Banks When there are surpluses that are not required for the moment, we look for places of

5.2.1 Banks When there are surpluses that are not required for the moment, we look for places of

safekeeping. Squirrels store nuts in the hollows of trees, bees store honey in their hives, and some people store surplus cash under the mattress at home. Thieves and predators may rob the owners of these stored treasures. The very first banks may have been the religious temples of the ancient world, for the storage of gold and jewels. Their owners may have felt that the temples were the safest places available in which to store gold since the temples were constantly attended, well built, and sufficiently sacred to deter some would-be thieves. Modern workers receive pay- checks periodically, such as weekly or monthly, and deposit them in a local bank to

be withdrawn later when needed. It is safer to put the money in the bank that is better guarded than a mattress at home, with the added advantage of being able to pay bills by checks rather than carrying a lot of cash through the streets.

The concept that cash saving deposits could be used to generate loan income was recorded from the eighteenth century BCE in Babylon, in the form of loans from temple priests to merchants. One justification for charging interest is to com- pensate for the lender’s risk that the merchant may not be able to pay back the loan; another justification is the time value of money, as people usually feel that a nugget of gold today is worth more than a nugget next year. A bank combines these two functions: accepting deposits that are liquid and can be withdrawn at any time, and making loans with longer fixed periods at high interest rates. When a farmer needs funds in the springtime to buy seeds and fertilizers, which can be repaid in the autumn when the crop is sold, he can borrow from a bank for 6 months and pay interest. When a store wants to buy inventory in time for Christmas shopping, or to open a new branch, it can finance these activities from savings, investors, or a bank loan. A homebuyer finances the purchase with a long-term mortgage where the house is the collateral in case the borrower is unable to pay back the loan and inter- est on time.

The ascent of Christianity in Rome exerted an influence and led to restrictions to banking, as the charging of interest and usury were seen as immoral and sinful. Jewish entrepreneurs were not restricted from lending money to Christian custom- ers, and established themselves in the provision of financial services, which were in increasing demand by the expansion of European trade and commerce. The pilgrims and Crusaders needed money to finance their journeys from Western Europe to Jerusalem. The Templars became the bankers of kings in the Holy Land and the financiers of pilgrims and crusaders. After the loss of Jerusalem and the Holy Land to the Moslems, the Templars concentrated on banking in Europe and established the first multinational corporations. King Philip IV of France was deeply in debt to the Templars from his war with the English, so he destroyed the Templars to acquire their wealth in 1307 and had the Grand Master burned at the stake.

The first Medici Bank was established in 1397 in Florence with branches in Rome and Venice, became a patron of art, and also made intellectual contributions to the accounting system of double entry of credits and debits. The Medici family created a dynasty of wealth and influence and produced Dukes, Popes, and Queens of France. Modern Western economic and financial history traced back to the coffee

159 houses of London, and the London Royal Exchange was established in 1565. At that

5.2 ECONOMIC THREATS

time, moneychangers were already called bankers with a hierarchical order: at the top were the bankers who did business with heads of state, next came the city exchanges, and at the bottom were the pawnshops with the three spheres symbol attributed to Lombard banking and adopted by the Medici family. Many European cities today have a Lombard Street where the pawnshops were located at one time. Banking offices were usually located near centers of trade, and in the late seven- teenth century, the largest centers for commerce were the seaports of Amsterdam, London, and Hamburg.

There are two principal risks to a banker: (i) The “liquidity risk” is when the bank has tied up too much of its assets in long-term loans that cannot be readily recalled, and runs out of cash when too many depositors want to withdraw funds at one time. (ii) The “credit risk” is when the borrowers are unable to pay back the loans and interests on time. As long as the bank is only a depository of money, the depositors have complete liquidity since the bank can pay back all the deposits at once. However, an observant banker with an almost constant

2 million dollars in deposits might note that all the new depositions of another million tend to arrive on the 30th day of each month, and that the withdrawals are distributed at an average rate of $30,000 or 3% each day. Thus, it would seem safe to lend out up to 1 million dollars on loans of 6 months to 20 year contracts and run very little risk of a “bank run” when too many depositors demand withdrawals on the same day. A conservative banker may think that it is safe to lend out 50% of the stable deposits, to earn 5% interest or $25,000 a year; as he reasons that the daily withdrawal of 3% would not make a big disturbance on the 50% cash in the bank. An aggressive banker may think that it is more profitable to lend out 90% of the stable deposits, and earn $45,000 a year. The aggressive banker runs a bigger risk, as there is only 10% cash left in the bank to service the 3% withdrawals from depositors, which become critical if the withdrawal rate is tripled to 9% per day or even higher. The rate of with- drawal usually goes up many times near Christmas when there is a large need to buy presents for the holiday; the retail stores also have to borrow money from the banks to buy inventory and get ready for the biggest sales month of the year. If there is a rumor that a bank is running out of money, many depositors will converge on the bank and demand their money back, creating a panic. A con- servative banker is safer but makes less money, while an aggressive banker runs

a greater risk of bankruptcy but makes more money. Such risky behaviors are encouraged when the bank board gives a bonus to the managers that bring in unusually high profits; so the risk-taking bankers are paid more than the conserv- ative bankers, but a failure can bring the entire bank down. The bank managers that can receive a bonus for higher profits may value their bonuses more than they value the welfare of the owners of bank shares. There were numerous times in history when bankers became too aggressive and risk-taking, which led to bank failures as well as a general economic depression on the entire community and world, such as in the global financial crisis of 2008.

A method to reduce credit risks is the system of credit rating by an indepen- dent agency, to evaluate whether the borrower is likely to pay back on time, to

160 CHAPTER 5 SECURITY

determine the appropriate interest rate to charge the borrower, and to identify ade- quate collateral in case of a failure. This is usually based on the financial history of the borrower, as well as the nature of the assets and liabilities. The best-known credit rating agencies include Moody and Standard & Poor’s; these agencies issue credit ratings to individuals, corporations, and even sovereign nations. On August

11, 2009, the consumer rate for a 15 year home mortgage was 4.93%, a 30 year mortgage was 5.68%, and a 48 month auto loan was 7.24%. The corporate invest- ment grade AAA bonds, of the highest quality with the smallest degree of risk, had the lowest yield at around 4.20%. The Baa bonds are medium grade and subject to moderate credit risk and had an intermediate yield of 6.25%. The speculative grade are known as high yield or “junk” obligations subject to high risk, and the lowest rated CCC bonds that may be in default have yields of up to 17.06%.

The system of credit rating cannot protect the banks or the savers when there is a general economic recession or depression, and when the largest banks run out of money so that many consumers and businesses have no money to spend or become too worried to spend. At such times, many businesses contract or close down, leading to unemployment and loss of income. In the Depression of 1929, the conservative US government did nothing, and the situation became worse. John Maynard Keynes came out with the theory that the government needed to spend money to stimulate the economy, even by borrowing money. This policy was adopted by Franklin D. Roosevelt from 1932 to 1941; then World War II took over and became an economic stimulant. In the economic downturn of 2008, the US government once again became the spender of the last resort to stimulate the economy and loaned massive amounts of money to shore up stricken banks who were considered to be “too big to fail”—which is interpreted to mean “not permitted to fail.”