Tabl. 6. Goldsmiths as bankers

The first row shows what the goldsmith did before he made this loan. He had a hundred dollars of gold, which he owed to the people who had deposited it with him, so his assets and liabilities were the same. But when he lent, say, $10 of gold to the firm, he actually had only $90 of gold in his vault plus the value of his loan. His assets still equalled his liabilities, but he was going to get some interest.

It so happened that the firm, that took out the loan, didn't really want to carry that $10 of gold around, so it asked the goldsmith if, instead of actually taking the gold, it could be given a deposit. The third row of Tabl. 6 shows what happened then. Although the goldsmith's assets and liabilities were the same, but were then worth $110, not $100. When the firm wrote a cheque for $10, and that person came in to collect his $10 worth of gold, the goldsmith's assets failed, but so did his liabilities (the fourth row of the table). The important point to notice here is that it made no difference to the goldsmith whether his initial loan was in actual gold or in a form of a deposit.

Now let's turn to the question of reserves. Reserves are the amount of gold that is immediately available in the vault to meet depositors' demands. People originally deposited $100 of gold with the goldsmith. The goldsmith lent $10, leaving himself with $90. As a banker he was relying on the fact that not everyone would want their gold back at the same time. If they had done, he couldn't have paid out. His reserves of $90 were not enough.

The goldsmith in the table has a 100% reserve ratio. The reserve ratio is the ratio of reserves to deposits. Once he has made his loan, he has a 90% deposit ratio. This is a small risk with a small profit. How much dare he lend out in order to make a profit through his interest charges? What are the risks involved^ Suppose the goldsmith took too much of a risk. He lent 80% of the gold he had. This panicked people. They doubted he could pay them all back, he was bound to lose some of the gold he had lent, so they rushed to get their gold back before it was too late. That was what we would now call a run on the bank, a financial panic. And the financial panic leads to exactly what people fear. the bank cannot pay them, goes bankrupt, and they go bankrupt as well.

MODERN BANKING

The goldsmith bankers were an early example of a financial intermediary.

A financial intermediary is an institution that specializes in bringing lenders and borrowers together.

A commercial bank borrows money from the public, crediting them with a deposit. The deposit is a liability of the bank. It is money owed to depositors. In turn the bank lends money to firms, households or governments wishing to borrow.

Banks are not the only financial intennediaries. Insurance companies, pension funds, and building societies also take in money in order to relend it. The crucial feature of banks is that some of their liabilities are used as a means of payment, and are therefore part of the money stock.

Commercial banks are financial intermediaries with a government licence to make loans and issue deposits, including deposits against, which cheques can be written.

Let's start by looking at the present-day UK banking system. Although the details vary from country to country, the general principle is much the same everywhere.

In the UK, the commercial banking system comprises about 600 registered banks, the National Girobank operating through post offices, and a dozen trustee saving banks. Much the most important single group is the London clearing banks. The clearing banks are so named because they have a central clearing house for handling payments by cheque.

A clearing system is a set of arrangements in which debts between banks are settled by adding up all the transactions in a given period and paying only the net amounts needed to balance inter-bank accounts.

Suppose you bank with Barclays but visit a supermarket that banks with Lloyds. To pay for your shopping you write a cheque against your deposit at Barclays. The supermarket pays this cheque into its account at Lloyds. In turn, Lloyds presents the cheque to Barclays, which will credit Lloyds' account at Barclays and debit your account at Barclays by an equivalent amount. Because you purchased goods from a supermarket using a different bank, a transfer of funds between the two banks is required. Crediting or debiting one bank's account at another bank is the simplest way to achieve this.

However on the same day someone else is probably writing a cheque on a Lloyds' deposit account to pay for some stereo equipment from a shop banking with Barclays. The stereo shop pays the cheque into its Barclays' account, increasing its deposit. Barclays then pays the cheque into its account at Lloyds where this person's account is simultaneously debited. Now the transfer flows from Lloyds to Barclays.

Although in both cases the cheque writer's account is debited and the cheque recipient's account is credited, it does not make sense for the two banks to make two separate inter-bank transactions between themselves. The clearing system calculates the net flows between the member clearing banks and these are the settlements that they make between themselves. Thus the system of clearing cheques represents another way society reduces the costs of making transactions.