Greece, which loaned at high rates of interest the gold and silver deposited for safekeeping.
Private banking existed by 600 B.C. and was considerably developed by the Greeks, Romans,
and Byzantines. Medieval banking was dominated by the Jews and Levantines because of
the strictures of the Christian Church against interest and because many other occupations
were largely closed to Jews. The forerunners of modern banks were frequently chartered for
a specific purpose, e.g., the Bank of Venice (1171) and the Bank of England (1694), in
connection with loans to the government; the Bank of Amsterdam (1609), to receive
deposits of gold and silver.
Banking developed rapidly throughout the 18th and 19th centuries, accompanying the
expansion of industry and trade, with each nation evolving the distinctive forms peculiar to
its economic and social life. Over a period of time banking has undergone lot of changes and
now banking is not restricted to only taking deposits and lending. Though deposit taking and
lending still remains the core banking activity, now banking includes
services like wealth management services for ultra rich high net worth individuals, housing
finance, mergers and acquisitions advisory services, leasing, trade finance, automobile
finance, education finance, and the list goes on. The following section describes how
banking has developed over all these years since its inception.

1.2 History of Banking

Banking is one of the most important services in financial sector. It also provides fuel for
economic growth of a country. It offers safety and liquidity for the investors, both on short
and long term basis, offering comparatively a fair return for them. Banks are the principal
source of credit for dealers, households, small businesses like retail traders and large
business houses. Efficiency of a bank depends on their ability to satisfy their investors by
offering comparatively a better interest rate to depositors and at the same time offering
credit to their borrowers comparatively at cheaper interest rates. With a narrow interest
rate spread (difference between borrowing and lending rate), they should make profit also.
Looking into the present profile of a bank, it has grown up phenomenally offering large
number of products other than the rational functions of accepting deposits and lending
funds. It is worth analyzing the historic background of evolution of banking services.

3
When and how the banks appeared? Linguistics (the science of language) and etymology
(the study of origin of words) suggest an interesting story about the origin of banking. Both
the old French word ‘banque’ and the Italian word ‘banca’ were used centuries ago to mean
a ‘bench’ or ‘money changers table’. This describes quite well what historians have observed
concerning the first bankers who lived more than 2000 years ago. They were money
changers situated usually at a table or in a small shop in the commercial district aiding
travelers who came to town by exchanging foreign coins for local money or discounting
commercial notes for a fee in order to supply merchants with working capital.

European Banks during early stages were only for safe keeping of valuables like gold, silver
bullion as people had the fear of loss of their assets due to theft, expropriation by
government or war. Merchants who collected their payments, in the form of gold and silver
in other countries, deposited their collections in the nearest bank instead of carrying such
assets and exposing themselves to the risk of sea piracy or storms in the sea.
During the reigns of King Henry VIII and Charles I in England government’s efforts to seize
the gold and silver from the public made them to deposit their stock of gold and silver with
goldsmith shops who in turn issued paper tokens or certificates indicating the details of gold
and or silver deposited with them. This certificate began to circulate as money because it
was more convenient and less risky for them to carry this certificate. These goldsmiths also
offered the service of valuing the gold and silver and issuing ‘valuation certificate’. Most of
the customers brought gold, silver or ornaments to these goldsmiths and got it examined to
find out whether they were genuine or fake. Even today certain ‘approved valuers’ provide
this service. The early bankers might have used their own capital for funding such activities
but it was not long before the idea of attracting deposits and securing temporary loans from
wealthy customers became an important source of bank funding. Loans were then made
available to shippers, landowners and merchants at lowest interest of 6% per annum and as
high as 48% per month for riskier ventures. Most of the banks in early stages were of Greek
origin.

Gradually the banking industry spread outward from the classical civilization of Greek and
Rome into northern and western parts of Europe. Banking industry encountered religious
protests during the Middle Ages primarily because the loan given to the poor was at higher
interest rate. However, in Europe, when the Middle Ages drew into close and the
Renaissance started, bulk of deposits and loans were from wealthy customers and the
religious opposition died down slowly. Between 15th to 17th centuries, due to the
development of navigation facilities, new trade routes and cross country trade activities,
nucleus of world commerce gradually shifted from Mediterranean region towards Europe
and British Islands where banking became a primary leading industry. Industrial revolution
was planted during the same period, which demanded a well developed financial system.
When production activities expanded at a mass scale, it required an equal quantum of
expansion of global trade to absorb the output produced and new methods of trade
payments and credit availability. Banks, which had the competency and capacity to manage
the needs, grew faster. Some of the institutions that had the fastest growth during this
period were Medici Bank in Italy and Hochstetter Bank in Germany.

When colonies were established in North and South America, banking practices were
revised and new practices were introduced. In the beginning of 19th Century, however, the

4
state governments in US began chartering banking companies. Many of them were simply
extensions of other commercial enterprises in which banking services were largely
secondary to merchant’s sales. Developments of large professionally managed banking firms
were centered in few commercial centers especially in New York. During Civil War, federal
government became a major force in US banking. Congress established office of the
Comptroller of Currency (OCC) in 1864 for the purpose of chartering national banks. This
divided the bank regulatory system with both federal government and the states playing key
roles in the control and supervision of banking activities, which continues even today.

1.3 Services Offered by Banks

Financial institutions can be defined according to the services they provide to public. In
United States any institution accepting deposits subject to withdrawal on demand such as
drawing a check or by making an electronic withdrawal and making loans of commercial or
business nature is defined as a ‘bank’. Several financial service companies and leading bank
holding companies filed application for ‘non-bank banks’ because they could establish these
service units freely across state lines and also have an access to federal deposit insurance. In
1987 Congress put a halt to further non-bank bank expansion by subjecting the parent
companies of non-bank banks to the same regulatory restrictions that traditional banking
organizations are subjected to. Moreover
Congress defined bank as ‘a corporation that is a member of the Federal Deposit Insurance
Corporation’. By this law a bank’s identity depends on which government agency insures its
deposits.

With all the legal maneuverings the safest approach to identify what is a bank is probably to
view these institutions in terms of what types of services they offer to public. Banks are
today offering a wide range of financial services and can be labeled as ‘financial
departmental stores’.

1.3.1 Traditional Services Offered by Banks

a. Carrying out currency exchanges
b. Discounting commercial notes and making business loans
c. Offering savings deposits
d. Safe keeping valuables
e. Supporting government activities with credit by purchasing government bonds
f. Offering checking accounts demand deposits
g. Offering trust services managing financial affairs and property of individuals and
business forms for a fee

1.3.2 New Services Offered by Banks

a. Granting consumer loans
b. Financial Advisory Services
c. Credit and debit cards
d. Cash management
e. Equipment leasing

5
 f. Venture capital loans
g. Insurance services
h. Retirement plans
i. Security brokerage investment services
j. Mutual funds and annuities
k. Investment banking and merchant banking services

Looking into the additional services that are extended by a bank today, it is evident that
beginning with a safe custodian for gold and silver, banking has moved into an era of
offering all types of financial services under one unit. Their service menu is constantly
growing leading to a trend of ‘banking revolution’. These rapid changes may leave banks of
next generation almost unrecognizable from those of today.

1.4 Trends in Banking Services

While tracing the evolution of banking services one cannot lose sight of the following
trends:
a. Proliferation of new services and innovation of new customer friendly products
b. Rising competition
c. Deregulation of banking and financial markets
d. Raising operational costs
e. Invasion of information technology – electronic funds transfer – data transfers
f. Consolidation of banking industry – mergers and acquisitions
g. Globalization of financial services
h. Transparency in banking operations
i. Capital adequacy to withstand credit and operational risks.

1.5 Classification of Banking Systems

Banking systems have evolved to meet the requirements that arose at different points of
time in various economies and also the regulatory intervention that followed. Banking can
be broadly classified as:

1.5.1 Central Banking System

Central Banking system is a non-commercial banking system which consists of the National
supervisory framework for regulation of banking and controlling the money supply in the
economy.

The need for a central bank is felt only when there is a banking system in place. Most central
banks evolved in order to take care of actual or potential problems in the banking system.
Central banking was initially practiced with the help of a large number of informal norms,
conventions and self-imposed codes of conduct. These were later formalized into theory
and institutionalized into laws that apply to today’s central banking institutions. The first
central bank, the Sveriges Riksbank,was established in Sweden in 1668; and the second was
the Bank of England (BoE), set up in 1694 under a Royal Charter. Most of the bigger
European central banks were established in the nineteenth century, while the German

6
Bundesbank and the U.S. Federal Reserve System in the twentieth century. The early central
banks were established primarily to finance commerce, foster growth of the financial
system and to bring about uniformity in issuance of currency notes.

After the First World War, the role of central banks became even more important. Their role
of supervising the business of private commercial banks was extended and lender of-the-
last-resort function to stabilize the banking system during financial panics was
strengthened. The First World War also led to the central banks’ increasing involvement in
extending credit to their governments. In order to handle their new role as brokers for
government debt, central banks were allowed to trade government paper in the open
market and were entitled to develop open market policy instruments for fine-tuning of
interest rates and for credit and money supply expansion. This gave rise to more
discretionary powers to central banks to conduct their operations. Since 1933 in the US and
shortly after the Second World War in Germany, central banks were empowered to change
minimum reserve requirements, which constituted an important direct tool of monetary
policy.
Central banks have evolved in accordance with the specific requirements of the economies
in which they are situated and in response to the kind of demands made on them. The
genesis of central banking is different between developed and developing countries. As a
result, the role of central banks in developing countries of today is typically different from
that of the developed country central banks when they were developing. In industrial
countries this purpose centered on the need to have a lender-of the-last-resort, in
developing countries such as India, central banks came into existence when banking was
underdeveloped. In fact, the central banks were instrumental in influencing the spread of
commercial bank networks in developing countries. 2 Central banks act as lender of last
resort for banks/financial institutions that do not have any other means of borrowing left
and whose failure would adversely affect the economy.

1.5.1.1 Regulatory Evolution

The origin of banking regulation in a broad sense or the primitive form of banking regulation
can be traced back to the end of the Middle Age right after the emergence of banking
industry. But systematic and extensive banking regulation originated only in the mid-
nineteenth century when the government involvement in the national economy began to
expand. Before that, banks were not or little regulated, a situation often referred to as free
banking or laissez faire banking.

Late Medieval Period

The late medieval (late 13th century) experience of Aragon demonstrates vividly the genesis
of banking regulation as a response to moral hazard following government guarantees. In
some city states such as Barcelona, Valencia, and Tortosa, the economy was booming and
the government had relatively abundant fiscal resources.
Understanding well the importance of bank stability to the society, the kings of these cities
offered guarantees to bank deposits. Government insurance caused moral hazard problems:
irresponsibility, speculation, and lack of foresight on the part of some early bankers led to
fraudulent bank failures during the last third of the thirteenth century. In response to
fraudulent bankruptcies, the legislatures in Barcelona and Lerida passed the first laws
governing banking in Catalonia in 1300 and 1301, respectively. The law in Barcelona

7
provided stringent rules to punish those bankers who went bankrupt: they should be
publicly denounced, not only in the streets of Barcelona but also in all the towns where they
had done business. They could not open any exchange or bank thereafter, and would be
imprisoned and kept on bread and water until they paid off all their creditors. The
government also strengthened regulation of bank accounting system and enhanced the
creditor’s rights. The banker was declared responsible for all entries made for his clients,
and no one, not even the king, could postpone settlement of credit beyond the set time. In
Lerida, the king decreed that money changers were responsible to their creditors and that
their goods could be confiscated in cases of default.

To curb bankers’ moral hazard problem as a result of deposit guarantee, the government
required banks to submit a deposit as guarantee: no one would be allowed to open a bank
in Catalonia without first depositing 1000 silver marks in Barcelona and Lerida and 300
marks in all other towns and cities in Catalonia. Only after the deposit was paid could the
money changer place the tapestry bearing the shield of the city on his table, indicating that
his office was guaranteed. Those who did not pay the fee had to leave the wooden top of
their tables bare, without tapestries or other cloths, as a warning to their clients. This is in
nature similar to the deposit reserve or capital adequacy requirement in contemporary
banking practice, which no doubt can contribute to banking stability.

Early Nineteenth Century

As the government’s involvement in the national economy began to increase, the role of
governments to intervene in the economic affairs as well as the fiscal and financial capacity
of governments increased. The power of taxation and monetary policy equipped the
governments in respective economies with ever increasing financial resources. At the same
time, governments were subject to the pressure of public opinions and therefore became
concerned with social welfare. In this role, governments used to bail out failing banks in
order to provide a social safety net. The bailout of the Chilean Mortgage Bank is one of the
earliest examples of government bailouts in the 19th century.
During the same period, the concept of laissez faire was made popular by Adam Smith.
Laissez-faire is a French phrase meaning "let do, let go, let pass." It became used as a
synonym for strict free market economics during the early and mid-19th century. It is
generally understood to be a doctrine opposing economic interventionism by the state
beyond that which is perceived to be necessary to maintain peace and property rights.
Laissez faire banking or free banking refers to the institutions of banking with no or little
government regulation. Under this regime, there is no government control of the quantity
of exchange media, no state-sponsored central bank, no legal barriers to the entry,
branching, or exit of commercial banks, no government restriction on interest rates or bank
asset and liability portfolios, and no government deposit guarantee.
Furthermore, the government doesn’t have motivation and sufficient financial resources to
ensure the solvency of any bank. Contrary to what people might have imagined, free
banking was not a synonym of banking panics. Individual banks did fail occasionally in the
free banking era, but there did not seem to be major banking panics and crises. Some banks
did fail, but usually it was not because of bankers’ fraudulence or recklessness.
One important reason for bank failure in that period was that banks succumbed to the
political authority by extending loans in an inappropriate way. For example, some banks
with international business in Britain lent money to British aristocracy under political

8
pressure without daring to ask for collateral. Some British aristocrats simply defaulted on
loans to escape liability.
The Scottish experience of free banking in the 18th and 19th centuries presents a classic
example of how market discipline can stabilize the banking system. In the absence of
government regulation, market generates effective mechanism in disciplining bankers’
behavior. Virtually all bank owners carried unlimited liabilities: all but three of Scotland’s
banks operated with unlimited liability during the free banking era. This contributed to
banking stability by removing risk-taking tendency on part of bank owners. Bankers made
very careful decisions and risk management to avoid financial risk contagion. To protect
itself from any spillover effects from other banks’ difficulties, each bank attempted to
establish a distinct brand-name identity and reputation, and held as little of other banks’
liabilities as possible.

Late Nineteenth and Twentieth Century

Over a period of time, different economies depending upon their stage of development and
the specific constraints, formulated and developed national regulatory systems. At the same
time, financial liberalization was also becoming popular. To strengthen bank regulation and
supervision following financial liberalization often requires the government to choose
alternative regulation instruments and methods to monitor banks.
Unfortunately, in reality, many countries didn’t establish complementary banking
regulations, and as a result suffered from financial turmoil in the wake of financial
liberalization. Prominent among these were the Savings & Loans Associations Crisis in US,
Chilean and Mexican Crisis, etc.
When banking systems in a number of industrial countries weakened in the late 1980s,
pressure developed for harmonizing bank regulation among industrial countries, at least for
large internationally-active banks in these countries. The harmonization was intended both
to enhance safety by reducing the likelihood of individual failures that could spread the
adverse effects across national boundaries and to provide for a more level playing field, so
that banks in different countries would not benefit from any competitive advantages due to
subsidies from their governments, such as lower capital ratios in an environment of explicit
or implicit deposit insurance or other government support. In large measure, the call for
such transnational regulation reflects both the limited market discipline on banks in most
countries because of the existence of actual or conjectural government guarantees and the
greater difficulty in monitoring banks in non-home jurisdictions by both private stakeholders
and government regulators. This resulted into a capital measurement system commonly
referred to as the Basel Capital Accord. This system provided for the implementation of a
credit risk measurement framework with a minimum capital standard of 8% by end-1992.
Since 1988, this framework has been progressively introduced not only in member countries
but also in virtually all other countries with active international banks. In June 1999, the
Committee issued a proposal for a New Capital Adequacy Framework (Basel II) to replace
the 1988 Accord. Following extensive interaction with banks and industry groups, the
revised framework was issued on 26 June 2004.

9
1.5.2 Commercial Banking System
Commercial banking system consists of a network of banks which provide a variety of
banking services to the individuals and the businesses in the economy. The commercial
banking systems may be of two types:

1.5.2.1 Unit Banking System

Unit banking involves provision of banking services by a bank in a limited local area.
Sometimes, unit banks are also permitted to have branches in a limited area. The unit banks
are connected through correspondent bank system which provides for the transfer of funds
between unit banks. The advantage of unit banking is that it facilitates the mobilization of
deposits and their deployment for needs of the local community where the bank is located.
a. Unit banking gave way to branch banking system due to the following reasons:
b. Economic interdependence among various states
c. Infrastructure development
d. Growth of big business firms
e. Mobility of population
f. Increasing emphasis on convenience
g. Commercial Banking System
h. Unit Banking
i. Branch Banking

1.5.2.2 Branch Banking System

In Branch banking system the bank has a head office which controls and directs the
branches located in multiple locations. The branches may be located in the same city, same
state, across states, or even across countries. The head offices as well as the branches are
under the control of the same board.

Branch banking offers the following advantages:

a. Facilitate the allocation of savings to their most efficient use across the nation
irrespective of their origin i.e. savings may originate at different locations and may
be deployed at different locations.
b. Diversifications of risk as risks are spread over an entire range of commercial assets
c. Leads to uniform structure of interest rates
d. Facilitates the penetration of best banking services to the far flung areas of the
nation

A major drawback of the branch banking system is that there is excessive centralization and
branches have to look up to the head office for many issues. Further, in branch banking the
personnel may also get relocated to various branches during their employment with the
bank and if they are from a different area or state, they may not be aware of the special
problems faced by the locals/natives of that area/state.

10
1.5.3 Classification of Commercial Banking Services
Commercial banking activities may be classified into:

1.5.3.1 Retail Banking

Retail banking refers to the mobilization of deposits from individuals and providing loans to
individuals and small businesses. Retail banking is characterized by large volume of small
value transactions. For example, the deposit accounts, personal loans to individuals, credit
cards, home mortgage loans, etc come under retail banking.

1.5.3.2 Wholesale Banking

Wholesale banking is also known as business to business banking. It refers to the
transactions between banks and large customer like corporate and government involving
large sums of money. It also includes the transactions between banks. It includes general
lending to businesses as well specialized services like mergers and acquisitions advisory
services, leasing, investment management services, etc.
Commercial Banking
1.5.3.3 Universal Banking
Universal banking is the combination of retail and wholesale banking. It includes activities
like general deposit taking and lending, trading in financial assets, brokerage services,
investment management, insurance, foreign exchange transactions, etc.

1.6 Structure of Financial System

A typical financial system consists of:

Financial Markets

Financial Instruments

Financial Institutions

Types of Financial Institutions

Financial Institutions consist of organizations like banks, finance companies, etc.
Depending on the degree of specialization and the type of activities performed, financial
Institutions can be classified into the following broad categories:

Regulatory Institutions

Financial Intermediaries, and

Other Institutions

The regulatory institutions supervise the functioning of the various institutions and markets
in the economy with a view to regulate and develop the financial system as a whole. The
financial intermediaries on the other hand help in channelizing the flow of funds in the
economy from surplus/saving units (individuals as well as corporate) to deficit units in the
economic system.

11
Financial intermediaries play an important role of channelizing the flow of funds in the
economy. They can be further classified into:

Depository Institutions

Non-Depository Institutions

Depository Institutions

These institutions play an important role in the development of the financial markets. These
institutions play an important role in channelizing the savings in the economy.

Depository institutions mainly include:

Commercial Banks,

Savings and Loan Associations, and

Credit Unions

Commercial Banks - These are depository institutions which are in the business of deposit
taking and lending. They provide a range of products and services for individuals as well as
businesses.

Savings & Loan Associations – These institutions provide savings account facilities and are
also into mortgage lending. Many of them provide a range of services similar to a
commercial bank.

Credit Unions - These are not-for-profit financial cooperatives that offer personal loans and
other consumer banking services. Commercial banks, savings & loan associations and credit
unions together hold a large share of the nations’ money stock in the form of various types
of deposits and help in their transfer to effect payments. They also lend these funds directly
to individuals and businesses for a variety of purposes and also lend them indirectly through
investment in financial instruments.

Non-Depository Institutions
These institutions perform a variety of functions other than banking. The following are the
common types of non-depository institutions:

Finance Companies

Mutual Funds

Security Firms – Investment bankers, brokers and dealers

Pension Funds

Insurance Companies

12