Like any other company, banks are in the business to make money. Banks have essentially evolved from moneylending, which was simply driven by the desire to make profit. This is of course an over-simplification of their activities and history. Moreover, this is only one part of the story. Banking has played a crucial role in society since its birth, and a lot of what has been achieved throughout history is due to the existence of these institutions. They allow individuals to become homeowners by providing them with the necessary funds to afford a house; they facilitate payments by allowing us to make transfer to accounts around the world; they give credit to companies to finance their operations and consequently create jobs. After centuries of financial innovation, the role that banks play in modern society goes far beyond simply “making money”.
Banks play a key role in the economy by acting as financial intermediaries: they collect deposits from savers and lend them to individuals and corporations who are “in need” of funds. As mentioned before, an individual who is looking to buy a house is likely to take out a mortgage from a bank, which in fact will mainly consist of savers’ deposits. Another example would be a small firm which is likely to have a credit line with one or more banks to purchase the required equipment to keep their business running. Banks are essentially helping to allocate “excess funds” to other activities that help drive the economy and create wealth. In other words, they help to bridge the gap between borrowers and lenders.
As I mentioned before, despite their economic importance banks are in the business to make profits and generate value for its owners, like any other company. They do so by benefiting from the difference between the interest rate that they pay to depositors and the interest rate that they charge borrowers, known as the Net Interest Margin. This is the main source of profit for traditional banks. It is important to remember that savers, like any type of lender, must be compensated for postponing current spending. Consequently, borrowers, who are on the other side of the transaction are charged interest.
Moneylending however, is far older than banks, and it can be traced back as far as Ancient Greece. For much of its history is has been condemned as an immoral activity. Those involved with lending money on interest were cast as usurers and were often frowned upon. Nevertheless, with time financial innovation was able to overcome that stigma. By the end of the Medieval Ages, Italian bankers would go around usury laws by disguising loans through complex exchanges of money between currencies. The word bankers stems from the fact that they would carry out their activities while seating at benches in the streets of cities like Florence and Venice. Given the existence of multiple currencies at the time and the growth of trade, there were a lot of opportunities to make profits.
The Italian banking system developed by powerful houses of bankers, such as the Medici, provided a foundation for other European banks, where most financial innovation would occur in the following centuries. For example, the Amsterdam Wisselbank founded in 1609 pioneered a system of money transferring between accounts, which enabled merchants to engage in greater commercial activity since there was no need for exchanging actual coins. Other major breakthroughs were achieved by the Stockholms Banco (1657) with the creation fractional reserve banking, and also with the creation of the Bank of England in 1694. All of these developments contributed significantly to the role that banks play in today’s society.
Ascribing an initial purpose to banks can be misleading due to the significant changes it went through over time. Both deregulation and financial innovation have helped to shape banks’ purpose in today’s world. We must remember that despite their profit motive, they play a crucial role in the economy. At the moment, the wave of finance-focused technology start-ups known as FinTech have been disrupting the banking sector. The future of the industry is uncertain, but we can be confident that, just as in the past, their role within society will evolve.
Actually, there is an interesting idea behind this.
We all know what banks do today and (mostly) appreciate how they have become an essential part of our everyday life. But I believe banks’ initial purpose was to facilitate trade. And this is how it started.
It’s not a secret that when humankind set off “building civilization” they started with agriculture (not solely, of course, but I’m simplifying here). Farmers having a surplus of the goods they produced started to exchange those goods to ones they needed (but didn’t or couldn’t produce). This is what we call trade. (I will omit the barter economy part, which, according to some sources, never happened and go straight to monetary exchange.)
In international trade deals, a man would travel thousands of kilometers, import/export goods and close the deal with payment carrying lots of gold. Since ancient times were not the safest, merchants decided not to carry gold, but give it to a banker (in their early form). Bankers were collecting gold from merchants issuing IOUs. IOUs provided two essential properties to merchants: a. It was easy to carry them comparing to gold; b. It was safer to travel large distances while having means of payment. Thus, bankers become middlemen in international trade deals. This is where the name commercial bank comes from.
Nowadays banks do the same thing via issuing a letter of credit, for example, but I wouldn’t call this their primary role.