The Origin of Banking

There is a just-so story that explains the existence of money. Before money, the story goes, we all had to barter for the goods we wanted. If I wanted wheat and had chickens, I needed to find someone who wanted chickens and had extra wheat. Money solves this “double coincidence” problem by letting me sell my chickens to buy your wheat. If we didn’t have money we’d invent it immediately.

The problem with this simple story is that it may not match history. There has never been a pure barter economy, according to anthropologists. Pre-money economies were organized in a variety of other ways, including central planning, informal gift economies, and IOUs denominated in cows.

Sir Jon Hicks’ classic A Market Theory of Money fills this gap.  Hicks was a major figure in 20th Century economics who eventually won a Nobel, and here at last is a straightforward story that explains why we have banks at all. It’s still not clear to me that this account is historically grounded – or that we can understand what a modern bank does, or should do, on the basis of historical parable — but at least this account provides a better history than barter.

With that cautionary note, here’s Hicks’ story of banking. He begins in a world where money is already the usual form of payment, and breaks down a transaction into three pieces:

  1. Buyer and seller reach an agreement on what is to be sold at what price
  2. Buyer delivers the goods
  3. Payer delivers the cash

Step 1 has to come first, but payment and delivery may come in any order at any time after that, depending on the agreement that the parties made. The gap between contracting and payment is credit. Credit is a very old idea, and central to modern economies. Hicks argues that “payment on the spot” is actually the uncommon case, at least for orders over a certain size:

I may pay spot for a newspaper as I walk along the street, but I may also give an order to a newsagent to deliver a copy to my house each morning. I should not then pay for each issue as I received it; I should wait until the end of the month when he sent in his bill. … It is probably true that only for small transactions – small that is, from the point of view of one or other of the parties concerned – that the spot method of payment is ordinarily preferred. People are not, and never have been, in the habit of carrying about them a sufficient quantity of coin or notes to pay for a house or pay for furnishing it.

The key observation is that credit is typical, not extraordinary. Any time we pay a bill – whether a at restaurant or for a credit card — we have been extended credit.

In the gap between contracting and payment there is debt, and debt is measured in money (at least on the buyer’s side; for the seller, debt is measured in goods or services owed.) There has long been argument over what exactly money is, or more usefully what it does, but in a credit-based theory of the economy it has two clear roles:

We seem thus to be left with two distinguishing functions of money: standard of value and medium of payment. Are they independent, or does one imply the other? It is not easy to see that there can be payment, of a debt expressed in money, unless money as a standard has already been implied in the debt that is to be paid. So money as a means of payment implies money as a standard. But could a debt expressed in money be discharged other than in money? Surely it could.

It could for instance be set off against another debt, the debt from A to B being cancelled against a debt from B to A.

This is Hicks’ entry into the concept of an IOU, which seems to be fundamental to modern finance – perhaps the fundamental idea, the notion underlying every financial instrument of every kind. Yes, you can pay money to settle a debt, but you can also cancel one debt against another, netting the debts. This means that a debt owed to you has monetary value! From there, it’s a small step to the idea that a third party debt can be used as a form of payment. Suppose B owes A a debt, and C owes B a debt of a different amount.

A is then asked to accept part payment in the form of a debt from C to B, which is to offset the balance of debt between A and B, a balance we take to be in favour of A. But A can hardly be expected to consent to such an arrangement unless he considers that C is to be trusted. So there is a question of trust, or confidence, as soon as a third party is brought in.

This short paragraph states a pattern that has been at the core of trade for centuries, and is at the core of finance today: the transferability of debts made possible by the assurance of good credit. This was a common pattern in the trade fairs of Renaissance Italy, where merchants would meet to settle tangled webs of IOUs with each other and with the banks. It happens today when a bank B lends money to A to buy a house, creating a mortgage debt from A to the bank, then sells the right to collect that debt to another bank C. For this to happen, B has to guarantee to C that A is creditworthy enough to repay.  It’s less obvious, but equally applicable, when A pays B by check. B doesn’t have “money” when they have the check, but a promise from A’s bank to pay. But we’re not there yet. Here’s how Hicks builds up to tradable debt:

The quality of debt from a particular trader depends on his reputation: it will regularly be assessed more highly by those who are in the habit of dealing with him, and know that his a accustomed to keeping is promises, than by those who do not have the advantage of this information.

Thus the value of a debt is sensitive to information. It’s not clear to me whether anyone would have used this language in, say, Renaissance Italy. Hicks, writing in 1989, would have been influenced by recent, eventually Nobel-wining work on information in economics. The information view of value explains how formerly solid debt-based assets – for example, mortgage-backed securities – can evaporate almost instantly if there is a credible threat of non-payment. Although debt is tradable like money in the good times, in bad times everyone wants hard currency, not promises to pay currency.

Hicks says that this information problem – really a reputation problem – leads to the creation of a market for guarantees that a bill will be paid.

Thus we may think of each trader as having a circle of traders around him, who have a high degree of confidence in him, so that they are ready to accept his promises at full face value or near it; there is no obstacle to offsetting of debts within that circle from lack of confidence in promises being performed. If he wants to make purchases outside his circles he will not be so well placed. Circles however may overlaps: though C is outside A’s circle, he may be within the circle of D, who himself is inside the circle of A. Then though A would not accept a debt from C if offered directly, he may be brought to accept it if it is guaranteed by D, whom he knows D is then performing a service to A, for which he may be expected to charge.

This is a market for acceptances of bills of exchange, a financial instrument that seems to be uncommon today, but was quite common in 19th century merchant banking, as described by Bagehot. From the merchant’s point of view, the objective of all of this is to get paid sooner. Suppose you sell goods to B in exchange for a bill with a specified due date, say 60 days from now. That’s a debt, and one way to use it is just to wait 60 days until B pays cash. Or you could trade that debt immediately with any person C who thinks B trustworthy – perhaps for cash, perhaps to settle a debt with C, perhaps to make a purchase. If you wanted to trade with someone who didn’t know B, you could first buy an acceptance and then trade the bill together with the acceptance – the debt together with its guarantee.

An acceptance is basically insurance: a guarantee that a bill will be paid, in fact the promise to pay the bill if the debtor defaults. The guarantor is willing to do this because they know, or have some way to evaluate, the reputation of the debtor, and because they charge a fee for the service. The equivalent modern instrument would be something like a “credit default swap.”

Notice that we don’t have banks yet. Instead, this story tells of the creation of the first markets for debt, facilitated by intermediaries who guarantee repayment. And here’s where I start to hesitate. It’s a nice story, certainly an account of how this could have happened. But I’m not enough a historian to know if this is how it did happen. Like barter, this could be an attractive myth. Still, it’s a useful account of a problem to be solved – how do I trade my debt assets outside the small circle of people who know the debtor personally? For if debt is tradable, then I suddenly have a lot more capital at my disposal: not just the cash I’m currently holding, but all of the cash that is owed me.

According to Hicks, the next step in the story of banking is the creation of two special kinds of intermediaries. The first sells guarantees (acceptances) on debt. They either know many debtors well, like a credit rating agency, or they know where to buy acceptances from someone who does know. The other kind of intermediary pays cash for debts along with their acceptances, at a discount from the face value of the debt, that is, a fee.

Until that point, the principal reason why the market value of one bill should differ from another is the difference in reliability; but bills, between which no difference in reliability is perceived, may still differ in maturity. A trader who is in need of cash needs it now, not (say) six months hence. So there is a discount on a prime bill which is a pure matter of time preference – a pure rate of interest.

Here Hicks is distinguishing between what would today be called credit risk, the risk of non-repayment which is solved by acceptances, and “time preference,” that is, the advantage of having cash now instead of later, which costs interest. These two components of price (and more besides such as liquidity risk) are implicit any time debt is sold. Hicks believes that separating these out is a necessary step to explaining how banking arose:

The trouble is that the establishment of a competitive market for simple lending is not at all a simple matter. The lender is paying spot, for a promise the execution of which is, by definition, in the future. Some degree of confidence in the borrower’s creditworthiness – not just his intention to pay but his ability to pay, as it will be in the future – is thus essential to it. There cannot be a competitive market for loans without some of this assurance.

It’s a fine argument, and indeed there is always both credit risk and time preference in lending (or buying debt for cash, which is nearly the same thing.) But I’m not convinced this is a historical account. Did the biblical money lenders really distinguish between credit risk and time preference when they set their interest rates? I suspect the answer is no. Yet surely there were reasons that the first money lenders came into existence – that is, motivating problems that offer hints as to what banks do. It may be possible to offer an account of the creation of banking which is both simpler, more motivating, and more historical than Hicks’ story of acceptances and discounts.

From a network of discounters for bills – intermediaries who are willing to lend cash against a guaranteed debt – we finally come to banks proper. Hicks explains the origin of banking by asking how trade volume could ever increase when there’s a fixed supply of cash among merchants:

What then is to happen if trade expands, so that more bills are drawn, and more come in to be discounted? Where is the extra cash that is needed to come from? Any one of the dealers could get more cash by getting other dealers to discount bills that he holds. But the whole body of dealers could not get more that way. They must get cash from outside the market. They themselves must become borrowers.

The solution was to combine this business with another sort of business, which in the days of metallic money we know to have already made its appearance.

This other business is goldsmiths, or perhaps moneychangers, both of which would store a customer’s coins in their vault. There has long been a need for secure money storage, something better than cash under the mattress. The innovation of modern banking is to recognize that not every customer will withdraw all their coins all at once.

Then, once that happens, there will be a clear incentive to bring together the two activities – lending to the market, and ‘borrowing’ as a custodian from the general public – for the second provides the funds which in the first are needed. At that point the combined concern will indeed have been becoming a bank.

This, then, is the essence of banking: take deposits, make loans. Crucially, a loan is in fact borrowing from the depositors and lending at different time scale (maturity transformation). The debtor pays back the loan at a later date, or perhaps little by little as with a mortgage, but the depositors can demand the whole of their account as cash at any moment. It is only by hoping that not everyone wants their cash back all at the same time that a bank can exist. A bank which did not borrow from its depositors would be incapable of extending credit, at least beyond the capital that its owners are putting in.

This is the “fractional reserve” system which has existed for centuries. Banks are by law allowed to lend at most some large fraction of their deposits, hedging against many depositors asking for their money back all at once (though note, today banks can always borrow more reserves from the central bank, so capital reserve requirements don’t really constrain lending.)

On this account, the central features of a bank are:

  • Taking deposits, which can be withdrawn at any time
  • Making loans, which are repaid slowly

In other words: short-term borrowing to finance long term lending. There’s nothing surprising in this description, and it captures the inherent risk-taking in banking, since it may happen that everyone wants their deposits back as cash all at once. Today, US banks are insured up to $250,000 per account by the FDIC, which simultaneously pays out if needed and makes payout less necessary since the guarantee makes bank runs less likely.

But something key is missing: the banks’ central role in the payment system allows them to create high quality tradeable debt — that is, bank deposits. For most people, bank balances are money, therefore a bank can create money. To explain how, Hicks examines the evolution of a bank’s debt to its depositors.

It would however always have happened that when cash was deposited in the bank, some form of receipt would be given by the bank. If the receipt were made transferrable, it could itself be used in payment of debt, and that should be safer [than moving cash around physically.]

Hicks uses this idea of a “receipt” to trace the development of the bank check, and from there the modern reality that bank deposits are money as far as you and I are concerned. Consider how one person pays another through the banking system:

It would at first be necessary for the payer to give an order to his bank, then to notify the payee that he had done so, then for the payee to collect form the bank. Later it was discovered that so much correspondence was not needed. A single document, sent by debtor to creditor, instructing the creditor to collect from the bank, would suffice. It would be the bank’s business to inform the creditor whether or not the instruction was accepted, whether (that is) the debtor had enough in his account in the bank to be able to pay.

The key point is that with a check – or with any of our modern means of electronic payment – no cash is ever withdrawn from the bank! We have simply rewritten the amounts owed by the banks to each customer. That is, if I pay you, my bank owes me less cash and your bank owes you more. It would be no problem if in fact my cash had been loaned out to someone else during this whole time.

In fact, banks don’t really loan cash either.

When the bank makes a loan it hands over money, getting a statement of debt (bill, bond, or other security) in return. The money might be taken from cash which the bank had been holding, and in the early days of banking that may have often happened. But it could be all the same to the borrower if what he received was a withdrawable deposit in the bank itself. The bank deposit is money from his point of view, so from his point of view there is nothing special about this transaction. But from the bank’s point of view, it has acquired the security without giving up any cash; the counterpart, in its balance-sheet, is an increase in its liabilities. … But from the point of view of the rest of the economy, the bank has ‘created’ money. This is not to be denied.

Bank deposits are not cash. They are debt to customers.  But we are happy to have bank deposits because banks have become the way in which we pay each other. When someone owes us money, we are satisfied with “money in the bank” rather than cash in hand. This all goes back the the tradability of debt that Hicks started with: Banks create debt of high quality, that is, debt which can be traded from hand to hand nearly as well as cash, or perhaps better. In that very real sense, banks create money.

Hicks has tried to explain how this combination of features we call banking arose. The story he gives is a progression from debt trading, to acceptances, to loaning cash against bills, to merging with the money storage industry, to a central role in the payment system, to creating money by lending some large fraction of customer deposits. I am not convinced that banks actually arose in this sequence. However, it does highlight some of the needs and problems that led to the creation of banking. Namely: consumers need a place to store money, businesses need credit, and everyone needs a payment system.

But the advantage of Hicks’ telling is that it highlights the central role of credit/debt. As soon as debt can be freely traded to a third party, it is a kind of money. It is this trust that allows a bank to create money. How much money a bank should create is a different question, which Hicks’ parable cannot tell.  Rather, I find this pattern of tradable debt useful for thinking about all the different forms that banking takes, including by the many financial institutions that don’t call themselves banks.

15 thoughts on “The Origin of Banking”

  1. I also highly suggest Debt: The First 5,000 Years. It also goes into the barter myth and continues all the way up to the 2008 crisis. It’s a pretty life changing book. Several people suggested to me before I finally read it.

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  5. Hi Jonathan,

    one of these statements seems wrong:
    – The gap between contracting and payment is credit.
    – In the gap between contracting and payment there is debt.

    Should it be like “The gap between contracting and goods delivery is credit”, or something like that?


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