11.3. The Development of Banking

Since demand deposits and other checkable deposits make up such a large portion of the money supply, you can probably understand why banks and other similar businesses are so important in our economy.

The development of our banking system began in the Middle Ages. The major forms of money in those days, gold and silver coins, were inconvenient to carry and liable to be stolen. To make business transactions safer and more convenient, people began depositing their coins with local goldsmiths, who gave them a written receipt in exchange for the coins. In this way, the goldsmith provided services similar to those banks offer today.

Merchants accepted the receipts in payment for goods because they could redeem them for gold at a goldsmith's shop. In time, goldsmiths' receipts became very popular with merchants and travelers who had to move large sums of money. As their use spread, the earliest form of paper money in Western Europe came into being.

Originally, a goldsmith's receipts were fully backed by gold. That is, they represented a specific amount of gold in storage. In time, however, goldsmiths noticed that on most days the gold that people with­drew was less than the amount deposited. This allowed them to lend some of their depositors' gold to other people for a fee—interest. In many instances, the borrowers, too, were content simply to take paper receipts rather than the actual metal. In a sense, the goldsmiths were creating money. This was the beginning of modern banking.

11.4. Banking Today

In the Middle Ages merchants had to depend on the honesty of a goldsmith or money lender. Today, to ensure the safety of deposits, state and federal gov­ernments highly regulate the banking industry. Federal law defines a bank as a "financial institu­tion that accepts demand deposits and makes com­mercial loans." For that reason, savings and loan associations, mutual savings banks, and credit unions are commonly called thrift institutions or "thrifts." The term "bank" technically refers to a commercial bank.

The general public is rarely that precise. Most peo­ple today say "bank" when they are speaking of any financial institution that provides the following ser­vices.

Accepting and Holding Deposits. People deposit their savings in banks and thrifts because they know their money will be returned when they want it. In addition to the physical protection against fire and theft, banks and thrifts also offer deposit insur­ance. Deposit insurance guarantees all savings accounts up to a principal value of $100,000. Deposits in banks and thrifts can be in the form of savings accounts or checking accounts.

Making Loans. A main function of banks and thrifts is to act as "financial middlemen." They do this by channeling money from depositors—those wishing to save money for future use—to borrowers, those wanting to spend it now. Banks and thrifts do this by making loans to businesses and consumers.

This is a vital financial service that also earns money. Interest from loans is one of their principal sources of income. Business loans enable firms to meet current bills and finance expansion. Consumer loans enable individuals and families to enjoy goods and services immediately, while paying for them with future earnings.

Collecting and Transferring Funds. Managing checking accounts for their customers is a major responsibility for most banks and a great conve­nience for businesses and individuals alike.