What is financial market?

 Sets of investments instruments and intermediaries that allows savings to be invested

The main financial instruments are:

 Shares- represent the ownership part of a company that has issued them giving to shareholders
the right to any dividend that may be distributive by the company .
 Bonds – represent a loan for an individual grants to the issuing institution for a predetermined
period of time typically the remuneration the person who buys the bonds is represent by the
interest paid by the issuer from time to time.

Who are the people operating the financial markets?

Financial Intermediary such as banks

Investment funds that collect savings and invest them in a right options such as shares.

Insurance company that takes on3 the risks with customers in exchange by the payments of the people.

How are financial markets regulated?

In the financial markets there are strict rules and supervisor authorities such as the supervisor authority
of the Italian financial products market concept. The bank of Italy, the supervisory authority for private
insurance eva’s which oversee trade and intermediaries due to the nature of their activity and financial
intermediaries to be very stable or rather have a capital higher than a certain threshold.

Discussion: What are the financial markets for? What is their purpose?

By allocating resources and generating liquidity for firms and entrepreneurs, financial markets play a
critical role in supporting the smooth running of market economies. The financial markets make it
simple for buyers and sellers to swap their assets. According to Hayes (2021), financial markets create
securities products that provide a return for those who have excess funds (Investors/lenders) and make
these funds available to those who need additional money (borrowers). The purpose of the financial
markets which they can provide an opportunity to invest money in shares to build up money for the
future and allow people to take out insurance.

What Are Some Examples of Financial Markets and Their Roles?

Financial markets refer generally to any market where the buying and selling of securities take place.
Some examples of financial markets include the stock market, the bond market, and the commodities
market. Financial markets can be further broken down into capital markets, money markets, primary
markets, and secondary markets.

Let's take a closer look at three of the most common types of financial markets.

Stock Market

The stock market is where shares of publicly traded companies are bought, sold, and issued. It is a
collection of several exchanges where companies choose to list their stocks.
The most prominent exchanges in the U.S. are the New York Stock Exchange (NYSE) and the Nasdaq. The
NYSE is the largest stock exchange in the world and boasts some of the oldest publicly traded U.S.
companies. The Nasdaq, meanwhile, includes the biggest names in technology such as Apple, Alphabet,
and Microsoft.

The U.S. stock market—as represented by the S&P 500—has returned an average of about 11% over the
past 50 years.

Other large exchanges around the world include the Tokyo Stock Exchange (Japan), Shanghai Stock
Exchange (China), and the London Stock Exchange (England).

The stock market is considered a capital market because it provides long-term financing for companies.

Bond Market

The bond market refers broadly to the marketplace where investors buy and sell debt securities. Bonds
are typically traded, but notes and bills are also exchanged.

Both governments and companies issue debt for a variety of reasons such as reducing overall debt,
funding growth projects, or simply helping maintain day-to-day operations.

The bond market can be further segmented into two categories: the primary market and the secondary
market. New debt is created on the primary market where bond issuers raise capital directly from bond
buyers. The secondary market is where investors trade previously issued debt securities.

Individual investors typically participate in the bond market through retail brokers.

Fun Facts: While stock market news dominates financial headlines, the bond market is actually bigger
in terms of value. At the time of writing, the total value of the global bond market was about $130
trillion versus $95 trillion of the global equity market.

Commodities Market

The commodities market refers to the marketplace where investors buy, sell, and trade raw products
such as oil, gold, or corn. Major commodity exchanges in the U.S. are the Chicago Mercantile Exchange
(CME), the New York Mercantile Exchange (NYMEX), and the Intercontinental Exchange (ICE).

Hard commodities are natural resources that are mined, such as gold and oil. Soft commodities are
typically agricultural, including corn and livestock.

Commodity markets can include physical trading. But these days, the vast majority of commodities
trading is done through the use financial derivatives. Derivatives allow investors to profit from
commodities without having to physically possess them.

Retail investors usually don't have direct access to commodities markets. But average individual
investors can still gain exposure to commodities through stocks, bonds, and ETFs.
What Are Financial Markets?

Financial markets refer broadly to any marketplace where the trading of securities occurs, including the
stock market, bond market, forex market, and derivatives market, among others. Financial markets are
vital to the smooth operation of capitalist economies.

KEY TAKEAWAYS

 Financial markets refer broadly to any marketplace where the trading of securities occurs.
 There are many kinds of financial markets, including (but not limited to) forex, money, stock,
and bond markets.
 These markets may include assets or securities that are either listed on regulated exchanges or
else trade over-the-counter (OTC).
 Financial markets trade in all types of securities and are critical to the smooth operation of a
capitalist society.
 When financial markets fail, economic disruption including recession and unemployment can
result.

Understanding the Financial Markets

Financial markets play a vital role in facilitating the smooth operation of capitalist economies by
allocating resources and creating liquidity for businesses and entrepreneurs. The markets make it easy
for buyers and sellers to trade their financial holdings. Financial markets create securities products that
provide a return for those who have excess funds (Investors/lenders) and make these funds available to
those who need additional money (borrowers).

The stock market is just one type of financial market. Financial markets are made by buying and selling
numerous types of financial instruments including equities, bonds, currencies, and derivatives. Financial
markets rely heavily on informational transparency to ensure that the markets set prices that are
efficient and appropriate. The market prices of securities may not be indicative of their intrinsic value
because of macroeconomic forces like taxes.

Some financial markets are small with little activity, and others, like the New York Stock Exchange
(NYSE), trade trillions of dollars of securities daily. The equities (stock) market is a financial market that
enables investors to buy and sell shares of publicly traded companies. The primary stock market is
where new issues of stocks, called initial public offerings (IPOs), are sold. Any subsequent trading of
stocks occurs in the secondary market, where investors buy and sell securities that they already own.

Important: Prices of securities traded in the financial markets may not necessarily reflect their true
intrinsic value.

Types of Financial Markets

Stock Markets

Perhaps the most ubiquitous of financial markets are stock markets. These are venues where companies
list their shares and they are bought and sold by traders and investors. Stock markets, or equities
markets, are used by companies to raise capital via an initial public offering (IPO), with shares
subsequently traded among various buyers and sellers in what is known as a secondary market.
Stocks may be traded on listed exchanges, such as the New York Stock Exchange (NYSE) or Nasdaq, or
else over-the-counter (OTC). Most trading in stocks is done via regulated exchanges, and these play an
important role in the economy as both a gauge of the overall health in the economy as well as providing
capital gains and dividend income to investors, including those with retirement accounts such as IRAs
and 401(k) plans.

Typical participants in a stock market include (both retail and institutional) investors and traders, as well
as market makers (MMs) and specialists who maintain liquidity and provide two-sided markets. Brokers
are third parties that facilitate trades between buyers and sellers but who do not take an actual position
in a stock.

Over-the-Counter Markets

An over-the-counter (OTC) market is a decentralized market—meaning it does not have physical

locations, and trading is conducted electronically—in which market participants trade securities directly
between two parties without a broker. While OTC markets may handle trading in certain stocks (e.g.,
smaller or riskier companies that do not meet the listing criteria of exchanges), most stock trading is
done via exchanges. Certain derivatives markets, however, are exclusively OTC, and so make up an
important segment of the financial markets. Broadly speaking, OTC markets and the transactions that
occur on them are far less regulated, less liquid, and more opaque.

Bond Markets

A bond is a security in which an investor loans money for a defined period at a pre-established interest
rate. You may think of a bond as an agreement between the lender and borrower that contains the
details of the loan and its payments. Bonds are issued by corporations as well as by municipalities,
states, and sovereign governments to finance projects and operations. The bond market sells securities
such as notes and bills issued by the United States Treasury, for example. The bond market also is called
the debt, credit, or fixed-income market.

Money Markets

Typically the money markets trade in products with highly liquid short-term maturities (of less than one
year) and are characterized by a high degree of safety and a relatively low return in interest. At the
wholesale level, the money markets involve large-volume trades between institutions and traders. At
the retail level, they include money market mutual funds bought by individual investors and money
market accounts opened by bank customers. Individuals may also invest in the money markets by
buying short-term certificates of deposit (CDs), municipal notes, or U.S. Treasury bills, among other
examples.

Derivatives Markets

A derivative is a contract between two or more parties whose value is based on an agreed-upon
underlying financial asset (like a security) or set of assets (like an index). Derivatives are secondary
securities whose value is solely derived from the value of the primary security that they are linked to. In
and of itself a derivative is worthless. Rather than trading stocks directly, a derivatives market trades in
futures and options contracts, and other advanced financial products, that derive their value from
underlying instruments like bonds, commodities, currencies, interest rates, market indexes, and stocks.
Futures markets are where futures contracts are listed and traded. Unlike forwards, which trade OTC,
futures markets utilize standardized contract specifications, are well-regulated, and utilize
clearinghouses to settle and confirm trades. Options markets, such as the Chicago Board Options
Exchange (CBOE), similarly list and regulate options contracts. Both futures and options exchanges may
list contracts on various asset classes, such as equities, fixed-income securities, commodities, and so on.

Forex Market

The forex (foreign exchange) market is the market in which participants can buy, sell, hedge, and
speculate on the exchange rates between currency pairs. The forex market is the most liquid market in
the world, as cash is the most liquid of assets. The currency market handles more than $5 trillion in daily
transactions, which is more than the futures and equity markets combined. As with the OTC markets,
the forex market is also decentralized and consists of a global network of computers and brokers from
around the world. The forex market is made up of banks, commercial companies, central banks,
investment management firms, hedge funds, and retail forex brokers and investors.

Commodities Markets

Commodities markets are venues where producers and consumers meet to exchange physical
commodities such as agricultural products (e.g., corn, livestock, soybeans), energy products (oil, gas,
carbon credits), precious metals (gold, silver, platinum), or "soft" commodities (such as cotton, coffee,
and sugar). These are known as spot commodity markets, where physical goods are exchanged for
money.

The bulk of trading in these commodities, however, takes place on derivatives markets that utilize spot
commodities as the underlying assets. Forwards, futures, and options on commodities are exchanged
both OTC and on listed exchanges around the world such as the Chicago Mercantile Exchange (CME) and
the Intercontinental Exchange (ICE).

Cryptocurrency Markets

The past several years have seen the introduction and rise of cryptocurrencies such as Bitcoin and
Ethereum, decentralized digital assets that are based on blockchain technology. Today, hundreds of
cryptocurrency tokens are available and trade globally across a patchwork of independent online crypto
exchanges. These exchanges host digital wallets for traders to swap one cryptocurrency for another, or
for fiat monies such as dollars or euros.

Because the majority of crypto exchanges are centralized platforms, users are susceptible to hacks or
fraud. Decentralized exchanges are also available that operate without any central authority. These
exchanges allow direct peer-to-peer (P2P) trading of digital currencies without the need for an actual
exchange authority to facilitate the transactions. Futures and options trading are also available on major
cryptocurrencies.

Examples of Financial Markets

The above sections make clear that the "financial markets" are broad in scope and scale. To give two
more concrete examples, we will consider the role of stock markets in bringing a company to IPO, and
the role of the OTC derivatives market in the 2008-09 financial crisis.

Stock Markets and IPOs

When a company establishes itself, it will need access to capital from investors. As the company grows it
often finds itself in need of access to much larger amounts of capital than it can get from ongoing
operations or a traditional bank loan. Firms can raise this size of capital by selling shares to the public
through an initial public offering (IPO). This changes the status of the company from a "private" firm
whose shares are held by a few shareholders to a publicly-traded company whose shares will be
subsequently held by numerous members of the general public.

The IPO also offers early investors in the company an opportunity to cash out part of their stake, often
reaping very handsome rewards in the process. Initially, the price of the IPO is usually set by the
underwriters through their pre-marketing process.

Once the company's shares are listed on a stock exchange and trading in it commences, the price of
these shares will fluctuate as investors and traders assess and reassess their intrinsic value and the
supply and demand for those shares at any moment in time.

OTC Derivatives and the 2008 Financial Crisis: MBS and CDOs

While the 2008-09 financial crisis was caused and made worse by several factors, one factor that has
been widely identified is the market for mortgage-backed securities (MBS). These are a type of OTC
derivatives where cash flows from individual mortgages are bundled, sliced up, and sold to investors.
The crisis was the result of a sequence of events, each with its own trigger and culminating in the near-
collapse of the banking system. It has been argued that the seeds of the crisis were sown as far back as
the 1970s with the Community Development Act, which required banks to loosen their credit
requirements for lower-income consumers, creating a market for subprime mortgages.

The amount of subprime mortgage debt, which was guaranteed by Freddie Mac and Fannie Mae,
continued to expand into the early 2000s, when the Federal Reserve Board began to cut interest rates
drastically to avoid a recession. The combination of loose credit requirements and cheap money spurred
a housing boom, which drove speculation, pushing up housing prices and creating a real estate bubble.
In the meantime, the investment banks, looking for easy profits in the wake of the dotcom bust and the
2001 recession, created a type of MBS called collateralized debt obligations (CDOs) from the mortgages
purchased on the secondary market.

Because subprime mortgages were bundled with prime mortgages, there was no way for investors to
understand the risks associated with the product. When the market for CDOs began to heat up, the
housing bubble that had been building for several years had finally burst. As housing prices fell,
subprime borrowers began to default on loans that were worth more than their homes, accelerating the
decline in prices.

When investors realized the MBS and CDOs were worthless due to the toxic debt they represented, they
attempted to unload the obligations. However, there was no market for the CDOs. The subsequent
cascade of subprime lender failures created liquidity contagion that reached the upper tiers of the
banking system. Two major investment banks, Lehman Brothers and Bear Stearns, collapsed under the
weight of their exposure to subprime debt, and more than 450 banks failed over the next five years.
Several of the major banks were on the brink of failure and were rescued by a taxpayer-funded bailout.

Financial Markets FAQs

What Are the Different Types of Financial Markets?

Some examples of financial markets and their roles include the stock market, the bond market, forex,
commodities, and the real estate market, among several others. Financial markets can also be broken
down into capital markets, money markets, primary vs. secondary markets, and listed vs. OTC markets.

How Do Financial Markets Work?

Despite covering many different asset classes and having various structures and regulations, all financial
markets work essentially by bringing together buyers and sellers in some asset or contract and allowing
them to trade with one another. This is often done through an auction or price-discovery mechanism.

What Are the Main Functions of Financial Markets?

Financial markets exist for several reasons, but the most fundamental function is to allow for the
efficient allocation of capital and assets in a financial economy. By allowing a free market for the flow of
capital, financial obligations, and money the financial markets make the global economy run more
smoothly while also allowing investors to participate in capital gains over time.

Why Are Financial Markets Important?

Without financial markets, capital could not be allocated efficiently, and economic activity such as
commerce & trade, investment, and growth opportunities would be greatly diminished.

Who Are the Main Participants in Financial Markets?

Firms use stock and bond markets to raise capital from investors; speculators look to various asset
classes to make directional bets on future prices; hedgers use derivatives markets to mitigate various
risks, and arbitrageurs seek to take advantage of mispricings or anomalies observed across various
markets. Brokers often act as mediators that bring buyers and sellers together, earning a commission or
fee for their services.

Money markets

 Market for short term loan finance for businesses and households
 Money is borrowed and lent normally for up to 12 months
 Includes inter-bank lending i.e. the commercial banks providing liquidity for each other
 Includes short term government borrowing e.g. 3-12 month Treasury Bills – to help fund the
government’s budget (fiscal) deficit

Capital markets

 Market for medium-longer term loan finance

  Capital markets are the markets where securities such as shares and bonds are issued to raise
medium to long-term financing
 Includes raising of finance by the government through the issue/sale of medium term - long
term government bonds for example 10 year and 20 year bonds (loans)

Currency markets

 A market where currencies (foreign exchange) are traded. There is no single currency market – it
is made up of the thousands of trading floors
 Gains or losses are made from the movement of exchange rates – speculative activity in the
currency market is often high
 The spot exchange rate is the price of a currency to be delivered now, rather than in the future.
 The forward exchange rate is a fixed price given for buying a currency today to be delivered in
the future

BANKING BACKGROUND
History of Banking

 Bank is a term that has become an integral part of our lives from saving money, booking online
tickets, taking a loan to any of the money related operations.
 Banks have become the bridge that connect us with money but how did they come into
existence all of a sudden.

First banking system was started in Italy.

 In the Middle Ages Italians used to carry out their commercial trading and transactions sitting on
a bench.
 In Italian the word “Banco” refers to a bench with the intervention of many clients and
customers the word Banco underwear changes and became Bank.
 Banking system was stated right in the Paleolithic Age with the advent of barter system, people
exchanged and traded goods they already had for things they needed.
 Common commercial tool for trading.
 Gold coins are commonly used in everyone as a trading tool which led to the birth of banks.
 Inception of Banks was mainly due to two kinds of people the Merchants and the Goldsmiths.
 Traditional banking system was initiated through the concept of safe deposists.
 Bank of Saint George is the world’s first bank in Italy in 1407.

THE HISTORY OF BANKS

For as long as civilization has existed, banking has existed. In fact, even before civilization existed, there
were ‘bank-like’ systems. It is nigh on impossible to cover the complete history of banks in such a short
piece, but we are going to give you a decent overview of how the banks came to be.

EARLIEST BANKING SYSTEMS

It is impossible to say exactly when banking properly began. We do, however, have evidence that it may
have started to properly occur around 8000 BC, although these were not banking in the way that we see
things now. It was more record keeping of trades that were being made. There may have been specific
institutions developed specifically for banking, but we can’t possibly know for sure. All we have records
of are people making trades and record their trades down in a log.

THE EARLIEST ‘PROPER’ BANKS

The first proper banks would have sprung up in ancient Mesopotamia. We have evidence that there
were temples and palaces throughout Babylonia and other cities which provided lending activities.
Although, a lot of this was not in the form of financial lending. Instead, banks would lend out seeds and
the like. The idea is that by lending out seeds, farmers would have products that they could work with.
When it came to the harvest, the farmers would pay back their seed loan from the harvest.

There are also records of credit from around this time. In fact, we have a history of credit and other
banking activities throughout Asian civilization. The Temple of Artemis, for example, was a deposit for
cash and there were records of debts held here. Mark Anthony plays a major role in these banks. He is
said to have stolen cash from these banks.

BANKS DURING THE MEDIEVAL PERIOD

Banks really started to come into their own during the medieval period. Most of these banks were
merchant banks, however. Again, this was a lot about crop loan and for financing expeditions across the
silk routes. Some of the earliest forms of brokering took place in these banks.

It is actually from around this time that bankruptcy started to spring up. The earliest banks were in Italy.
Bankrupt comes from the word ‘banca rotta’ in Italian. When a trade failed to deliver on their promised
route, then they would have been declared ‘banca rotta’.

MODERN BANKING IN THE 17TH TO 19TH CENTURIES

Perhaps the biggest changes to the world of banking came in the 17th to 19th centuries, particularly in
London. In fact, the way in which banks work will be based completely around these banking concepts,
i.e. issuing bank debt, allowing deposits to be made into banks etc.

The first ‘proper’ bank could be said to be the Goldsmiths of London. It is now a bank, but back then it
was more a series of vaults which charged a fee for their services. People would deposit their precious
materials into these vaults, and they would be able to collect them. Over time, Goldsmiths started to
provide loans.

The first bank to offer banknotes was the Bank of England. Bank notes were, initially, promissory notes.
You would deposit cash into the bank and be offered a note to say that it was there. Over time, the bank
started to offer cheques, overdrafts, and traditional banking services. This was important when the
Industrial Revolution in the United Kingdom was starting to get into ‘full swing’.

ROTHSCHILDS

International financing in the 19th Century took hold due to the Rothschilds. They got started by loaning
money to the Bank of England and purchasing stocks. Over time, the Rothchild family (still the richest
family in history), started to invest in multiple projects around the world and financing military efforts.
They were also taking in deposits from people and creating new banks.

20TH CENTURY

It was in the 20th Century when banks started to pop up in the way we know them properly. Post-World
War II, banks started to lend money to countries as a whole, and retail banking started to become a
proper ‘thing’. In fact, a lot of the technology that was developed throughout the 20th Century is still in
use today, e.g. the ATM systems and SWIFT payments.

The Evolution of Banking Over Time

What Is the History of Banking?

Banking has been around since the first currencies were minted—perhaps even before that, in some
form or another. Currency, in particular coins, grew out of taxation. As empires expanded, functional
systems were needed to collect taxes and distribute wealth.

KEY TAKEAWAYS

Banking institutions were created to provide loans to the public. As economies grew, banks allowed
members of the general public to increase their credit and make larger purchases.

Historically, temples were considered the earliest forms of banks as they were occupied by priests and
became a haven for the wealthy.

The earliest Roman laws allowed for the taking over of land in lieu of loan payments that were owed
between debtors and creditors.

A well-known economist, Adam Smith, theorized during the 18th century that a self-regulated economy,
known as "the invisible hand," would allow for markets to reach equilibrium.

The panic of 1907 was a trigger of two brokerage firms that had become bankrupt causing a recession
when liquidity was was restricted. This led to the creation of the Federal Reserve Bank.

PERSONAL FINANCE BANKING

The Evolution of Banking Over Time

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By ANDREW BEATTIE Reviewed by KHADIJA KHARTIT Updated May 29, 2021

TABLE OF CONTENTS

EXPAND

What Is the History of Banking?

Understanding Banking History

The First Bank

Visa Royal

Adam Smith and Modern Banking

Merchant Banks

J.P. Morgan and Monopoly

The Panic of 1907

The End of an Era

World War II Stimulates Recovery

The Benefits of Banking

What Is the History of Banking?

Banking has been around since the first currencies were minted—perhaps even before that, in some
form or another. Currency, in particular coins, grew out of taxation. As empires expanded, functional
systems were needed to collect taxes and distribute wealth.

KEY TAKEAWAYS

Banking institutions were created to provide loans to the public. As economies grew, banks allowed
members of the general public to increase their credit and make larger purchases.

Historically, temples were considered the earliest forms of banks as they were occupied by priests and
became a haven for the wealthy.

The earliest Roman laws allowed for the taking over of land in lieu of loan payments that were owed
between debtors and creditors.

A well-known economist, Adam Smith, theorized during the 18th century that a self-regulated economy,
known as "the invisible hand," would allow for markets to reach equilibrium.1

The panic of 1907 was a trigger of two brokerage firms that had become bankrupt causing a recession
when liquidity was was restricted. This led to the creation of the Federal Reserve Bank.2

Understanding Banking History

The history of banking began when empires needed a way to pay for foreign goods and services with
something that could be exchanged easily. Coins of varying sizes and metals eventually replaced fragile,
impermanent paper bills.

Coins, however, needed to be kept in a safe place, and ancient homes did not have steel safes.
According to World History Encyclopedia, wealthy people in ancient Rome kept their coins and jewels in
the basements of temples. The presence of priests or temple workers, who were assumed devout and
honest, and armed guards added a sense of security.

Historical records from Greece, Rome, Egypt, and Ancient Babylon have suggested that temples loaned
money out in addition to keeping it safe. The fact that most temples also functioned as the financial
centers of their cities is a major reason why they were ransacked during wars.

Coins could be hoarded more easily than other commodities, such as 300-pound pigs for example, so a
class of wealthy merchants took to lending coins, with interest, to people in need. Temples typically
handled large loans and loans to various sovereigns, and wealthy merchant money lenders handled the
rest.

The First Bank

The Romans, who were expert builders and administrators, extricated banking from the temples and
formalized it within distinct buildings. During this time, moneylenders still profited, as loan sharks do
today, but most legitimate commerce—and almost all government spending—involved the use of an
institutional bank.

According to World History Encyclopedia, Julius Caesar, in one of the edicts changing Roman law after
his takeover, gives the first example of allowing bankers to confiscate land in lieu of loan payments. This
was a monumental shift of power in the relationship of creditor and debtor, as landed noblemen were
untouchable through most of history, passing debts off to descendants until either the creditor or
debtor's lineage died out.

The Roman Empire eventually crumbled, but some of its banking institutions lived on in the form of the
papal bankers that emerged in the Holy Roman Empire and the Knights Templar during the Crusades.
Small-time moneylenders that competed with the church were often denounced for usury.

Visa Royal

Eventually, the various monarchs that reigned over Europe noted the strengths of banking institutions.
As banks existed by the grace, and occasionally explicit charters and contracts, of the ruling sovereignty,
the royal powers began to take loans to make up for hard times at the royal treasury, often on the king's
terms. This easy financing led kings into unnecessary extravagances, costly wars, and arms races with
neighboring kingdoms that would often lead to crushing debt.

In 1557, Philip II of Spain managed to burden his kingdom with so much debt (as the result of several
pointless wars) that he caused the world's first national bankruptcy—as well as the world's second,
third, and fourth, in rapid succession. This occurred because 40% of the country's gross national product
(GNP) was going toward servicing the debt. The trend of turning a blind eye to the creditworthiness of
big customers continues to haunt banks today.

Adam Smith and Modern Banking

Banking was already well-established in the British Empire when Adam Smith introduced the "invisible
hand" theory in 1776. Empowered by his views of a self-regulated economy, moneylenders and bankers
managed to limit the state's involvement in the banking sector and the economy as a whole.1 This free-
market capitalism and competitive banking found fertile ground in the New World, where the United
States of America was about to emerge.

Initially, Smith's ideas did not benefit the American banking industry. The average life for an American
bank was five years, after which most banknotes from the defaulted banks became worthless. These
state-chartered banks could, after all, only issue banknotes against the gold and silver coins they had in
reserve.

A bank robbery meant a lot more then than it does now in the age of deposit insurance and the Federal
Deposit Insurance Corporation (FDIC). Compounding these risks was the cyclical cash crunch in America.

Alexander Hamilton, a former Secretary of the Treasury, established a national bank that would accept
member banknotes at par, thus floating banks through difficult times. After a few stops, starts,
cancellations, and resurrections, this national bank created a uniform national currency and set up a
system by which national banks backed their notes by purchasing Treasury securities, thus creating a
liquid market. The national banks pushed out the competition through the imposition of taxes on the
relatively lawless state banks.

The damage had been done already, however, as average Americans had already grown to distrust
banks and bankers in general. This feeling would lead Texas's state to outlaw corporate banks—a law
that stood until 1904.

Merchant Banks

Most of the economic duties that would have been handled by the national banking system, in addition
to regular banking business like loans and corporate finance, fell into the hands of large merchant banks
because the national banking system was sporadic. During this unrest that lasted until the 1920s, these
merchant banks parlayed their international connections into political and financial power.

These banks included Goldman Sachs, Kuhn, Loeb & Co., and J.P. Morgan & Co. Originally, they relied
heavily on commissions from foreign bond sales from Europe, with a small back-flow of American bonds
trading in Europe. This allowed them to build capital.

At that time, a bank was under no legal obligation to disclose its capital reserves, an indication of its
ability to survive large, above-average loan losses. This mysterious practice meant that a bank's
reputation and history mattered more than anything. While upstart banks came and went, these family-
held merchant banks had long histories of successful transactions. As large industries emerged and
created the need for corporate finance, the amounts of capital required could not be provided by any
single bank, and so initial public offerings (IPOs) and bond offerings to the public became the only way to
raise the required capital.

The public in the United States, and foreign investors in Europe, knew very little about investing because
disclosure was not legally enforced. For this reason, these issues were largely ignored, according to the
public's perception of the underwriting banks. Consequently, successful offerings increased a bank's
reputation and put it in a position to ask for more to underwrite an offer. By the late 1800s, many banks
demanded a position on the boards of the companies seeking capital, and if the management proved
lacking, they ran the companies themselves.
J.P. Morgan and Monopoly

J.P. Morgan & Co. emerged at the head of the merchant banks during the late 1800s. It was connected
directly to London, then the world's financial center, and had considerable political clout in the United
States. Morgan and Co. created U.S. Steel, AT&T, and International Harvester, as well as duopolies and
near-monopolies in the railroad and shipping industries, through the revolutionary use of trusts and a
disdain for the Sherman Antitrust Act.

Although the dawn of the 1900s saw well-established merchant banks, it was difficult for the average
American to obtain loans. These banks didn't advertise, and they rarely extended credit to the
"common" people. Racism was also widespread, and although bankers had to work together on large
issues, their customers were split along clear class and race lines. These banks left consumer loans to the
lesser banks that were still failing at an alarming rate.

The Panic of 1907

The collapse in shares of a copper trust set off a panic, a run on banks, and stock sell-offs, which caused
shares to plummet. Without the Federal Reserve Bank to take action to calm people down, the task fell
to J.P. Morgan to stop the panic. Morgan used his considerable clout to gather all the major players on
Wall Street to maneuver the credit and capital they controlled, just as the Fed would do today.2

The End of an Era

Ironically, this show of supreme power in saving the U.S. economy ensured that no private banker would
ever again wield that power. Because it had taken J.P. Morgan, a banker who was disliked by much of
America for being one of the robber barons along with Carnegie and Rockefeller, to save the economy,
the government formed the Federal Reserve Bank (the Fed) in 1913. Although the merchant banks
influenced the structure of the Fed, they were also pushed into the background by its formation.

Even with the establishment of the Fed, financial power and residual political power were concentrated
on Wall Street. When World War I broke out, America became a global lender and replaced London as
the center of the financial world by the end of the war. Unfortunately, a Republican administration put
some unconventional handcuffs on the banking sector. The government insisted that all debtor nations
must pay back their war loans, which traditionally were forgiven, especially in the case of allies, before
any American institution would extend them further credit.

This slowed down world trade and caused many countries to become hostile toward American goods.
When the stock market crashed on Black Tuesday in 1929, the already sluggish world economy was
knocked out. The Fed couldn't contain the crash and refused to stop the depression; the aftermath had
immediate consequences for all banks.

A clear line was drawn between banks and investors. In 1933, banks were no longer allowed to
speculate with deposits, and Federal Deposit Insurance Corporation (FDIC) regulations were enacted to
convince the public it was safe to come back. No one was fooled and the depression continued.

World War II Stimulates Recovery

World War II may have saved the banking industry from complete destruction. WWII and the
industriousness it generated stopped the downward spiral afflicting the United States and world
economies.

For the banks and the Fed, the war required financial maneuvers using billions of dollars. This massive
financing operation created companies with huge credit needs that, in turn, spurred banks into mergers
to meet the demand. These huge banks spanned global markets.

More importantly, domestic banking in the United States had finally settled to the point where with the
advent of deposit insurance and mortgages, an individual would have reasonable access to credit.

The Benefits of Banking

With the exception of the extremely wealthy, few people buy their homes in all-cash transactions. Most
of us need a mortgage, or some form of credit, to make such a large purchase.

Banks have come a long way from the temples of the ancient world, but their basic business practices
have not changed. Banks issue credit or loans to people who need them, but they demand interest on
top of the repayment of the loan. Although history has altered the finer points of the business model, a
bank's purpose is to make loans and protect depositors' money. Even today, where digital banking and
financing are replacing traditional brick and mortar locations, banks still exist to perform this primary
function.

Name of Banking Type Firm Definition or Description

Commercial Banks
Money Center Banks Largest commercial banks based in leading
financial centers.
Community Banks Smaller, locally-focused commercial and savings
banks.
Savings Banks Attract savings deposits and make loans to
individuals and families.
Cooperative Banks Help farmers. ranchers and consumers acquire
goods and services.
Mortgage Banks Provide mortgage loans on new homes but do
not sell deposits.
Investment Banks Underwrite issues of new securities from their
corporate customers.
Merchant Banks Supply both debt and equity capital to
businesses.
International Banks Commercial banks present in more than one
nation.
Industrial banks State-chartered loan companies owned by
financial or non-financial corporations.
Wholesale Banks Larger commercial banks serving corporations
and governments.
Retail Banks Smaller banks serving primarily households and
small businesses.
Limited Purpose Banks Offer a narrow menu of services, such as credit
 card companies and subprime lenders.

Bankers’ Banks Supply services (e.g. check clearing and security

trading) to banks.
Minority Banks Focus primarily on customers belonging to
minority groups.
National Banks Function under a federal charter through the
Comptroller of the Currency of the nation.
State Banks Function under charters issued by banking
commissions in various states.
Insured Banks Maintains deposits backed by federal deposit
insurance plans (e.g. the FDIC)
Member Banks Belong to the Federal Reserve System or BSP.
Affiliated Banks Wholly or partially owned by a holding company
Virtual Banks Offer their services only over the internet.
Fringe Banks Offer payday and title loans, cash checks or
operate as pawnshops and rent-to-own firms.
Universal Banks Offer virtually all financial services available in
today's marketplace.