F_A_I_R__U_S_E__C_L_A_I_M_E_D

George Selgin 
Professor of Economics 
Terry College of Business 
University of Georgia 
Athens, GA 30601

(Prepared for the Encyclopaedia Britannica) 

BANKING

I. Introduction: Defining Characteristics of Banks 

A bank is a firm that, besides providing other kinds of financial services, serves as 
a middleman or "intermediary," borrowing funds from persons and firms having income
or wealth to spare, lending them to persons and firms whose desired acquisitions run 
beyond their immediately available means, and profiting from the difference between the 
interest they charge to borrowers (or earn on securities) and the cost, including interest 
payments, of attracting and servicing deposits. 

Genuine banks are distinguished from other kinds of financial intermediaries by 
the readily transferable or "spendable" nature of their IOUs, which allows those IOUs to 
serve as means of exchange, that is, as money. The principal types of genuine banks in 
the modern industrial world are commercial banks, which are typically private-sector, 
profit-oriented firms, and central banks, which are public-sector institutions. Commercial 
banks accept deposits from the general public and make various kinds of loans (including 
commercial, consumer and real estate loans) to individuals as well as businesses and, in 
some instances, to governments. Central banks, in contrast, deal mainly with their 
sponsoring national governments, with commercial banks, and with one another. Besides 
accepting deposits from and extending credit to these clients, central banks also issue 
paper currency and are responsible for regulating commercial banks and national money 
stocks. 

In the United States a distinction exists between commercial banks and so-called 
"thrifts," which include savings and loan ("S&L") associations and savings banks. Like 
commercial banks, thrifts accept deposits and fund loans; but unlike commercial banks 
thrifts have traditionally focused on residential mortgage lending rather than commercial 
lending. The growth of a separate thrift industry in the U.S. has been fostered by 
regulations unique to that country, and therefore has no counterpart elsewhere. 

Moreover the ongoing deregulation of U.S. commercial banks, occurring in the wake of a 
hundreds of S&L failures during the late 1980s, leave the future of the U.S. thrift industry 
in doubt. 

Unlike commercial and central banks, other ("nonbank") financial intermediaries 
do not contribute to their nations' money supplies, or contribute to them only to a 
relatively limited (though generally increasing) extent. Such non-bank intermediaries 
include investment and merchant "banks" (which deal only with large business clients 
and are mainly concerned with underwriting and distributing new issues of corporate 
bonds and equity shares), finance companies (which specialize in making risky loans, and 
do not accept deposits), insurance companies, mutual funds, and pawnshops. In some
countries, including Germany, Switzerland, France, and Italy, so-called "universal" banks 
supply both traditional (or "narrow") commercial banking services and various nonbank 
financial services such as securities underwriting and insurance. Elsewhere, in contrast, 
regulations, long-established custom, or both have served to limit the extent to which 
commercial banks have taken part in the provision of nonbank financial services. 

I. 1. Bank Money 

Although the earliest forms of money were so-called "commodity" moneys, that 
is, moneys that consisted of commodities such as seashells and tobacco and, in more 
recent times, precious-metal coins, practically all money today takes the form of "bank 
money," that is, of commercial or central bank IOUs. Commercial bank money today 
consists mainly of deposit balances that can be transferred either by means of paper 
orders known as checks or electronically using plastic "debit" cards. A relatively recent 
and as yet quantitatively unimportant form of commercial bank money consists of 
amounts credited to so-called "smart" cards, including Mastercard's Mondex card, which 
are functionally similar to private banknotes, being claims against banks that can be 
transferred directly from cardholder to cardholder instead of merely transferring funds 
from one bank account to another, as checks and debit card transactions do. 

Yet another kind of commercial bank money, circulating "banknotes" that are direct claims
against the issuing institution (rather than claims to any specific depositors'
account balance), was once more important than transferable bank deposits, but today is 
supplied only by a handful of commercial banks, including ones located in Northern 
Ireland, Scotland, and Hong Kong. For the most part, paper currency today consists, not 
of redeemable notes issued by commercial banks, but of irredeemable notes, known as 

"fiat money" (from the Medieval Latin term meaning "let it be done"), issued either by 
central banks and other public monetary authorities. 

All past and present forms of commercial bank money share in common the 
characteristic of being redeemable in some underlying "base" money, meaning either a 
fiat money (as is the case everywhere today) or a commodity money such as gold or 
silver coin (as was the case everywhere a century ago). Bank customers typically enjoy 
the right to seek unlimited redemptions of commercial bank money on demand (that is, 
without delay); and a commercial bank's refusal to honor its obligation to redeem its bank 
money on demand generally signifies the bank's failure. The same rule applies to 
requests for redemption made by one bank upon another in behalf of the first bank's 
clients, as when a check drawn upon one bank is presented to another for collection. To
provide for routine redemptions of its IOUs a bank must retain some base money or 
"cash" reserves, which it may hold either as actual coin or central bank notes or as deposit 
credits with a central bank. 

While commercial banks remain the most important sources of convenient 
substitutes for base money, they are no longer exclusive suppliers of such substitutes as 
they had been in the past. Most money-market mutual funds, for example, allow their 
owners to write checks, as do credit unions (which differ from commercial banks in being 
owned by and lending only to their own depositors). Some non-bank financial firms 
issue travelers' checks, which resemble old-fashioned banknotes except in having to be 
endorsed by their users and in being useful for a single transaction only before being 
redeemed and retired. 

I. 2. Bank Loans 

The existence of traveler's checks and other "spendable" nonbank IOUs has 
tended to blur somewhat the traditional distinction between banks and other financial 
intermediaries. Banks remain distinct, nonetheless, because of the special government 
regulations to which they alone tend to be subject (which are discussed below), and also 
because of their heavy involvement in lending to consumers and, especially, to 
businesses. Because only relatively large firms can succeed in issuing marketable 
securities (corporate bonds or equity shares) bank loans have long been the most 
important source of funds for non-financial businesses throughout the industrialized 
world. In the United States, for example, the amount of funding that business enterprises 
on the whole obtain from banks is roughly twice what they acquire by marketing their 
own bonds, and is far greater still than what enterprises acquire by issuing shares. In 
Germany and Japan bank loans supply a still larger share of total business funding. 
Although all banks make loans, the types of loans they make, and the relative 
importance of different loan types, differs considerably from bank to bank. Commercial 
loans (meaning loans to all kinds of businesses, which can be made for periods lasting 
from a few weeks to a decade or more) are, not surprisingly, a very important part of the 
"commercial" banking business everywhere. Yet many commercial banks devote a 
greater share of their lending to financing real estate purchases and improvements 
(through mortgages and home-equity loans) or to direct consumer loans (including 
personal and auto loans). Also, although banks are, among intermediaries, by far the 
most important source of loans, most do not restrict themselves entirely to lending, but 
acquire and hold other assets as well, including government and corporate securities and 
foreign exchange.

II. The Beginnings of Banking 

Some authorities, relying upon a broad definition of banking that equates it 
with any sort of intermediation activity, trace banking as far back as ancient 
Mesopotamia, where temples, royal palaces, and some private houses served as 
storage facilities for valuable commodities such as grain, the ownership of which 
could be transferred by means of written receipts. There are records of loans by the 
temples of Babylon as early as 2000 B.C. Temples were considered especially safe 
depositories because, as sacred places, their contents were supposed to protected from 
theft by gods. In ancient times companies of traders also carried on "banking" 
functions connected with the buying and selling of goods. 

Banking in the strict sense, that is, the business devoted to the depositing and 
lending of money and to the creation of generally spendable IOU's that could serve in 
place of coins or other commodity moneys, had its origins in medieval times. In Europe 
so-called "merchant bankers" anticipated the development of banking in this strict sense 
by offering, for a consideration, to assist merchants in making distant payments using 
bills of exchange instead of actual coin. The merchant banking business arose from the 
fact that many merchants traded internationally, holding assets at different points along 
trade routes. For a certain consideration, a merchant stood prepared to accept instructions 
to pay money to a named party through one of his agents elsewhere; the amount of the 
bill of exchange would be debited by his agent to the account of the merchant banker, 
who would also hope to make an additional profit from exchanging one currency against 
another. Because there was a possibility of loss, any profit or gain was not subject to the 
medieval ban on usury. There were, moreover, techniques for concealing a loan by 
making foreign exchange available at a distance but deferring payment for it so that the 
interest charge could be camouflaged as a fluctuation in the exchange rate. 
The earliest genuine European banks, in contrast, dealt neither in goods nor in 
bills of exchange but in gold and silver coins and bullion, and emerged in response to the 
risks involved in storing and transporting precious metal moneys and, often, in response 
to the deplorable quality of available coins, which created a demand for more reliable and 
uniform substitutes. 

In continental Europe dealers in foreign coin or "money changers" were 
among the first to offer basic banking services, while in London money "scrivenors" 
and goldsmiths played a similar role. Money scrivenors were notaries who found 
themselves well positioned for bringing borrowers and lenders together, while 
goldsmiths began their transition to banking by keeping money and valuables in safe 
custody for their customers. Goldsmiths also dealt in bullion and foreign exchange, 
acquiring and sorting coin for profit. As a means of attracting coin for sorting, they 
were prepared to pay a rate of interest, and it was largely in this way that they 
eventually began to out-compete money scrivenors as deposit bankers. 

In every case deposit "banking" at first involved little more than the receipt of
coins for safekeeping or warehousing, for which service depositors were required to pay a 
fee. By early modern times this warehousing function had given way in most cases to 
genuine intermediation, with "deposits" becoming debt as opposed to bailment contracts, 
and depositors sharing in bank interest earnings instead of paying fees. [Make cross-
reference to EB's "bailment" article.] Concurrent with this change was the 
development of bank money, which began with transfers of deposit credits by means of 
oral and later written instructions to bankers and also with the endorsement and 
assignment of written deposit receipts, each of which presupposed legal 
acknowledgement of the fungible status of deposited coins. Deposit transfers by means 
of written instructions led directly to modern checks, while the assignment of bank-issued 
deposit receipts to third parties led indirectly (by way of the legal notion of negotiability) 
to the development of banknotes made payable, not to a specific person, but simply to 
"the bearer." 

Although the Bank of England is usually credited with being the source of the 
western world's first widely circulated banknotes, the Bank of Stockholm (predecessor of 
the present Bank of Sweden) is known to have issued banknotes several decades before 
the Bank of England's establishment in 1694, and some authorities claim that notes issued 
by the Bank of Genoa, although payable only to specific persons, were made to circulate 
by means of repeated endorsements. In Asia paper money has a still longer history, its 
first documented use having been in China during the 9th century, when "flying money," 
a sort of draft or bill of exchange developed by merchants, was gradually transformed 
into government-issued fiat money. The 12th century Tartar war caused the government 
to abuse this new financial instrument, earning China credit, not merely for the world's 
first paper money, but also for the world's first known episode of hyperinflation. 
Following several more such episodes the Chinese government elected to refrain 
altogether from issuing paper currency, leaving the matter to private bankers. By the late 
19th century China had developed a fascinating and, according to many accounts, 
successful bank money system, consisting of paper notes issued by unregulated local 
banks and redeemable in copper coin. During the early 20th century the system was 
undermined, first by demands made upon the banks by the Republican government, and 
then by the Nationalist governments' decision to centralize and nationalize China's paper 
currency system. 

The development of bank money increased bankers' ability to extend credit by 
limiting occasions when their clients would feel the need to withdraw coin. The growing 
popularity of bank money reinforced this effect, by allowing bankers to take advantage of 
the "law of large numbers" whereby withdrawals by some clients tended to be offset by 
new deposits from others. However, so long as bankers had to compete with other 
bankers enjoying similar opportunities to create and issue bank money, cash reserves 
were needed, not merely to provide for occasional coin withdrawals, but also for the 
purpose of settling inter-bank accounts. Bankers generally found it to be in their interest 
to receive on deposit checks drawn upon or notes issued by rivals in good standing; and it 
became standard industry practice for such items to be returned to their sources or 
"cleared" on a routine (usually daily) basis, with net amounts due settled in coin or 
bullion. Starting in the late 18th century bankers found that they could further 
economize on cash reserves by setting-up "clearinghouses" in major cities for the purpose 
of overseeing non-local bank money clearings and settlements, as doing so allowed 
further advantage to be taken of opportunities for "netting out" offsetting items. 

III. Banking and Industrialization 

Many economists, starting with Adam Smith, have assigned to banks a crucial 
role in promoting industrialization. Historical research offers broad support for their 
views, while also suggesting that banking contributed most to the process of 
industrialization where it was allowed to develop most freely. The contrasting 
nineteenth-century experiences of Scotland and Sweden on one hand, and France and 
England on the other, serve as illustrative case studies. The commercial banks of 
Scotland and Sweden (where banks were subject to minimal regulatory restrictions) 
played a major part in those nations' early industrial development, whereas those of 
France and England (where the development of commercial banking was hampered by 
the concentration of special privileges in the Bank of France and Bank of England) were 
forced to play a secondary part only. In England, for example, prior to 1826 the Bank of 
England alone was allowed to operate as a joint-stock (share issuing) company, with 
other so-called "country" banks being forced to operate as unlimited-liability 
partnerships, and ones having no more than six partners at that. The six-partner rule 
severely limited country banks' size, as well as their opportunities for portfolio 
diversification; and it was largely owing to this limitation that dozens of them failed 
during the Panic of 1825. Because the Bank of England refused to establish branches 
outside of London, where it lent funds only to the government and to a select list of 
private merchants, provincial businessmen had either to risk dealing with 
undercapitalized and under-diversified banks or to forego banking services entirely. 
To the extent that regulations allowed them to do so early banks were bound to 
play an important if not crucial role in the early stages of the industrialization process. 
This conclusion follows logically from the scarcity of savings in pre-industrial 
economies. Poor nations have little if any wealth to devote to financial assets such as 
stocks or bonds; but even poor people often have some savings consisting of the cash 
they hold in their pockets. Historically, where banks were absent, cash holdings 
represented an investment in the mining and minting of precious or base metals; 
nowadays, cash consists mainly of central bank notes, which are usually backed by 
government securities. In either case the holding of cash represents a form of savings 
that cannot provide for the general funding of private industry. Commercial (as opposed 
to central) banks are uniquely capable of putting such monetary savings to productive 
use, by replacing balances of coin or other "base" money with bank money that may be 
largely backed by loans to the private sector. Commercial banknotes proved to be 
especially important during historical industrialization episodes, for such notes were 
more widely accepted than checks, and could be employed even by persons who lacked 
bank accounts. 

Once banks had secured enough savings to start the process of industrialization, 
that process itself generated further wealth, eventually allowing more persons the luxury 
of investing some of their savings in non-monetary instruments, including stocks and 
bonds. The rise of banking thus prepared the way for the emergence of non-bank 
investment markets, which ultimately freed industry from its former, utter dependence on 
bank-intermediated funds. In industrialized nations today, although the relative 
importance of commercial bank deposits as a source of business funds as declined 
considerably relative to that of direct funding (through public sales of bonds and shares), 
bank deposits continue to be the main source of funds for small and medium-sized 
businesses. Moreover, many parts of world remain unindustrialized and impoverished, 
owing in part at least to their poorly developed banking systems. 

On the other hand, heavy reliance upon bank money, and spendable bank deposits 
especially, as a substitute for basic money exposes economies to banking crises. Because 
banks hold only fractional reserves of basic money, any concerted redemption of a bank's 
deposits (as may occur if the bank is suspected of being insolvent) can cause it to fail, 
while any concerted redemption of all or most bank deposits (where withdrawn funds are 
not simply re-deposited in other banks) can altogether destroy an economy's banking 
system, depriving it of needed means of exchange as well as of business and consumer 
credit. Perhaps the most notorious example of this was the U.S. banking crisis of the 
early 1930s; more recently, in 1997, Indonesia, Korea, Thailand and Malaysia all 
experienced severe banking crises. Clearly, a nation's banking system will cease to 
contribute to its economic prosperity, and will instead become a burden, as soon as the 
system looses its ability to command the public's confidence. 

IV. Origins and Progress Central Banking 

The prevention of commercial banking crises is one of several responsibilities 
ordinarily assigned to central banks. Central banks maintain accounts for, and extend 
credit to, commercial banks and, in most instances, their sponsoring governments, but 
generally do not do business with the public at large. They are also distinguished from 
ordinary banks in enjoying various exclusive legal privileges, the most important of
which is the right to issue fiat money. Indeed, most central banks serve as their nations'
(or, in the case of the European Central Bank, several nations') only source of paper 
currency of any kind, commercial banks in most places having long ago been deprived of 
their ability to issue redeemable notes. It is from this monopolization of paper currency 
that central banks derive many of their extraordinary powers as well as their often 
exceptional interest revenues, which are known as "seignorage" (after the lords or 
"seigneurs" of medieval France who enjoyed the privilege of minting their own coins). 
Central banks today are charged with a broad range of public responsibilities. 
One, which has already been mentioned, is the prevention of banking crises, which 
chiefly involves supplying additional cash reserves to commercial banks that are in 
danger of failing as a result of extraordinary reserve losses. The others include managing 
the growth of national money stocks (and, indirectly, preventing undesired movements in 
general price levels, interest rates, and exchange rates), regulating commercial banks, and 
serving as sponsoring governments' fiscal agents, e.g., by purchasing government 
securities. 

The beginnings of central banking can, however, be traced to medieval "public 
banks" the purposes of which were entirely fiscal. The first of these, Barcelona's Taula 
de Canvi, set the pattern for many later examples. Although ostensibly established, in 
1401, for the safekeeping of city and private deposits, the Taula was also expected to aid 
the funding of Barcelona's government by channeling savings toward it. The bank was 
for this reason allowed to lend only to the government. The Taula also received tax 
payments and issued bonds, first for the municipal government only, and eventually for 
the Catalan government as well. In return for the special privileges it enjoyed the Taula 
was called upon to make such substantial loans to the city government, especially for the 
financing of military expenses, that it was forced, during the 1460s, to suspend the 
convertibility of its deposits, after which it was liquidated and reorganized. 
The success of later public banks generally depended upon the extent to which 
their sponsoring governments were willing to sacrifice bank safety for the sake of greater 
fiscal accommodation. Amsterdam's Exchange Bank, founded in 1609 (when 
Amsterdam was the largest and most prosperous city in Europe), was an especially 
successful example, having retained a solid reputation for more than a century thanks to 
its very limited lending activity. The bank's conservative policy allowed it to maintain 
reserves fully covering its outstanding notes and rendered it invulnerable even to the 
major panic provoked by Louis XVI's unexpected declaration of war in 1672. Although 
the Exchange Bank was not expressly required to maintain one-hundred percent backing 
for its notes prior to 1802, its reputation suffered when it allowed its reserves to decline 
considerably as a consequence of large-scale loans it made, first to the Dutch East India 
Company, and then directly to the Dutch government. 

While it was not the first important public bank, the Bank of England, founded in 
1694 for the purpose of advancing £1.2 million to the British government so that it could 
carry on a war with France, quickly became the world's most powerful and influential 
financial institution. It was also the first public bank to assume most of the features and 
responsibilities that characterize modern central banks, including the acceptance of an 
official role in preserving the integrity of the entire banking and monetary system, as 
opposed to merely looking after its own profits. For over a century, however, the bank 
accumulated special privileges, which were in every instance granted to it in exchange for 
its giving further assistance to the government, without acknowledging any change in its 
status as a strictly for-profit institution. By 1800 it had become England's only limited-
liability joint-stock bank, its charter having denied other banks the right to issue 
banknotes (then an essential source of bank funding) unless they were organized as 
private, unlimited liability firms having no more than six partners. The Bank of 
England's special privileges caused other banks to adopt the practice of keeping their 
balances with it, thus conferring on it to the status of "bankers' bank." 

Although private banknotes had ceased to circulate in London by 1780, they 
survived in the provinces where the Bank of England was prohibited from establishing 
branches. Following the Panic of 1825 the prohibition on joint-stock banking was lifted, 
though only for banks established beyond a sixty-five mile radius from the center of 
London. The same reform also allowed the Bank of England to set-up provincial 
branches; but this last measure did not prevent almost one hundred joint stock banks of 
issue from being established between 1826 and 1836. The Bank of England's monopoly 
status was thus curbed to some extent. Two further measures, however, ultimately served 
to enhance that status, reinforcing the bank's powers, and causing other banks to rely 
upon it as a source of currency for their routine needs as well as during emergencies. An 
1833 Act made Bank of England notes legal tender for sums above £5, strengthening the 
tendency for the nation's metallic reserves to concentrate in one place; "Peel's Act" of
1844 in turn awarded the Bank of England an eventual monopoly of paper currency by 
fixing the maximum note issues of other banks at levels outstanding just prior to the Act's 
passage, while requiring banks to give up their note issuing privileges upon merging with 
or being absorbed by other banks. 

The passage of Peel's Act marked the practical victory of proponents of currency 
monopoly in England over their opponents who favored "free banking," meaning a 
system in which all banks were equally free to issue redeemable paper notes. The free 
bankers maintained that the concentration of privileges in the Bank of England had 
allowed it to exercise an unhealthy influence upon the banking system as a whole, while 
depriving other banks of the strength and flexibility they needed to tide themselves 
through financial crises. Proponents of currency monopoly, on the other hand, favored 
having one bank alone bear ultimately responsibility both for preserving the long-run 
integrity of the currency and for preventing or at least containing financial crises. 
Although he himself favored free banking, Walter Bagehot, the second and most famous 
editor of The Economist magazine, played a key role in shaping the modern view of 
central banks as essential "lenders of last resort" by outlining, in Lombard Street (1873), 
the special responsibilities of monopoly banks of issue during episodes of financial 
crises, and especially by insisting that they put their own interests second to those of the 
economy as a whole by keeping lines of credit open to other solvent but temporarily 
illiquid banks. The victory of central banking over the free banking alternative in 
England was followed by similar victories in France, Germany, and elsewhere. 

In the United States, state banking laws prohibiting branch banking and Civil-War 
era restrictions on note issuance rendered the banking system vulnerable to periodic 
crises. The crises eventually gave rise to a banking reform movement, the ultimate 
outcome of which was the establishment, in 1914, of the Federal Reserve System. After 
1914 central banking spread rapidly. By the outbreak of World War II most independent 
nations had adopted it. Colonies, on the other hand, tended to rely on alternative 
currency arrangements, which typically involved using the currency of the colonial 
power's central bank as their reserve or "anchor" currency. Some employed the anchor 
currency itself as their local currency. A few, like Hong Kong, allowed several private 
banks of issue to supply their local currency. Still others, including British West Africa, 
relied upon so-called "currency boards," which issued local currency notes fully backed 
by the anchor currency. Upon achieving their independence in the decades following 
World War II, most former colonies abandoned their colonial monetary arrangements in 
favor of central banking, which experienced its heyday during the 1970s. Since then, 
several nations, having suffered recurring bouts of hyperinflation under their central 
banking arrangements, have abandoned those arrangements in favor of either modified 
currency-board like systems (Argentina from 1991 to 1999) or official "dollarization" 
(that is, the use of Federal Reserve dollars in lieu of their own distinct paper currency) 
(Ecuador since March 2000). 

The worldwide spread of central banking during the 20th century coincided with 
the worldwide abandonment of metallic monetary systems. Central banks have thus 
come to replace gold and silver mines as the world's ultimate sources of base money. As 
such they are responsible, not only for supplying most of the world's circulating paper 
currency, but also for supplying commercial banks with cash reserves and, indirectly, for 
regulating the quantity of commercial bank deposits and loans. 
V. Commercial Bank Management 

In its essence, the banking business boils down to one of granting bank deposit 
credits or issuing paper IOUs to individuals or firms in exchange for their holdings of or 
other claims to base money (coins or fiat paper money) and using the base money thus 
obtained, or that part of it not needed as cash reserves, to purchase other IOUs. The 
business may be most readily understood by considering the elements of a simplified 
bank balance sheet, where a bank's available resources-its "assets"-are reckoned 
alongside its obligations or "liabilities." Bank liabilities consist mainly of various kinds 
of deposit credits (or simply "deposits"), including many that can readily be spent and
thereby transferred in whole or in part by their holders, by means of checks or 
instructions conveyed to the bank's computer using a debit card. Bank assets consist 
mainly of various kinds of loans and marketable securities, and of reserves of base 
money, which may be held either as actual central bank notes and coins or in the form of 
a credit (deposit) balance at the central bank. The difference between the fair market 
value of a bank's assets and the book value of its outstanding liabilities represents the 
bank's net worth. A bank lacking positive net worth is said to be "insolvent," and 
generally cannot remain open unless it is kept afloat by means of central bank support. 
The fact that a bank must stand ready to convert a significant portion of its 
liabilities, including all of its checkable or "debitable" deposits, into cash on demand 
poses a fundamental challenge: because most bank loans have definite maturity dates (the 
exception being so-called "call" loans, which are repayable at the lender's discretion), 
banks, unlike some other financial intermediaries, cannot avoid having to "borrow short 
and lend long," that is, they cannot avoid having to exchange IOUs that may be redeemed 
at any time for ones that will not come due until some definite future date. Banks are for 
this reason uniquely subject to "liquidity risk"-the risk of not having enough cash (base 
money) on hand to meet liability holders' demands for immediate payment-even though 
they may be perfectly solvent. 

V.1. Asset Management. 

There was a time when bankers limited themselves to what has come to be known 
as "asset management" as a means for limiting their exposure to various risks, including 
liquidity risk. That is, they concentrated on adjusting the composition of their bank's 
assets-its portfolio of loans, securities, and cash-while exercising little if any direct 
control over its liabilities and overall size, which were strictly a matter of the number of 
customers who were prepared to lodge part of their savings with it. In general bank 
managers sought to maintain a mix of assets capable of earning the greatest interest 
revenue consistent with keeping risks within acceptable bounds. To achieve this goal in 
practice meant holding average cash reserves sufficient for meeting routine demands 
(including, in many instances, the demand for reserves to satisfy minimum statutory 
requirements), while devoting remaining funds mainly to short-term (and supposedly 
"self-liquidating") commercial loans. The presence of many short-term loans among a
bank's assets meant that some bank loans were always coming due, so that a bank could 
meet exceptional cash withdrawals or settlement dues through the simple device of 
refraining from renewing or replacing some maturing loans. 

The practice among early bankers of focusing on short-term commercial loans, 
which was reasonable enough given the assets they had to choose from, eventually 
became the basis for the so-called "real bills doctrine," according to which there could be 
no risk of banks overextending themselves, or generating inflation, so long as they stuck 
to the short-lending rule of thumb, and especially if they limited themselves to 
discounting commercial bills or promissory notes supposedly representing real goods in 
various stages of production. Critics of the doctrine, starting with the London banker 
Henry Thornton (in his 1802 Inquiry into the Nature and Effects of the Paper Credit of 
Great Britain) fault it for treating both the total value of outstanding commercial bills and 
the proportion of such bills presented to banks for discounting as being independent of 
interest rates applied to bank loans and discounts. If such rates are set low enough, the 
critics observe, both the volume of loans and discounts will increase and the outstanding 
quantity of bank money will expand; and this expansion may in turn cause the general 
price level to rise. As prices rise, the nominal stock of "real bills" will tend to grow as
well. Inflation might therefore continue forever despite banks' strict adherence to the 
real-bills rule. 

Although the real bills doctrine continues to command a small following among 
academic economists, by the late 19th century bankers themselves had generally 
abandoned the old-fashioned practice of limiting themselves to short-term commercial 
loans, instead preferring to mix such loans with longer-term investments, where the latter 
tend to offer higher yields. This change in emphasis has to a considerable extent been a 
response to substantial improvements in the marketability of long-term investment 
securities, which makes it easy for an individual bank to find buyers for such securities 
whenever it seeks to exchange them in a hurry for cash. Banks also have been able to 
make greater use of so-called money-market assets, such as Treasury bills, which 
combine short-maturities with ready marketability and are also a favored form of 
collateral for central bank loans. 

Commercial banks in some nations, including Germany, also make long-term
loans to industry despite the fact that such loans are neither "self-liquidating" nor readily 
marketable. These banks must ensure their liquidity by maintaining relatively high levels 
of capital (including conservatively-valued shares in the enterprises they are helping to
fund) and by relying more heavily on longer-term borrowings (including time deposits as 
well as the issuance of bonds or debentures). In other nations, including Japan and the 
United States, the long-term financing of industry is mainly handled by specialized 
financial institutions rather than by banks in the strict sense of the term. 

V .2. Liability and Risk Management 

The asset management approach to banking is based on the assumption that a 
bank's liabilities are both relatively stable and unmarketable: a bank relies on a market for 
its deposit IOUs that is largely a function of the bank's location, with changes in the 
extent of the market (and hence in the total amount of resources available to fund the 
bank's loans and investments) being largely beyond of its immediate control. Beginning 
in the 1960s, however, this assumption was gradually abandoned, first in North America 
and then elsewhere as well. In the United States rising interest rates, together with 
regulations limiting interest payments on bank deposits, made it increasingly difficult for 
banks to attract and maintain deposits. Consequently bankers began to make use of a 
variety of alternate devices for acquiring funds, including repurchase agreements (the 
selling of securities on condition that buyers agree to repurchase them at a stated date in 
the future) and negotiable CDs (certificates of deposit) (which can be traded in a 
secondary market). In short, banks discovered ways in which to buy funds, instead of 
simply waiting for funds to flow to them in the normal course of business, and were thus 
able to manage the liability as well as the asset side of their balance sheets. Such active 
purchasing and selling of funds by banks, which has come to be known as "liability 
management," makes it easier for bankers to fully exploit profitable lending opportunities 
without being precluded from doing so by a lack of funds to lend out. For this reason it 
quickly spread beyond the United States, first to Canada and the United Kingdom, and 
eventually to banking systems in other nations as well. 

A still more recent approach to bank management, the so-called "risk 
management" approach. The novelty of the risk management approach rests in its 
treatment of banks as "bundles of risks" and of the primary challenge facing bank 
manager's as being that of establishing an acceptable overall degree of risk exposure. 
This means coming up with some reasonably reliable measure of a bank's overall 
exposure to various risks, and then adjusting the bank's portfolio to achieve both an 
acceptable overall risk level and the greatest shareholder value consistent with that risk
level. 

Modern banks are exposed to a wide variety of risks, including credit risk (the 
risk that borrowers will fail to repay their loans on schedule), interest-rate risk (the risk
that market interest rates will rise relative to rates being earned on outstanding long-term
loans), market risk (the risk of suffering losses in connection with asset and liability 
trading), foreign-exchange risk (the risk of a foreign currency in which loans have been 
made being devalued during the loans' duration) and sovereign risk (the risk that a 
government will default on its debt) as well as liquidity risk, The risk-management 
approach differs from earlier approaches to bank management in advocating, not simply 
the avoidance of most of these risks, but their "optimization," which is often best 
accomplished, not by avoiding certain kinds of assets (and special risks they carry) but by 
mixing and matching various risky assets, including traditionally "forbidden" assets (such 
as forward and futures contracts, options, and other so-called "derivatives") which, 
despite being risky themselves, can also be designed to hedge losses on other risky assets. 
Suppose, for example, that a bank manager wishes to protect his bank against the 
possibility of a fall in the value of its bond holdings owing to a rise in market interest 
rates during the next three months. The manager might do so by using a three-month 
forward contract-that is, by selling the bonds for delivery in three months time-or, 
more likely, by taking a short position in bond futures. In the event that interest rates 
really do rise, profits from the forward contract or short futures position should serve to 
completely offset the loss in the bond's capital value. 

A shortcoming of the risk management approach is its reliance upon techniques 
for measuring overall risk exposure, such as "value at risk" (which measures the 
maximum likely loss on a portfolio during the next 100 days or so) that generally fail to 
allow for the high-impact, low-probability events, such as the bombing of Central Bank 
of Sri Lanka in 1996 or the 2001 attack on the World Trade Center. In the end, 
traditional bank-management tools, including reliance upon bank capital, must continue 
to play a role, and even then some responsibly managed banks are likely to fall victim to 
unforeseen events. 

V.3. The Role of Bank Capital

Because even the best risk management techniques cannot altogether insulate 
banks from losses, banks cannot rely on deposits alone to fund their investments, but 
must be funded in part by their owners' equity or share capital, and bank managers must 
concern themselves, not only with the composition of their assets and liabilities, but with 
the extent of their equity capital also. A bank's shareholders, being residual claimants, 
share in its profits but are also the first to bear any losses stemming from poorly 
performing loans or investments. When the value of a bank's assets declines, 
shareholders bear the loss, at least up to the point at which their shares become worthless, 
while depositors stand to suffer only if losses mount enough to exhaust the bank's equity, 
rendering it insolvent. In that case, the bank may be closed, and its assets liquidated, with 
depositors (and, after them, if anything remains, other creditors) receiving pro-rated 
shares of the proceeds. 

Where bank deposits are not insured or otherwise guaranteed by government 
authorities, bank equity capital serves as depositors' principal source of security against 
bank losses, and as such plays a crucial role in making bank deposits a viable substitute 
for other assets, including base money. Historically, market incentives alone often 
sufficed to encourage banks to maintain substantial capital-asset ratios, to advertise those 
ratios, and even, in some instances, to forego limited liability status in favor of unlimited 
liability (which makes bank owners personally liable for losses suffered by their banks, 
instead of limiting their exposure to the value of their investments). Government 
authorities have, nonetheless, often felt compelled to regulate bank capital, by making a 
certain absolute level of capitalization a condition for entry into the banking business, by 
specifying a minimum necessary ratio of capital to assets or liabilities, or by imposing 
extended (e.g. double or unlimited) liability on bank shareholders. 

Government-sponsored implicit or explicit deposit guarantees have, however, 
tended to weaken market based incentives favoring the maintenance of substantial bank 
capital cushions, by making those cushions appear redundant to depositors, and thereby 
making it easier for poorly capitalized banks to compete with well capitalized ones. 
Consequently, as the number of nations having deposit insurance schemes of some kind 
has increased, and as central banks have become more and more inclined to offer support 
to troubled banks, regulators have become more concerned than ever about inadequate 
bank capital ratios, and have become more aggressive in their endeavors to enforce 
minimal capital requirements. 

While central bank guarantees make it easier, for any given level of risk exposure, 
for banks to thrive despite having low capital ratios, other aspects of central bank conduct 
can have a decided influence upon banks' exposure to risk. Central bank policies that 
result in substantial, unpredictable price level changes make it difficult for bank 
managers to correctly evaluate borrowers' collateral and potential earnings, while policies 
that lead to rising inflation and interest rates with tend to expose banks to losses on 
longer-term loans and investments taken on when interest rates were still low. The 
worldwide increase in bank failure rates during the 1970s and 1980s, following an earlier 
postwar era markedly free of financial crises, was largely a result of unexpected changes 
in national inflation rates, which rose substantially throughout the industrialized world 
between the mid-1960s and 1980, and then fell again. 

VI. Central Banks' Influence upon Commercial Banking 

Because the health of a nation's banking industry depends to such a large extent 
upon the conduct of that nation's central bank (or on the conduct of some foreign or 
multinational central bank that either directly supplies the nation with base money or 
indirectly regulates the nation's monetary base), a more comprehensive review of central 
bank operations and their influence upon economic performance generally and upon the 
performance of banks in particular seems in order. 

Let us begin by recalling the chief feature that distinguishes central banks from
commercial banks. This is their ability to issue irredeemable or "fiat" paper notes, which 
in most nations are the only available form of paper currency, as well as the only form of 
money having unlimited legal tender status. Besides being held by the general public, 
central bank notes also serve, together with central bank deposit credits, as commercial 
banks' cash reserves. It is central banks' monopoly of paper currency and bank reserves 
that allows them to exercise control over the total supply of money (including 
commercial bank deposits) available in the economies over which their monopoly 
privileges extend. By altering national money stocks, central banks are able indirectly to 
influence rates of spending and inflation, and, to a far more limited extent, rates of 
employment and production of goods and services. 

Besides influencing the conduct and performance of commercial banks by altering 
the total supply of bank reserves and (less directly) by determining the course of 
inflation, central banks can influence the fate of individual banks, as well as the stability 
of the banking industry as a whole, by granting or refusing emergency assistance in its 
role as lender of last resort. Finally, central banks typically take part in the regulation of 
commercial banks. In this capacity they may enforce a variety of regulatory rules 
governing such things as cash reserve ratios, interest rates, investment portfolios, equity 
capital, and entry into the banking industry. Let us consider in turn each of these 
channels of central bank influence upon commercial banking activity. 

VI. I. Monetary Control 

A fundamental understanding of central banks' influence upon national monetary 
conditions is best obtained by first considering monetary conditions prior to the advent of 
central banking, when base money consisted solely of coins made of precious metal. 
Before central banks appeared the rate of growth of the world money stock depended 
mainly on the output of precious metals, which varied with profitability of precious metal 
mining. Because a rise in prices in this context implied a decline in the relative value of 
the money metal, mining profits deteriorated whenever prices rose, and improved 
whenever they fall. Consequently, price levels tended to be stable in the long run unless 
the metal content of individual coins (or of monetary units represented by coins) was 
altered. New ore discoveries and improved mining techniques could of course lead to 
lasting price-level increases, but these were seldom dramatic: even the relatively 
enormous inflow of gold and silver bullion to Europe during the first centuries following 
the discovery of the New World only resulted in average inflation rates there in the 
neighborhood of 2 to 4 percent. 

The appearance of ordinary (non-central) banks and bank money itself tended to 
raise prices by providing convenient substitutes for coin, thereby reducing the overall 
demand for precious metal. But the upward movement in prices was limited, owing to 
banks' continued need for coin reserves for the purpose of settling inter-bank accounts. 
Although some especially efficient commercial banking systems have functioned with 
cash reserves amounting overall to less than 3 percent of their deposits, the need to 
maintain even such a small reserve ratio ultimately sufficed to restrain the growth of bank 
deposits (and of banknotes, where commercial banks issued these as well), and thus 
placed an upward limit on prices, which could then increase further (assuming a stable 
output of goods) only as the stock of coin increased, or as banks gradually discovered 
ways to further economize on their reserves. Because individual banks tended to 
routinely return notes issued by, and checks drawn upon, rival firms, while insisting upon 
the settlement of adverse inter-bank balances in coin, no bank could afford to provide 
loans on terms more that were substantially more generous than those offered by its rivals 
unless it somehow managed to attract substantially more deposits. 

When central banks first began to appear their own deposits and notes were, like 
ordinary bank deposits, IOUs redeemable on demand for coins, so that the scarcity of
precious metal continued to place upper limits upon overall money stocks and general 
price levels. However, upon being deprived of the right to issue their own paper notes, 
commercial banks came to rely upon their holdings of central bank notes to meet their 
customers' demand for convenient means of payment, and so began to treat central bank 
notes and account balances as cash reserves, that is, as more convenient substitutes for 
coin in making over the counter payments and in settling inter-bank accounts. Central 
banks thus tended to acquire most of their nation's ultimate (coin) reserves, while in turn 
gaining the power to alter the quantity of reserves available to other banks merely by 
increasing their own lending activity. Central banks were thus enabled to pursue 
independent lending policies, as well as to serve as a "lenders of last resort." However, 
their powers remained limited so long as they were required to redeem their notes and 
deposits in precious metal coins or bullion. The limitation was especially strict when 
other nations' monetary systems were based upon the same precious metal standard, for 
in that case any tendency for prices in one country (measured according to that country's 
basic precious metal units) to exceed prices of similar goods elsewhere (measured using 
the same unit) tended to turn the balance of trade against the country with the higher price 
level, causing its central bank to suffer an "external drain" of reserves, and forcing it to 
curtail its lending so as to stem the flow. 

In England during the 18th and 19th century unexpected changes in the Bank of 
England's lending policy, brought about by external drains of specie to which it had 
become exposed, often triggered financial crises. These crises pointed to the ultimate 
incompatibility of central banking arrangements with precious metal monetary standards, 
although some theorists insisted upon viewing them as supporting a role for central banks 
in "managing" such standards. Eventually, however, fiscal pressures favoring more 
aggressive central bank lending, combined with further crises, forced the Bank of 
England and other central banks to suspend the convertibility of their IOUs into coin, first 
temporarily, and then, during the Great Depression, permanently, leaving the U.S Federal 
Reserve System alone committed to redeeming its IOUs in gold, and then only on behalf
of other central banks, until the early 1970s when Federal Reserve Notes also ceased to
be redeemable. 

The switch from redeemable notes to fiat money gave central banks ultimate 
control over national stocks of bank reserves and money by rendering them potentially 
free of any need to maintain reserves of any kind. Many central banks have chosen 
nonetheless to commit themselves to converting their money into money issued by a 
foreign central bank at a predetermined rate of exchange, and therefore have had to 
maintain reserves of foreign currency sufficient to allow them to honor their 
commitment. Such a rigid ("pegged" or "fixed") exchange rate regime disciplines any 
central bank committed to it by gearing that bank's rate of base money expansion to the
expansion rate the foreign currency to which its own currency is pegged. Central banks 
that allow their currency's exchange rates to "float" face no similar constraint, although in 
practice all central bankers seek to avoid dramatic exchange rate changes that can disrupt 
international transactions while being taken as evidence of irresponsible central bank 
management. 

Although fiat-money issuing central banks (or at least those not bound by a fixed 
exchange rate commitment) continue to pursue a variety of objectives, economists 
generally believe that the achievement of long-run price stability, meaning an annual rate 
of general price inflation somewhere within the range of zero to three percent, should be 
their principal policy aim. This consensus reflects economists' understanding of the 
economic and financial turmoil that is often associated with major price level 
movements, as well as their appreciation of the fact that central banks are perfectly 
capable of preventing substantial price level changes by means of responsible 
management of their own balance sheets. 

While other popular monetary policy objectives, including the financing of 
government expenditures, combating unemployment, and "smoothing" or otherwise 
regulating interest rates, are not necessarily at loggerheads with the price-level 
stabilization objective favored by economists, failure to subordinate such objectives to
that of price-level stability has often proven to be a recipe for high inflation. More 
precisely, inflation is the predictable consequence of attempts to rely upon monetary 
expansion as a solution to problems, including fiscal deficits, high unemployment, and 
high real rates of interest, whose origins are non-monetary. Only in those relatively rare 
cases in which government deficits, unemployment, and high interest rates can be 
attributed to money shortages will monetary expansion prove to be a lasting cure. But 
such instances are precisely those in which the price-level-stabilization and non-price-
level-stabilization objectives of monetary policy coincide. 

Central banks can control national money stocks in two ways: directly, by 
limiting their issues of paper currency, and indirectly, by altering available supplies of 
bank reserves and thereby influencing the value of deposit credits banks are capable of 
maintaining. Generally speaking, however, control is affected entirely though the 
market for bank reserves, with currency supplied to banks on demand in exchange for 
existing reserve credits. 

In most industrialized nations the supply of bank reserves is mainly regulated by 
means of central bank sales and purchases of government securities, foreign exchange, or 
other assets in secondary or "open" asset markets. When a central bank purchases assets 
in the open market, it pays for them with a check drawn upon itself. The seller then 
deposits the check with a commercial bank, which sends the check to the central bank for 
settlement, which takes the form of a credit to the bank's reserve account. Banking 
system reserves are thus increased by the value of the open-market purchase. Open-
market asset sales have the opposite consequences, with the value of checks written by 
securities dealers being deducted from the reserve accounts of the dealers' banks. The 
principal merit of open-market operations as a tool or "instrument" of monetary control is 
that such operations allow central banks to exercise full control over outstanding stocks 
of basic money. 

Two other instruments of monetary control of considerable importance are 
discount-rate changes and changes in mandated bank reserve requirements. Reserve 
requirement changes (that is, changes in minimum legal ratios of bank cash reserves to 
deposits of various kinds) work, not by altering the total outstanding value of bank 
reserves, but altering the total value of deposits supported by available cash reserves. 
Although reserve requirement changes are capable in principle of accomplishing any 
desired money stock adjustment, central banks have tended to rely less upon such 
changes, while becoming more reliant upon open market operations, because the money 
supply effects of reserve requirement changes are less predictable than those of a specific 
open market operation, and also because regulators, including many central bank 
authorities, have become increasingly inclined to view legally-mandated reserve 
requirements as a quite unnecessary source of banking system inefficiency. 

A third instrument of monetary control, discount rate changes, is also the one 
whose role is most frequently misunderstood by the general public. Instead of purchasing 
assets on the open markets, a central bank can purchase assets directly from a commercial 
bank. Traditionally such direct purchasing was known as "discounting" because assets 
were acquired at a discount from their face or maturity value, with the discount rate 
embodying an implicit rate of interest. Today, central bank support to commercial banks 
often takes the form of outright loans, and does so even in some instances (including the 
United States) where official central bank lending rates continue to be referred to as 
"discount" rates. 

It is sometimes assumed that, in setting their own "discount" rates, central banks 
are able to influence if not control market lending rates generally. In truth, most central 
banks supply relatively little base money in the form of direct loans or discounts to 
commercial banks: only troubled banks are likely to apply for such support, and even 
some of them may be turned away. Consequently, there need be no connection at all 
between the rates central banks charge commercial banks and commercial banks' own 
lending rates. Central bankers sometimes contribute to public misunderstanding of their 
influence upon market rates of interest by using changes in their discount rates as a 
means of signaling their intention either to increase or to reduce the availability of bank 
reserves, with the actual easing or tightening of bank reserve market conditions being 
accomplished, more often than not, by means of open market operations. 

Central bank actions that do add or subtract significantly from the total stock of
bank reserves are of course likely to influence market rates of interest. In particular, 
central banks wield a heavy influence upon rates that banks charge each other for short 
term, and especially overnight, funds. Indeed, in some countries, overnight inter-bank 
lending rates (including the Federal Funds Rate in the U.S., the London Inter Bank 
Offered Rate or LIBOR in England, and the Tokyo Inter Bank Offered Rate of TIBOR in 
Japan) function as important "intermediate" guides to monetary policy, with central banks 
stating their policy objectives in terms of particular overnight lending rate "targets." Yet
even in this respect central banks' ability to influence inflation-adjusted or "real" interest 
rates is very limited, and especially so in the long run. Thus, while in the short-run an 
increased supply of bank reserves may be associated with lower rates for inter-bank 
loans, as well as with a lowering of other lending rates, the increased supply of bank 
reserves will eventually translate into an expanded volume of bank loans and deposits, 
which will raise the demand for bank reserves, returning overnight lending rates to their 
original levels. Furthermore, unless the overall demand for money holdings has also 
increased, the increased money stock will sponsor increased expenditures, causing prices 
to rise. Higher prices will in turn generate an increased demand for funds, placing 
upward pressure on other interest rates. Assuming that prices rise once and for all, with 
no lasting change in the inflation rate, interest rates will tend to revert to their original 
levels. 

If, on the other hand, a central bank were to continue to inject reserves into the 
monetary system despite a rising price level, the result would be, not a one-shot increase 
in prices, but an increased rate of inflation, with people eventually taking the higher rate 
into account in making loan agreements. In that case interest rates, instead of merely 
returning to their original levels, would tend to rise above those levels by a percentage-
point amount equal to the percentage-point increase in the expected inflation rate. A 
central bank seeking to maintain low interest rates must therefore resist the temptation to 
continue injecting reserves into the banking system whenever rates seem "too high," lest 
it should end up driving them higher still. Conversely (and somewhat paradoxically) a 
central bank that is anxious to bring bank lending rates down from high-inflation levels 
will find it necessary to restrict the supply of bank reserves, even if doing so will cause 
some interest rates to increase in the short run. The desired result of reduced interest 
rates will be achieved once people perceive that the inflation rate has fallen. 

VI.2. "Last Resort" Lending 

The day-to-day monetary control activities of central banks serve to regulate the 
overall extent of bank lending and deposit creation activities. In contrast, in serving as 
"lenders of last resort," central banks offer financial support to individual banking firms, 
in order to keep the firms from failing prematurely and, more importantly, in order to 
prevent a general loss of confidence in the banking system from triggering system-wide 
bank runs. 

Ideally, central banks' last-resort lending activities are supposed to complement 
their basic monetary control objectives. A banking panic can involve large-scale 
withdrawals of currency from the banking system which, by exhausting bank reserves, 
might cause the banking system to collapse, depriving firms access to an essential source 
of funding, while making it extremely difficult for the central bank to steer clear of a 
deflationary crisis. By standing ready to provide aid to troubled banks, and thereby 
assuring depositors that at least some of the economy's banking firms are in no danger of 
failing, central banks make the challenge of monetary control easier while maintaining 
the flow of bank credit. 

However, as Bagehot understood long ago, last-resort lending by central banks 
will undermine the efficiency of a nation's banking system unless it is limited to solvent 
banks that happen, for some reason, to be temporarily short of cash. Otherwise-if this 
so-called "classical" rule is overlooked-insolvent banks will be kept afloat despite the 
fact that they have been making unsound use of scarce savings, and other banks will be 
encouraged to engage in risky lending and investment practices. Unfortunately, central 
banks have generally done a poor job of adhering to the classical rule of denying 
assistance to unsound banks, both because those in charge of them have lacked needed 
information concerning the quality of banks' lending portfolios, and because they have
feared the political and economic fallout that bank failures, and big-bank failures 
especially, might generate. 

A more fundamental criticism of the classical lender of last resort doctrine denies 
that banking crises are a problem inherent in fractional-reserve based banking system. 
According to this perspective, genuine banking panics (as opposed to isolated bank 
failures or bank runs) have been relatively rare events, which would be rarer still were it 
not for misguided banking regulations and monetary policies that render many banking 
systems artificially weak and crisis prone. Even the most influential banking crisis in 
modern history-the failure of thousands of U.S. banks during the months ending with 
F.D.R's declaration of a national bank holiday in March 1933-was, according to this 
perspective, a consequence of misguided government policies, including laws that 
prevented most U.S. banks from diversifying their assets and liabilities by establishing
branches within and across state lines. Some relatively unregulated banking systems of 
the past, including the systems of nineteenth and early twentieth-century Canada, 
Scotland, Sweden, and Switzerland, proved on the other hand been to be remarkably free 
of major crises. 

VII. Commercial Bank Regulation

Mention of the role bank regulations may play in promoting or aggravating 
banking crises brings us to the last of the three ways in which central banks influence the 
conduct and performance of commercial banks, namely, by subjecting them to special 
regulatory rules. Although central banks are by no means unique in this regard (non-
central bank authorities being at least partly responsible for the regulation of banks in 
many nations), central banks are nonetheless the principal bank regulatory agencies in 
most countries today. 

Most modern bank regulations today are ostensibly aimed at limiting bank 
failures, or at limiting bank depositors' exposure to losses stemming from bank failures. 
Such regulations are known as "prudential" regulations or, metaphorically, as banking 
systems' "safety net." But bank regulations, including some prudential regulations, may 
also have other purposes, which are often not officially acknowledged, including the 
limitation of competition within established banking industries and the enhancement of 
central banks' seignorage revenues. The consequences of bank regulation, like the 
motives responsible for it, vary. But even the most well intended regulations often have 
consequences far different from what regulators intend. 

VII. 1. Entry and Branching Restrictions 

Perhaps the most basic form of bank regulation consists of regulatory provisions 
barring or limiting entry into the banking business. The influence of Christian authorities 
in medieval Europe caused banking to be altogether prohibited in several cities, including 
Antwerp; while in the westernmost states and territories of the antebellum U.S. similar 
bans were outgrowths of populist anti-bank and hard-money sentiments. Today Islamic 
law prohibits conventional banking operations in a number of countries, forcing citizens 
of those countries to rely on special "Islamic banks" (discussed below) instead. 
Although the outright prohibition of banking has been relatively uncommon in 
modern times, less sweeping entry restrictions have not. In many nations entry into 
banking was long limited to privileged firms that had been granted special "charters" by 
their governments; and although many nations now have laws allowing banks to be 
established without need for specific legislative approval, many older chartered banks 
enjoy privileges denied to their un-chartered counterparts. 

Many nations also limit entry into their banking markets by foreign bank branches 
or subsidiaries, thereby insulating their domestic banking industries from foreign 
competition. Regulatory authorities often justify such policies by pointing to the 
difficulty of effectively regulating foreign institutions, and foreign bank branches 
especially (since such branches are mere appendages of a foreign enterprise rather than 
distinct firms). Nevertheless such entry barriers have the unintended consequence of 
limiting international diversification of bank assets and liabilities generally while forcing 
citizens of certain nations to do business with banks that are both under-diversified and 
poorly capitalized. 

A special case of "foreign" bank entry restrictions was the long-standing 
prohibition of branch banking within most of the United States, where unrestricted 
branch banking only became legal with the passage, in 1994, of the Riegel-Neal Interstate 
Banking and Branching Efficiency Act. U.S. branching restrictions had the unintended 
consequence of increasing the likelihood of catastrophic bank failures. During the first 
years of the Great Depression, for example, several thousand U.S. banks failed, and their 
failure was the major cause of a thirty-five percent reduction of the U.S. money supply 
that further deepened the depression. In contrast Canada, which did not restrict branch 
banking, did not experience a single bank failure during the entire Great Depression 
episode. 

VII. 2. Interest-Rate Controls 

What is probably the oldest form of bank regulation consists of laws restricting 
rates of interest bankers are allowed to charge on loans or pay on deposits. Orthodox 
Christianity held it to be immoral for a lender to earn interest from a venture that did not 
involve substantial risk of loss. However, this injunction was relatively easy to 
circumvent: interest could be excused if the lender could demonstrate that the loan was 
risky, or that it entailed a sacrifice of some profitable investment opportunity. Interest 
charges could also be built into exchange charges, with money lent in one currency and 
repaid (at an artificially enhanced exchange rate) in another. Finally, the taint of usury 
could be removed by recasting loans as investment share sale and repurchase agreements-
-not unlike today's overnight repurchase agrreements. Over time such devices became 
less necessary, as official Church doctrines were reinterpreted to accommodate the needs 
of business, until the term "usury" came to refer only to interest payments considered
"excessive." 

Islamic law, like medieval Christianity, prohibits the taking of interest, and 
continues to do preclude normal bank operations throughout much of the Muslim world 
today. Consequently throughout Islam financial intermediation, instead of being based 
upon debt contracts involving explicit interest payments, is conducted (as in some
medieval Christian arrangements) on a profit-and-loss sharing principle, with Islamic 
banks and their depositors taking part in the ownership of "creditors'" enterprises. 
Although the Islamic approach entails more cumbersome contracts, it did not prevent the 
emergence of effective banking systems during heyday of Islam. Nevertheless, Western-
style banks came to eclipse their Islamic counterparts. During the 1960s and early 1970s, 
when nominal market rates of interest climbed to double-digit values throughout much of 
the world, Islamic-style banking, which had long been in retreat, proved especially 
burdensome, and came close to vanishing altogether. Paradoxically enough, the energy 
crisis of 1973-74, which brought world interest rates to their peak levels, helped to revive 
it by substantially enriching oil-producing Islamic nations of the Middle East. Today, 
despite competitive disadvantages, sometimes reinforced by regulatory restrictions (as in
India, whose Banking Law does not provide for Islamic-style banks), but just as often 
offset by them (as in Pakistan, Iran and Sudan, where interest-based banking has been 
prohibited), hundreds of Islamic style financial institutions exist around the world, 
handling an annual value of close to $200 billion in transactions, and their number 
continues to grow. Some larger "Western" multinational banks have also begun to offer 
banking services consistent with Islamic law. 

Among some non-Islamic nations also interest rate regulations have persisted 
through modern times. Regulated deposit rates of interest remain the norm among less-
developed Asian countries, and were common in Latin American until the 1980s, when 
regulatory restrictions were relaxed or eliminated in many cases. Among developed 
nations both Sweden and the United States also restricted interest payments on various 
deposits until the 1980s. The strict regulation of lending rates has, on the other hand, 
been less common outside of Muslim nations, as the generally acknowledged need to 
allow for a variety of loans involving differing degrees of risk makes designing and 
enforcing such regulations difficult. 

Although the phasing-out of deposit rate restrictions in many nations since the 
1980s was an unavoidable response to sharp increases in market rates of interest during 
the inflationary '70s, interest-rate deregulation has in some places had adverse unintended 
consequences. In particular, where deposit guarantees are in place, banks have been 
tempted to make risky loans and investments so as to obtain funds from persons who lack 
any reason to be concerned about bank risk. Ironically, in the U.S. at least, the belief that 
interest-bearing deposits tended to be encourage excessive bank risk taking was one 
reason why deposit rates of interest were regulated in the first place. Yet, because 
deposits were not uninsured when interest rate regulations were first implemented, the 
belief was not well founded at the time, because depositors retained an incentive to avoid 
doing business with risky banks. 

VII. 3. Mandatory Cash Reserves 

Another long-established form of bank regulation consists of laws requiring banks 
to maintain minimum reserves of base money. Such reserve requirements have 
traditionally been justified on the grounds that they reduce banks' exposure to liquidity 
risk, while also aiding central banks' efforts to maintain control over national money 
stocks by preserving a more stable relationship between the outstanding quantity of base 
money (which central banks are able directly to regulate) and the outstanding quantity of 
bank money. 

A third purpose served by legal reserve requirements, albeit one often left 
unacknowledged by regulatory authorities, is that of securing government revenue. 
Binding reserve requirements contribute to the overall demand for basic money, which 
nowadays consists of central bank deposit credits and notes, and therefore enhance as
well the demand for government securities that central bank banks typically hold as 
backing for their outstanding liabilities. A greater portion of available savings is thus 
channeled from commercial bank customers to the public sector. Bank depositors feel 
the effect of the transfer in the form of lowered net interest earnings on their deposits. 
For this reason reserve requirements are properly viewed as a kind of "tax" on bank 
money. The higher the minimum legal reserve ratio, the greater proportion of savings 
transferred to the public sector and away from private investment. 

Economists have long maintained that legal reserve requirements are not 
necessary for effective monetary control, and that such requirements are self-defeating as 
means for reducing banks' exposure to liquidity risk. (If the requirements are rigidly 
enforced, banks may resist drawing upon reserves if doing so would mean violating the 
requirement.) As a result of such arguments, and also because governments have 
generally become less dependent on reserve-requirement "tax" revenue, more than a 
dozen countries, including Canada, Sweden, Switzerland, Australia, and New Zealand, 
have done away with mandatory reserve requirements during the last two decades. The 
lack of any adverse liquidity or monetary control repercussions from abolishing reserve 
requirements in these nations combined with the competitive edge that deregulation of
reserves has given to their banking systems has in turn tended to undermine support for 
legal reserve requirements elsewhere. 

VII. 4. Asset Portfolio and Activity Restrictions

The enforcement of minimum cash reserve ratios represents only one of many 
ways in which regulators have sought to influence the composition of commercial bank 
assets and liabilities. In many nations regulators dictate the kinds of non-cash assets 
banks are allowed to possess, either directly by requiring banks to hold particular assets 
or indirectly by preventing them from engaging in certain kinds of activities. In the 
antebellum United States, for example, many state-authorized banks were required to 
invest in specific government or railroad securities as a condition for issuing notes. 
During and after the Civil War nationally chartered banks were likewise required to 
"secure" their notes with government (in this case, Federal government) securities. 
Today the Community Reinvestment Act requires that insured U.S. banks direct a portion 
of their lending to local borrowers. 

Some relatively common examples of bank activity restrictions include laws 
preventing banks from owning non-bank firms or from owning, selling, or underwriting 
insurance policies, real estate, or "securities" (that is, stocks). But while restrictions on 
these activities are common, restrictions differ substantially from nation to nation, with 
some nations placing no restrictions at all on activities that are restricted by others and 
vice versa. Some patterns may be discerned nonetheless, with some nations-including 
those in Northern Europe-being generally permissive, and other-including Japan and 
the U.S.-being generally restrictive. 

Regulations can also influence the structure of bank liabilities as well as that of 
bank assets. For example, in Italy during medieval times and in Scotland in early modern 
times governments prohibited banks from issuing otherwise demandable notes bearing a 
contractual clause permitting temporary "suspensions" of payment. Today in most 
countries banks are altogether prohibited from issuing banknotes. Some regulators have 
sought as well to limit the extent of inter-bank liabilities so as to rule-out a "domino 
effect" from bank failures. Finally, regulators in many nations have required banks to 
take part in government deposit insurance schemes, which are discussed at further length 
below. 

VII. 5. Capital Standards 

Minimum capital requirements are another way in which regulators can influence 
the structure of banks' balance sheets. As we've seen, bank capital protects bank 
depositors from losses by treating bank shareholders as "residual claimants" who must be 
prepared to sacrifice their equity whenever a bank suffers losses that might otherwise 
impair its ability to honor commitments made to deposit holders. Although the value that 
informed bank customers place on a bank's having a substantial capital cushion might in 
principal supply bankers with a sufficient motive for maintaining adequate capital-to-
asset ratios, regulators, fearing that market incentives might prove inadequate, have often 
sought to enforce minimum capital requirements. In many past instances, however, such 
requirements have been set with no reference whatsoever to the nature of bank assets and, 
hence, to banks' actual exposure to risk. Such crude requirements could prove 
counterproductive, by conveying to depositors the false impression that all banks abiding 
by them were equally safe. 

In recent decades the more widespread availability of deposit insurance, together 
with the extended role of "implicit" central bank guarantees, have tended to undermine 
market-based incentives for maintaining high capital ratios, increasing the risk of bank 
failures and exposing insurance agencies and taxpayers to greater losses. Regulators 
have responded by placing greater emphasis than before upon minimum capital 
standards, while also attempting to make required capital-to-asset ratios vary with banks'
exposure to various risks. The most important step in this direction was the so-called 
Basle Accord, which was implemented by the G-10 nations in stages starting in 1988. 
The Accord established an eight percent capital/asset ratio target, with bank assets 
"weighted" according to the risk of loss, with weights ranging from zero (for top-rated 
government securities) to one (for some corporate bonds). 

VI. 6. Nationalization 

Instead of attempting to regulate privately owned banks, governments sometimes 
prefer to run the banks themselves. Both Marx and Lenin advocated the centralization of
credit through the establishment of a single monopoly bank, and the nationalization of 
Russia's commercial banks was one of the first reform measures taken by the Bolshevists 
when they came to power in 1917. Later socialist governments followed the Soviet lead. 
In every case, however, nationalization had severe unintended consequences. The Soviet 
Union, for example, found itself without a functioning monetary system following the 
Bolshevist reform; and even today, despite a considerable retreat from wholesale 
financial centralization, the Russian banking system still functions, as it did during the 
Soviet era, as little more than a conduit through which state enterprises receive subsidies 
in the form of rubles created by Russia's central bank. 

In other socialist economies also, including China, Korea, and Yugoslavia, 
complete centralization of banking gave way to less centralized and more autonomous 
but nonetheless "nationalized" banking systems, with various specialized financial 
institutions providing funds to particular economic sectors, and answering to authorities 
and enterprises within those sectors rather than to their central governments. 
Nationalized banks can also be found in many partially socialized or "mixed" 
economies, and especially in less-developed economies, where they sometimes coexist 
with privately owned banks. The general performance of such banks, like that of banks 
in socialist economies, has been poor, largely thanks to a lack of incentives needed to 
promote efficiency. Nationalized banks have tended to be overstaffed, slow in providing 
services to borrowers, and unprofitable. They have also tended to suffer higher 
delinquency rates on their loans, thanks in part to government-mandated lending to 
insolvent enterprises or to the public sector itself, and to outright corruption. For 
example, the long-established state-owned banks of Brazil, which made up more than 
half of Brazil's banking system assets as of the early 1990s, were by then saddled with 
large numbers of non-performing loans, many of which had been made to state-owned 
enterprises and to deficit-ridden state governments. Since the mid-1990s several of the 
banks have been liquidated, and over a dozen have been privatized or are slated for 
privatization.

The nationalization of commercial banking in mixed economies has often been 
justified on the grounds that nationalized banks could concentrate on promoting their 
nations' economic development rather than on increasing their owners' wealth. In 
practice, though, nationalized banks have tended to be less rather than more successful at 
promoting development than the majority of their privately owned counterparts. This has 
been due in part to the corruption and lack of competitive stimulus referred to above, but 
also to nationalized banks' inability, with their civil-service pay scales, to attract and 
retain good managers, and to their tendency to participate in grandiose but unsound 
development projects. Nationalized banks poor overall record in promoting development 
has given rise to bank privatization movements in many nations, which may ultimately 
reverse the tide of nationalized banking from its high mark set during the 1980s. 

VIII. 7. Deposit Insurance

A final and increasingly important form of bank regulation consists of mandatory 
deposit insurance-that is, the requirement that banks participate in a government-
designed insurance arrangement the immediate purpose of which is to protect bank 
deposit holders from losses stemming from bank failures. 

The 'why' of deposit insurance 

Although bank deposit insurance is sometimes viewed as being nothing more than 
a means for protecting individual (and especially small) bank depositors, its more subtle 
purpose is one of protecting entire national banking and payments systems by preventing 
costly bank runs and panics. According to a widely-held opinion, adverse news or 
rumors concerning an individual bank or small group of banks will tend to cause holders 
of uninsured deposits to stage runs, not only on the banks directly concerned, but on other 
banks as well: depositors' lack of information concerning the nature of their own bank's 
investments can encourage them to withdraw their money "just in case" their banks might 
be in the same boat as those already believed to be in trouble. Bank runs can thus 
become "contagious," spreading from bank to bank and, in the worst-case scenario, 
generating a system-wide banking panic, with depositors fleeing en masse from holding 
deposits to holding cash. Because banks' actual cash reserves amount to only a fraction
of their immediately withdrawable ("demand" or "sight" deposits), a generalized banking 
panic will ultimately result, not only in massive depositor losses, but also in the 
wholesale collapse of the banking system, with all the disruption of payments and credit 
flows any such collapse must entail. 

How deposit insurance works 

Deposit insurance eliminates or substantially reduces the likelihood of a banking 
panic by eliminating or reducing depositors' incentive to stage bank runs. In the simplest 
kind of insurance scheme, where deposits (or deposits up to a certain value) are fully 
insured, all or most deposit holders enjoy full protection of their deposits, and any 
promised interest payments, even if their bank does fail. Banks that become insolvent for 
reasons unrelated to panic may be quietly sold to healthy banks, immediately closed and 
liquidated, or (temporarily) taken over by the insurance agency. 

Origins of deposit insurance 

Government-sponsored deposit insurance was an idea first adopted in the United 
States, from which it eventually spread to many other countries. Although various U.S. 
state governments experimented with deposit insurance prior to the 1933, most of these 
experiments failed, and a few failed catastrophically when banks insured by them
engaged in excessive risk taking. National deposit insurance had itself been proposed on 
numerous occasions prior to 1933, but the idea garnered little support until large numbers 
of bank failures (and consequent, substantial depositor losses) during the first years of the 
Great Depression revived public interest in banking reform. Although the failures mainly 
involved small, unit banks, strong populist opposition to nationwide branch banking (a 
popular alternative to insurance, which sought to eliminate small and under-diversified 
banks by means of a substantial consolidation of the banking industry) combined with 
opposition from unit banks themselves to overcome resistance from larger banks and the 
Roosevelt Administration, resulting in the inclusion of federal deposit insurance as a 
component of the Banking Act of 1933. Originally the law provided coverage for 
individual deposits up to $5000. The limit has been raised since then on several 
occasions, and now stands at $100,000. 
W
hile the popularity of most of the other kinds of bank regulations discussed so 
far has dwindled in recent decades, deposit insurance schemes have become increasingly 
common: whereas only 17 countries had implemented such schemes prior to 1980, since 
then more than 50 others have done so, including most of the OECD nations. The 
particulars of these schemes differ substantially from country to country, with coverage 
ranging from a $183, with 75% coinsurance (Bulgaria) to full coverage (also known as a 
"blanket guarantee" (Turkey). In 1994, a uniform deposit insurance scheme became a 
component of the European Union's single banking market. Some nations that have 
resisted the trend so far are China (including Hong Kong), Singapore, the former Soviet 
states (excepting the Baltic nations and the Ukraine), Australia, New Zealand, Israel, and 
(not surprisingly) a number of predominantly Muslim countries. 

Deposit insurance has been embraced by almost every other nation despite the 
fact that it may have a potentially serious side effect, to wit: a tendency to undermine 
market discipline, by depriving many and in some cases most bank depositors of any 
incentive to avoid patronizing risky banks. When depositors bear little or none of the risk 
associated with bank failures, they will be inclined to select banks on the basis of such
considerations as non-risk-adjusted deposit rates of interest and convenience of location, 
ignoring safety considerations altogether. The lack of market discipline in turn 
encourages bankers to make loans and to purchase securities that pay higher rates of
interest, but are also more risky. The outcome of this "moral hazard" problem is a 
banking system that is generally less safe than it might have been in the absence of 
insurance. Individual bank depositors are thus protected from losses at the cost of higher 
overall bank losses, which must ultimately be borne by all bankers and, ultimately, bank 
depositors in the form of higher insurance premiums. In extreme cases losses may even 
mount to the point of bankrupting the deposit insurance agency, so that deposit 
guarantees can only be honored through resort to general tax revenues. This was, in 
essence, what happened in the United States Savings and Loan crisis of the 1980s, which 
bankrupted the Federal Savings and Loan Insurance Corporation set-up during the New 
Deal, and which eventually added several thousand dollars to the per-head tax burden. 
Thus although dramatic runs of the sort experienced during the 1930s were avoided, and 
losses were spread widely so that fewer families were ruined by bank (or, in this case,
Savings and Loan) failures, insurance had proven to be a very costly means for ruling-out 
panic. 

The moral hazard problem is greatest where insurance coverage is unlimited and 
where insurance premiums are not risk-based. Many contemporary deposit insurance 
schemes attempt to contain the problem by offering limited insurance coverage only 
(instead of blanket guarantees) or by charging risk-adjusted premiums (so that riskier 
banks pay higher insurance rates, which they must then pass on to their customers) or 
both. 

Insurance coverage can be limited either by stipulating a maximum insured 
account value or ceiling or by resort to coinsurance (that is, less than 100 percent 
coverage of all insured accounts). Either solution has its benefits and drawbacks. Thus, 
while coinsurance gives all depositors an incentive to look out for risky banks, it also 
reintroduces the possibility of general runs if the incentive to gather bank-specific 
information remains week. Insurance ceilings, on the other hand, expose larger 
depositors only to some risk of loss. Ceilings therefore place the burden of market-
discipline and monitoring with those who can best afford to bear it. But they also leave 
open the possibility of some banks catering to small depositors only, so as to evade 
market discipline altogether; a related problem stems from the possibility that persons 
will establish multiple bank accounts, each of which falls below the insurance ceilings. 
Despite these drawbacks limited coverage has almost universally supplanted 
blanket coverage. Korea, Japan, Ecuador, and Columbia recently switched from blanket 
to limited coverage, and Mexico intends to do the same in 2005. The regulatory 
authorities of Thailand, Indonesia, and Malaysia instituted blanket deposit guarantees in 
the midst of the 1997 financial crises, but intend to revert to limited coverage. As of this 
writing Turkey alone has a full-coverage insurance scheme (established in response to its 
own 1994 banking crisis) that is not supposed to be temporary. 

An alternative way to avoid the moral hazard problem is to allow deposit 
insurance premiums to vary according to how risky a bank's lending strategy is. This
approach has the advantage of forcing banks (and, ultimately, bank customers) to pay an
explicit price for making risky investments using insured funds, without limiting 
insurance coverage or otherwise dictating what sort of investments banks are allowed to 
make. Unfortunately this solution is beset by practical difficulties stemming mainly from
the difficulty of gathering reliable information concerning bank-specific risks. Partly for 
this reason risk-adjusted premiums have been resorted to in fewer than one-third of all 
deposit insurance schemes; and in these cases (which include the present U.S. 
arrangement) economists suspect that the range of premiums charged falls well short of 
what would be required to achieve "fair" insurance pricing of the sort that ought to suffice 
to eliminate moral hazards. 

A nation may, of course, avoid the moral hazard problem posed by mandatory 
deposit insurance by simply doing without deposit insurance altogether. Although the 
rapid spread of deposit insurance suggests that this is not a popular solution, research has 
shown that, on the whole, banking systems that have been "protected" by explicit deposit 
insurance schemes have suffered from more frequent banking crises than ones that have 
not. Although this finding does not imply that deposit insurance is necessarily a bad 
idea, it does suggest that many existing deposit insurance arrangements have been badly 
designed. 

VII. Recent Trends in Banking

While the rapid worldwide spread of deposit insurance schemes might appear to 
suggest a trend favoring increased government regulation of banks, other developments 
point the other way. Starting in the 1980s, governments around the world, and in 
industrialized nations especially, initiated programs of banking system deregulation, 
thereby allowing market forces to play a larger role in determining the structure and 
performance of their banking systems. Several factors lay behind this deregulatory 
movement. One was a general ideological and intellectual current favoring deregulation 
and privatization. In the case of banking this current was reinforced by numerous 
academic studies pointing to conventional bank regulations' undesirable, unintended 
consequences. A second factor consisted of technological advances, and advances in 
information-processing and communications technologies especially, that served to erode 
former nationally-defined financial market boundaries by making it easier for people to 
obtain banking services from foreign or "offshore" banks. As offshore banking becomes 
a closer substitute for banking with domestic firms, domestic regulatory authorities are 
compelled to relax regulations that place domestic banks at a serious competitive 
disadvantage relative to offshore rivals. A process of "competitive deregulation" is thus 
set in motion, with regulators in different nations endeavoring to maintain their "turf" by 
doing what they must to keep their nation's banking industries from shrinking. 
Although the beginnings of competitive deregulation can be traced at least as far 
back as the late 1950s, when some larger holders of U.S. dollar-denominated deposits 
were able to bypass U.S. interest rate restrictions by setting-up so-called "Eurodollar" 
accounts, since then it has become possible for almost anyone to do hold offshore dollar 
deposits in Luxembourg, the Bahamas, the Cayman Islands, and elsewhere and to 
transact with those deposits by phone or fax or through the internet. Banks, and larger 
banks especially, have in turn found it increasingly easy to base their operations in 
countries that don't burden banks with strict regulations or high taxes. 

Some relatively recent examples of deregulatory changes that may be understood 
as instances of "competitive re-regulation" include the repeal of the Glass-Steagall Act in 
the U. S., the (largely inflation-inspired) removal of interest rate ceilings throughout both 
the U.S. and Europe, and the elimination or reduction of minimum compulsory reserve
requirements across the globe. While some regulatory authorities and economists regret 
these changes, characterizing competitive deregulation as "competition in laxity" or a 
"race to the bottom," others have welcomed them on the grounds that they have allowed 
inefficient and largely counterproductive regulations to be eliminated while providing 
banks with a wider range of opportunities for managing and diversifying their assets and 
liabilities. 

A second trend in banking, which is at least partly a byproduct of deregulation, 
has been the increasing internationalization and consolidation of the banking industry. 
The number of banks worldwide has been declining, mainly as a result of mergers and 
acquisitions, while the availability and worldwide dispersal of banking facilities has been 
growing thanks to increased branch banking as well as to the spread of ATM machines 
and opportunities for on-line banking. This trend has been especially visible in the U.S., 
where the removal of restrictions on branch banking has caused the number of banks to 
decline from over 14 thousand in the mid 1980s to fewer than 8000 today. 

A final trend in banking, which has manifested itself in various ways, has been a 
decline in the importance of conventional commercial banks relative to other kinds of 
financial firms. One instance of this trend has been a general movement among 
industrialized nations especially favoring diversified financial firms (that is, firms 
combining conventional banking, insurance, and investment services) over pure banks in 
the strictest sense of the term. This trend also has been most apparent in the U.S., where 
restrictions on the mingling of diverse financial services were once especially strict. It 
has been least apparent in Europe, where such mingling has long been practiced under the 
rubric of "universal" banking. 

A second instance has been the rise of so-called "microlending" associations--
specialized banks that cater to a previously neglected segment of the market for banking 
services. Microlending, an idea pioneered in 1976 by the Grameen Bank of Bangledesh, 
now supplies funds to approximately 10 million poor persons in both poor and wealthy
nations worldwide, allowing them to set-up small businesses and to otherwise escape 
from poverty. Instead of relying upon collateral, as conventional banks do, to secure 
their loans, microlending institutions rely upon their borrowers' membership in village-
based peer groups that are collectively responsible for loan repayments. This collective 
responsibility gives the peer groups a strong incentive to screen-out bad credit risks, 
which they can do relatively easily because village members' reputations are relatively 
well known to them. The peer groups thus bear relatively easily what would otherwise be 
a prohibitively high cost of making non-collateralized loans. Remarkably, default rates 
for the Grameen Bank have actually been far lower than those for traditional banks, 
falling in the range of 2-3% as opposed to 60-70% for conventional bank loans. 

The relative importance of conventional banks has also declined as a result of 
firms' expanding opportunities for raising funds by issuing their own bonds (including 
low-grade "junk" bonds) and shares. Globalization has contributed to this trend as well, 
for it is now easier than ever before for firms operating in nations with poorly developed 
securities markets to market their securities abroad. Conventional banks have in turn 
been forced to respond to the declining importance of bank loans by increasing their 
involvement in securities-related activities and by offering other non-traditional services 
that generate "off-balance-sheet" revenues. 

While traditional banks have been either changing into or yielding ground to other 
types of financial intermediaries, private financial intermediaries of all kinds have been 
making headway against central banks by improving the convenience of their spendable 
IOUs relative to that of paper currency. They have done this mainly by developing and 
promoting facilities for online banking and for point-of-sale debit-card payments but also 
(to a smaller much smaller extent) by developing "digital cash" or "smart cards," which
can be used to make payments even by persons without bank accounts. Still, paper 
money is unlikely to be given up altogether; and even if it were given up central banks 
would continue to serve as ultimate sources of bank reserves, and as such would continue 
to exercise control over overall lending, spending, and price levels. 
-