The term bank apparently owes its origin to the “bank” or bench used by the moneychangers during the Middle Ages. Historically, some banks were called banks of deposit, and mainly held deposits of foreign and domestic currencies and arranged payment in foreign trade transactions. The Bank of Amsterdam was a bank of deposit.
Other banks created deposits that acted as a circulating medium of money in a society. One of the earliest banks in this category, the Bank of Venice, was formed when a group of the government’s creditors combined and began using government debt as a means of payment in trade. The famous merchant bankers, such as the Rothschilds, acted largely as brokers marketing government and corporate securities to wealthy patrons.
Central banks are bankers’ banks, and these banks trace their history from the Bank of England. These banks buy government debt, have a monopoly on the issuance of paper money, and often act as a lender of last resort to commercial banks. The term bank nowadays refers to these commercial banks.
Commercial banks in modern capitalist societies act as financial intermediaries, raising funds from depositors and lending the same funds to borrowers. The depositors’ claims against the bank, their deposits, are liquid, meaning banks are expected to redeem deposits on demand, instantly. Banks’ claims against their borrowers are much less liquid, giving borrowers a much longer span of time to repay money owed banks. Because a bank cannot immediately reclaim money lent to borrowers, it may face bankruptcy if all its depositors show up on a given day to withdraw all their money. Protecting banks and bank customers from bank failures of this sort is the aim of much government banking regulation.
The principle of fractional reserve banking lies at the heart of the modern commercial banking system. During a given period of time a bank will receive fresh deposits while existing deposits are withdrawn. Normally the fresh deposits and the withdrawn deposits cancel each other out. Despite daily deposits and withdrawals, a bank maintains an average level of deposits that represents funds the bank can largely keep loaned out. For safety banks hold back a certain fraction of deposits, called reserves (thus fractional reserve banking), to cover themselves over periods of time when withdrawn deposits exceed fresh deposits. Because these reserves earn no interest, banks are tempted to cut the margin of reserves a bit thin. If adequate, these reserves enable a bank to weather a crisis of confidence when masses of people suddenly withdraw deposits out of fear.
When a bank fails the bank’s customers, the depositors, suffer as much or more than the bank’s owners. This makes the banking industry an excellent candidate for government regulation. Bank lending policy can also aggravate the business cycle. During an economic downswing banks can become overly cautious, restricting the availability of loans and sending the economy into a steeper downward spiral. On the upswing, however, banks lose their caution, generously granting loans and propelling the economy into an inflationary boom. Government regulation strives to protect bank depositors from bank failures and to encourage banks to become a stabilizing force in the economy.