What Is the History of Banking?
Banking has been around since the first currencies were minted—perhaps even before that, in some form or another. Currency, in particular coins, grew out of taxation. As empires expanded, functional systems were needed to collect taxes and distribute wealth.
- Banking institutions were created to provide loans to the public. As economies grew, banks allowed members of the general public to increase their credit and make larger purchases.
- Historically, temples were considered the earliest forms of banks as they were occupied by priests and became a haven for the wealthy.
- The earliest Roman laws allowed for the taking over of land in lieu of loan payments that were owed between debtors and creditors.
- A well-known economist, Adam Smith, theorized during the 18th century that a self-regulated economy, known as "the invisible hand," would allow for markets to reach equilibrium.
- The panic of 1907 was a trigger of two brokerage firms that had become bankrupt causing a recession when liquidity was was restricted. This led to the creation of the Federal Reserve Bank.
Understanding Banking History
The history of banking began when empires needed a way to pay for foreign goods and services with something that could be exchanged easily. Coins of varying sizes and metals eventually replaced fragile, impermanent paper bills.
Coins, however, needed to be kept in a safe place, and ancient homes did not have steel safes. According to World History Encyclopedia, wealthy people in ancient Rome kept their coins and jewels in the basements of temples. The presence of priests or temple workers, who were assumed devout and honest, and armed guards added a sense of security.
Historical records from Greece, Rome, Egypt, and Ancient Babylon have suggested that temples loaned money out in addition to keeping it safe. The fact that most temples also functioned as the financial centers of their cities is a major reason why they were ransacked during wars.
Coins could be hoarded more easily than other commodities, such as 300-pound pigs for example, so a class of wealthy merchants took to lending coins, with interest, to people in need. Temples typically handled large loans and loans to various sovereigns, and wealthy merchant money lenders handled the rest.
The First Bank
The Romans, who were expert builders and administrators, extricated banking from the temples and formalized it within distinct buildings. During this time, moneylenders still profited, as loan sharks do today, but most legitimate commerce—and almost all government spending—involved the use of an institutional bank.
According to World History Encyclopedia, Julius Caesar, in one of the edicts changing Roman law after his takeover, gives the first example of allowing bankers to confiscate land in lieu of loan payments. This was a monumental shift of power in the relationship of creditor and debtor, as landed noblemen were untouchable through most of history, passing debts off to descendants until either the creditor or debtor's lineage died out.
The Roman Empire eventually crumbled, but some of its banking institutions lived on in the form of the papal bankers that emerged in the Holy Roman Empire and the Knights Templar during the Crusades. Small-time moneylenders that competed with the church were often denounced for usury.
Eventually, the various monarchs that reigned over Europe noted the strengths of banking institutions. As banks existed by the grace, and occasionally explicit charters and contracts, of the ruling sovereignty, the royal powers began to take loans to make up for hard times at the royal treasury, often on the king's terms. This easy financing led kings into unnecessary extravagances, costly wars, and arms races with neighboring kingdoms that would often lead to crushing debt.
In 1557, Philip II of Spain managed to burden his kingdom with so much debt (as the result of several pointless wars) that he caused the world's first national bankruptcy—as well as the world's second, third, and fourth, in rapid succession. This occurred because 40% of the country's gross national product (GNP) was going toward servicing the debt. The trend of turning a blind eye to the creditworthiness of big customers continues to haunt banks today.
Adam Smith and Modern Banking
Banking was already well-established in the British Empire when Adam Smith introduced the "invisible hand" theory in 1776. Empowered by his views of a self-regulated economy, moneylenders and bankers managed to limit the state's involvement in the banking sector and the economy as a whole. This free-market capitalism and competitive banking found fertile ground in the New World, where the United States of America was about to emerge.
Initially, Smith's ideas did not benefit the American banking industry. The average life for an American bank was five years, after which most banknotes from the defaulted banks became worthless. These state-chartered banks could, after all, only issue banknotes against the gold and silver coins they had in reserve.
A bank robbery meant a lot more then than it does now in the age of deposit insurance and the Federal Deposit Insurance Corporation (FDIC). Compounding these risks was the cyclical cash crunch in America.
Alexander Hamilton, a former Secretary of the Treasury, established a national bank that would accept member banknotes at par, thus floating banks through difficult times. After a few stops, starts, cancellations, and resurrections, this national bank created a uniform national currency and set up a system by which national banks backed their notes by purchasing Treasury securities, thus creating a liquid market. The national banks pushed out the competition through the imposition of taxes on the relatively lawless state banks.
The damage had been done already, however, as average Americans had already grown to distrust banks and bankers in general. This feeling would lead Texas's state to outlaw corporate banks—a law that stood until 1904.
Most of the economic duties that would have been handled by the national banking system, in addition to regular banking business like loans and corporate finance, fell into the hands of large merchant banks because the national banking system was sporadic. During this unrest that lasted until the 1920s, these merchant banks parlayed their international connections into political and financial power.
These banks included Goldman Sachs, Kuhn, Loeb & Co., and J.P. Morgan & Co. Originally, they relied heavily on commissions from foreign bond sales from Europe, with a small back-flow of American bonds trading in Europe. This allowed them to build capital.
At that time, a bank was under no legal obligation to disclose its capital reserves, an indication of its ability to survive large, above-average loan losses. This mysterious practice meant that a bank's reputation and history mattered more than anything. While upstart banks came and went, these family-held merchant banks had long histories of successful transactions. As large industries emerged and created the need for corporate finance, the amounts of capital required could not be provided by any single bank, and so initial public offerings (IPOs) and bond offerings to the public became the only way to raise the required capital.
The public in the United States, and foreign investors in Europe, knew very little about investing because disclosure was not legally enforced. For this reason, these issues were largely ignored, according to the public's perception of the underwriting banks. Consequently, successful offerings increased a bank's reputation and put it in a position to ask for more to underwrite an offer. By the late 1800s, many banks demanded a position on the boards of the companies seeking capital, and if the management proved lacking, they ran the companies themselves.
J.P. Morgan and Monopoly
J.P. Morgan & Co. emerged at the head of the merchant banks during the late 1800s. It was connected directly to London, then the world's financial center, and had considerable political clout in the United States. Morgan and Co. created U.S. Steel, AT&T, and International Harvester, as well as duopolies and near-monopolies in the railroad and shipping industries, through the revolutionary use of trusts and a disdain for the Sherman Antitrust Act.
Although the dawn of the 1900s saw well-established merchant banks, it was difficult for the average American to obtain loans. These banks didn't advertise, and they rarely extended credit to the "common" people. Racism was also widespread, and although bankers had to work together on large issues, their customers were split along clear class and race lines. These banks left consumer loans to the lesser banks that were still failing at an alarming rate.
The Panic of 1907
The collapse in shares of a copper trust set off a panic, a run on banks, and stock sell-offs, which caused shares to plummet. Without the Federal Reserve Bank to take action to calm people down, the task fell to J.P. Morgan to stop the panic. Morgan used his considerable clout to gather all the major players on Wall Street to maneuver the credit and capital they controlled, just as the Fed would do today.
The End of an Era
Ironically, this show of supreme power in saving the U.S. economy ensured that no private banker would ever again wield that power. Because it had taken J.P. Morgan, a banker who was disliked by much of America for being one of the robber barons along with Carnegie and Rockefeller, to save the economy, the government formed the Federal Reserve Bank (the Fed) in 1913. Although the merchant banks influenced the structure of the Fed, they were also pushed into the background by its formation.
Even with the establishment of the Fed, financial power and residual political power were concentrated on Wall Street. When World War I broke out, America became a global lender and replaced London as the center of the financial world by the end of the war. Unfortunately, a Republican administration put some unconventional handcuffs on the banking sector. The government insisted that all debtor nations must pay back their war loans, which traditionally were forgiven, especially in the case of allies, before any American institution would extend them further credit.
This slowed down world trade and caused many countries to become hostile toward American goods. When the stock market crashed on Black Tuesday in 1929, the already sluggish world economy was knocked out. The Fed couldn't contain the crash and refused to stop the depression; the aftermath had immediate consequences for all banks.
A clear line was drawn between banks and investors. In 1933, banks were no longer allowed to speculate with deposits, and Federal Deposit Insurance Corporation (FDIC) regulations were enacted to convince the public it was safe to come back. No one was fooled and the depression continued.
World War II Stimulates Recovery
World War II may have saved the banking industry from complete destruction. WWII and the industriousness it generated stopped the downward spiral afflicting the United States and world economies.
For the banks and the Fed, the war required financial maneuvers using billions of dollars. This massive financing operation created companies with huge credit needs that, in turn, spurred banks into mergers to meet the demand. These huge banks spanned global markets.
More importantly, domestic banking in the United States had finally settled to the point where with the advent of deposit insurance and mortgages, an individual would have reasonable access to credit.
The Benefits of Banking
With the exception of the extremely wealthy, few people buy their homes in all-cash transactions. Most of us need a mortgage, or some form of credit, to make such a large purchase.
Banks have come a long way from the temples of the ancient world, but their basic business practices have not changed. Banks issue credit or loans to people who need them, but they demand interest on top of the repayment of the loan. Although history has altered the finer points of the business model, a bank's purpose is to make loans and protect depositors' money. Even today, where digital banking and financing are replacing traditional brick and mortar locations, banks still exist to perform this primary function.