How banks work

A Brief History of Banking

To truly understand how banks function, it’s important to explore their history. Let’s look at the timeline:

Ancient Banking (2000 BCE – 100 CE)

The origins of banking trace back to ancient Mesopotamia, where merchants offered grain loans to farmers and traders. Temples and palaces in Babylon, Egypt, and Greece served as repositories for valuables and issued loans. The Code of Hammurabi from Mesopotamia included laws related to financial transactions, showcasing early advanced financial systems.

Banking in Ancient Rome (100 BCE – 500 CE)

Roman banking involved currency exchange, deposit taking, and lending. Bankers and money lenders operated in forums, providing services such as money changing and loans to individuals and businesses.

Medieval Banking (500 CE – 1400 CE)

After Rome’s fall, banking declined in Western Europe but flourished in the Byzantine Empire and Islamic world. The Knights Templar established an early international banking system for pilgrims.

The Rise of Modern Banking (1400 CE – 1700 CE)

The Renaissance saw innovations like double-entry bookkeeping, pioneered by the Medici family. Central banks, like the Bank of Amsterdam and Bank of England, were established to regulate financial systems and issue currency.

The Industrial Revolution (1700 CE – 1900 CE)

Rapid economic growth fueled the rise of joint-stock banks, central banks, and banknotes. This era brought significant advancements in banking and global trade.

The 20th Century

The gold standard dominated early 20th-century monetary systems, but its limitations during crises, like the Great Depression, led to its decline. Innovations like credit cards, ATMs, and online banking transformed the industry.

The 21st Century

With the internet, online banking and digital currencies like Bitcoin emerged. The 2008 financial crisis spurred regulatory reforms like the Dodd-Frank Act, but many underlying issues remain unresolved.

How Banks Work: From Gold Standard to Fractional Reserve Banking

The Gold Standard

Under the gold standard, a country’s currency was tied to a fixed amount of gold, ensuring stability. However, it was inflexible during economic crises and led to problems like limited liquidity and speculative attacks. Most countries abandoned the gold standard during the 20th century, transitioning to the modern system.

Fractional Reserve Banking

In this system, banks are required to hold only a fraction of deposits as reserves, lending the rest. This fuels economic growth by increasing the money supply but comes with risks like inflation, excessive risk-taking, and bank runs.

Types of Banks and Their Roles

Retail Banks

These serve individuals and small businesses, offering savings accounts, loans, credit cards, and payment services.

Commercial Banks

Catering to businesses, they provide loans, trade financing, treasury management, and foreign exchange services.

Investment Banks

Specialized in capital markets, investment banks handle mergers, acquisitions, underwriting, and asset management.

Central Banks 

Central banks oversee monetary policy, regulate the banking sector, and act as lenders of last resort during crises.

The Future of Banking

While banking has evolved significantly over centuries, its foundations remain crucial to the global economy. As we navigate challenges like digital currencies and regulatory pressures, the future of banking will likely bring more innovation and disruption.