Introduction
The trend decline in the share of financial assets intermediated on bank balance sheets has caused concern for the survival of banking. First noticed in the 1920s in the United States (cf. Currie, 1934), the problem reappeared some 30 years later (cf. Goldsmith, 1958) and after another 30-some years is again today cause for concern.2 The phenomenon has also been observed in a wide range of countries including the UK and France (cf. Goldsmith, 1969). However, the decline of French banking, which occurred during the 1970s and 1980s, now seems to have been reversed, and the decline seems to have abated in a number of other countries, including the US. As yet, there has been little evidence in Germany, although it is widely predicted to occur as a response to the creation of the European Economic and Monetary Union (EMU) in Europe in 1999.
There is some dispute concerning the proper measure of the activity of banks in the economy and just exactly what these measures show. A commonly used benchmark is banksâ share of assets held by all financial institutions. In the US this share has fallen from around 50% in the 1950s to around 25% in the 1990s. The figure was as high as 70% in the mid-19th century and over 60% in 1900 (cf. Goldsmith, 1958, 1969). On the other hand, measures of bank loans as a percentage of GDP show a rise from around 20% in the 1950s to over 30% in the 1990s and a rise in total bank assets as a proportion of GDP from 40% to 50% over the same period (cf. Boyd and Gertler, 1994). For the UK, the share of banks in total liabilities of financial intermediaries has fallen from over 60% in 1913 to under 30% in the 1990s (Kaufman and Mote, 1994, p. 8). Further, there are difficulties in defining appropriate measures for banksâ activity (cf. Kaufman and Mote, 1994, pp. 4â5) as well as in defining what should be classified as a bank.
A number of major countries, such as the US, Italy, France, and Japan, emerged from the war with âsegmentedâ banking systems in which legal restrictions limited the activities permitted to deposit-taking banks. These regulations created a legal and functional separation between âcommercialâ banks and ânon-bankâ financial institutions. The basic distinction was to restrict commercial banksâ investments to short- and medium-term lending, whereas non-banks were forbidden from issuing short-term demand or sight deposits.
In contrast, countries such as Germany and the UK maintained their prewar systems of bank regulation, which placed virtually no limitation on banksâ assets or liabilities. France eventually introduced this type of banking regulation in 1984, while the US is still debating reform that will abolish the existing separation of commercial and investment banking. European Community banking laws now allow banks the right of establishment under the regulatory regime operating in their home country. This has meant that most countries have revised their banking laws to allow their domestic banks the same freedom of operation granted to banks in France, Germany, and the UK. This is the case of Italy, which has recently changed its banking legislation to allow what has come to be called âuniversalâ banking. The US is the only country that has retained full segmentation, although with an increasing number of exceptions to the prevailing legislation. Under âSection 20â exemptions, specially authorized, highly capitalized banks were allowed to earn up to 5% of the income from special affiliated institutions undertaking activities normally excluded under prevailing US legislation. The limitation on earnings was increased to 10% and, in 1997, to 25%. Japan, whose post-war banking laws were patterned after those in the US, is also in the process of removing restrictions on bank activity.
It has been suggested that the change in the position of banks in the financing of business and household borrowing represents a process of financial disinter-mediation in which the number of intermediary agents involved in financial transactions is reduced. In particular, transactions take place directly between original contracting counterparties in the market rather than being arranged by banks acting as intermediaries.
Although changes are clearly taking place in the activities of banks, it is not clear that there has been a decrease in bank intermediation. For example, an increasing proportion of the demand deposits lost by commercial banks have been shifted to investment and mutual funds of various types that invest by lending to firms that were formerly borrowing funds from the commercial banks. Rather than a process of disintermediation, it is the form of bank intermediation that appears to have changed. In countries such as France, Italy, and even to some extent in the US, where banks have been permitted to extend their activities, their overall participation in the process of intermediation does not seem to have changed substantially. On the other hand, if banks are forbidden from organizing and participating in extended activities such as the sale and management of trust and investment funds, then it seems clear that the overall level of bank intermediation will fall. This has been the case of the commercial banks in the US operating without the Section 20 exemption.
This suggests that the âcrisisâ in banking is primarily a crisis relating to a particular definition of bank, the âcommercialâ bank, rather than financial institutions as a whole. Further, this suggests that it is primarily a crisis of American commercial banks, although banks in other countries are facing difficulties of a different nature. To the extent that banks are granted greater leeway to enter activities that had previously been forbidden to them by post-war regulations, their share in the intermediation of financial assets should not be expected to change substantially.
To evaluate the importance of this crisis in banking, it is thus necessary to evaluate the importance of the particular banking form, the âcommercial bank,â to the operation of the economy. To this end, Section 2 identifies two basic or âidealâ forms of bank, which seem to lie at the origins of the history of banking. Section 3 discusses the ways in which these two forms tended to merge the two diverse types of activity and the action of regulators to limit this integration. Section 4 attempts to discover the origin of modern commercial banks in the interaction between this tendency for banks to merge the two ideal forms of activity and the regulators attempts to keep them separate. It also seeks the reasons for the dominant presence of commercial banks, in particular in countries such as the US. Section 5 discusses the cause of the difficulties of commercial banks and the importance of these difficulties for the economy. As France has made a transition from a segmented system to a universal bank system, Section 6 investigates the way the French government responded to the similar difficul-ties facing French commercial banks in the post-war period and the impact of its new banking laws. The final section concludes that the difficulties facing commercial banks will not have dire consequences for the financing of the economy, although it is quite likely that the banking form that replaces commercial banks will have consequences for the stability of the banking system and thus on the performance of the economy as a whole. Whether banks, and the banking system, become more unstable depends on the prudential supervision and regulatory structures introduced that will determine the new form of banks and banking structure.
Two views of what banks do
The basic reason for modern economistsâ interest in banks is the idea that the rate of inflation is influenced by the growth of the supply of money. If banks are involved in the creation of the money supply, then control of banks must be an integral part of anti-inflation policy. As a result attention has been concentrated on the question of whether bank credit is money.
This approach denies money an impact on the operation of the real economy; it is a âveilâ that must be pierced to discover the actual operation of the economic system. If this is the case, even if bank credit is money, banks are only of peripheral interest, for their ability to create credit will have no impact on the real system. This is a question of the difference between what Schumpeter called âreal analysisâ and âmonetary analysis.â But, even monetary analysis is only concerned to show that pure barter exchange and âthe expression of the quantities of commodities and services and of exchange ratios between themâ (Schumpeter, 1954, p. 278) are not sufficient for an understanding of the operation of the real economic system. Thus money is only considered important because it has a direct effect on the barter exchange process. The impact of money on the real economy is the result of its use as a means of exchange and is of importance because its use in exchange is capable of disturbing the ârealâ barter exchange ratios.
From this point of view, banks are of importance only if the creation of bank credit can influence real exchange ratios, that is, in Hayekâs terminology, if money is not neutral. However, if bank credit is just a substitute for âmoney,â then banks remain largely irrelevant, even under âmonetary analysis,â because the creation of money is outside their control. Thus, in either approach, the importance of banks turns on whether their credit is considered as âmoney.â These questions were debated in the Bullionist Controversy over the resumption of specie payments after the 1797 Bank of England suspension of payment of its credit notes. Half a century later, the Banking and Currency Schools revisited the question. On this occasion the point under discussion had shifted to the substitution for banknotes for a new kind of bank credit, the transferable or chequeable deposit.
The joint-stock banks that were opened in London could not issue notes because this privilege was reserved to the Bank of England. There was, however, no restriction to prevent them from granting credits in the form of deposits subject to cheque. Because the framers of the Bank Act of 1844 thought that they had legislated the full substitution of banknotes and gold, the appearance of a new form of bank credit, the chequeable deposit, raised the question of whether or not deposits could be treated as equivalent to banknotes.
Given economistsâ obsession with the relation between money and prices, it is not surprising that these discussions are based on bank credit as a substitute for specie as a means of payment. However, there is another reason why banks may be of importance to the operation of the economy and which historically precedes the issue of notes. Indeed, it was only late in the history of banking, around the middle of the 19th century, that banks came to be primarily associated with their creation of means of exchange represented by the issue of circulating credits or âbanknotes.â The issue of notes as the main source of bank liabilities is a relatively new invention, given important impetus by the formation and ultimate success of the Bank of England. Before that time concentration was on the relation between banks and economic development. Indeed, banks were generally considered as quasi-alchemical institutions, capable of magically turning lead into gold by providing the capital required to promote economic development independently of the availability of real resources.
What is a bank?
Sir John Clapham, in his classic history of the Bank of England, observes that the note
issue was the last of the classical banking functions to evolve spontaneously in England, and it was Englandâs main contribution to the evolution of European banking. Deposit in some form or another, if only in the form of leaving your valuables with a man whom you trust who has a strong room, is very ancient; money lending perhaps more ancient still. Discount, the purchase of bills of exchange, goes back to the 12th century in Europe and was well-known in England in the later Middle Ages. But the combination of all these functions in one pair of hands, which constituted modern banking, and the supplementing of deposit by use of the âwrite-offâ from one account to another, and of the cheque for making payments to anyone, only took place finally in England between 1630 and 1670
(Clapham, 1945, I, p. 5)
Claphamâs four banking functions may be summarized under the headings of Income, Safety, Convenience, and Issue. Income relates to bank investments such as lending and discounting, covering the purchases of both the liabilities of private individuals, as well as liabilities of the public sector. He notes that â[a] banking system is so closely associated with public borrowing and with what is the oldest and most jealously guarded function of the state, the issue of money, that governments can seldom afford to leave it entirely unlicensed and uncontrolledâ (Clapham, 1945, I, p. 2). The Issue function is considered the most recent, first developed by the Bank of Sweden (1661) but suspended after only three years. The Bank of England in 1694 was among the first banks to have issued notes redeemable by the bearer rather than by the original creditor.
It is the Issue function that has attracted the attention of economists, overshadowing the Income function, which is largely overlooked in the analysis of the impact of banks on the economy. In simplified terms, this emphasis on the role of money as a means of payment has tended to concentrate attention on the liability side of the bank balance sheet at the expense of the asset side, which represents bank investments. Although assets must always equal liabilities, it should be obvious that the successful operation of any firm, whether it be a manufacturer or a bank, will depend on how the structure of its entire balance sheet contributes to the generation of net profits.
Clapham notes that the real novelty of the Bank of England was that its balance sheet was composed of government debt as its major income-earning asset and by notes payable to bearer as its major liability. Eventually, discounts were added to its assets, and a wider variety of note liabilities were issued, but it is this combination of long-term government debt financed by the issue of short-term circulating notes that is the distinguishing feature of the Bank. However, if the major innovation in banking in the 17th century was the issue of circulating bearer instruments, then the major function of banks before this date must have been independent of the creation of notes or deposits as substitutes for money.
Perusal of the available historical record3 appears to support this supposition, for institutions defined as âbanksâ have been known to operate in some form or other in Italy at least since Roman times. During this period the operations carried out by institutions functioning under the name âbankâ have covered wide combinations of assets and liabilities. Because there have been continuous innovations in both assets and liabilities and their combinations, what in any period has been called a âbankâ has experienced periods of crisis that have usually provoked changes in structure and methods of operation. Some of these crises have been caused by dysfunction in the balance sheet combinations of the banks themselves. Others have arisen because of competition from financial institutions employing...
