Money and banking

Money and banking “No matter what you are talking about – conversation is always about money”. This statement is obvious nowadays and it was the same situation long-long ago. Money is a measure of all values, the means of payment, the medium of exchange, no matter what form it is. It is called an essential tool of civilization. In the past most societies used different objects as money.

Some of these were valuable because they were rare and beautiful, others – because they could be eaten or used. But although everyday objects were extremely practical kinds of cash in many ways, they had some disadvantages, too. For example, it was difficult to measure their value accurately, divide some of them into a wide range of amounts, keep some of them for a long time, use them to make financial plans for a future. Another kind of economy, close to this one in terms of inconvenience is barter economy.

It has no medium of exchange at all. Goods are traded directly or swapped for other goods. In a barter economy the seller and the buyer each must want something the other has to offer. In other words there has to be a double coincidence of wants. We can make rather strong assumption that trading is very expensive under such economy. People must spend a lot of time and effort finding others with whom they can make mutually satisfactory

swaps. So there is no surprise that money (and commodities generally accepted in payment for goods) became more popular making the trading process simpler and more efficient. Nowadays money as a medium of exchange is used in one-half of almost all exchanges. Workers exchange labour services for salary and wages, people buy and sell goods in exchange for money. We accept money not to consume it directly but because it can subsequently be used to buy things we

do consume. In addition to the function of the medium of exchange money has some more functions. Money can also serve as a standard of value. Society considers it convenient to use a monetary unit to determine relative costs of different goods and services. In this function money appears as the unit of account (единица учета) - the unit in which prices are quoted and accounts are kept. In Russia prices are quoted in rubles; in

Britain in pounds sterling; in the USA in US dollars. Usually it is convenient to use the units in which the medium of exchange is used as the unit of account as well. However there might be exceptions. During inflation of the local currency prices may be quoted in hard currencies. Money is a store of value because it can be used to make purchases in the future. Nobody would accept money as payment for goods supplied today if the money was going to be worthless

when they tried to buy goods with it tomorrow. But money is neither the only nor necessarily the best store of value. Houses, stamp collections and interest-bearing bank accounts all serve as store of value. Since money pays no interest and its real purchasing power is eroded by inflation, there are almost certainly better ways to store value. Finally we can speak about one more function of money – as a standard of deferred payment or a unit of account over time.

When you borrow, the amount to be repaid next year is measured in some hard currencies not to lose value due to inflation. Another aspect concerned money I’d like to cover is about different kinds of money. What can we use as a medium of exchange? In prisoner-of-war camps, cigarettes served as money. In the19th century money was mainly gold and silver coins.

These are examples of commodity money, ordinary goods with industrial uses (like gold) and consumption uses (cigarettes), which also serve as a medium of exchange. A token money is a means of payment whose value or purchasing power as money greatly exceeds its cost of production or value in uses other than as money. A 10$ note is worth far more as money than as a small piece of high-quality paper.

By collectively agreeing to use token money society economizes on the scarce resources required to produce money. But there is one essential condition for the survival of token money – private production of it is illegal. In modern economies token money is supplemented by IOU money. An IOU money is a medium of exchange based on the debt of a private firm or individuals. A bank deposit is IOU money because it is a debt of the bank.

You can write a cheque to yourself or a third party and the bank is obliged to pay whenever the cheque is presented. Bank deposits are a medium of exchange because they generally accepted as payment. As I’ve already told you, bank’s accounts can act as a type of money. Now for people it’s a usual thing to transfer money with the help of banks from one city to another or even from country to country, we keep money in banks and take it periodically using cash dispensers.

But it wasn’t the same picture throughout the history and the story of the development of banks is long, but interesting. In the times when people used gold, gold bullion as money they wanted a safe place to keep it. So they deposited it with goldsmiths, people who worked with gold for jewellery and had a guarded vault to keep it safe. And when people wanted some of their gold to pay for things with, they went and fetched it from the goldsmith. But then one day people found it a lot easier to give

the seller a letter than it was to fetch some gold and then physically hand it over to him. Nowadays we would call this letter a cheque. Once these letters became acceptable as a way of paying for goods, the system of deposits was started. It was the first development that turned goldsmiths into bankers. And there was the second one – these goldsmiths realized they had a great deal of unused gold lying in their vaults doing nothing. Thus the first bank loan took place.

Of course it wasn’t goldsmith’s gold, but he reckoned it was unlikely that everyone who had deposited gold with him would want it back at the same time, so he could get profit by lending money with a little interest to be paid back. These goldsmith bankers were an early example of a financial intermediary – an institution that specializes in bringing lenders and borrowers together. Modern banking system has similar main principles of organization of its activity, of course much more

developed. In the recent years we can observe different types of bank. First of all – central banks. There are a few functions of a central bank. First of all, it implements monetary policy by setting interest rate ceiling and floors, I mean limiting the fluctuations of the interest rate; by printing or destroying money, by buying and selling government bonds to and from commercial banks.

The second task of a central bank is exchange rate supervision always to be sure that there are enough reserves to counteract any upswing or downswing of this exchange rate. It also supervises commercial banking in terms of their liquidity, and acts as a lender of last resort in case one of commercial banks goes bankrupt. It is believed that central banks should be independent from the government as it is in Switzerland and Germany.

But in many countries including Britain, France, Russia central banks are influenced by governments in this or that way. Commercial or retail banks are businesses that trade in money. They receive and hold deposits in current and saving accounts, pay money according to customers’ instructions, lend money, and offer investment advice, foreign exchange facilities, and so on. They make a profit from the difference (known as a spread or margin) between the interest rates they

pay to lenders or depositors and those they charge to borrowers. So when lending money, bankers have to find a balance between yield and risk, and between liquidity and different maturities. In some European countries, notably Germany, Austria, Switzerland, there are universal banks which combine deposit and loan banking with share and bond dealing, investment advice, etc. Yet even universal banks form a subsidiary, known as

finance house, to lend money – at several per cent over the base lending rate – for hire purchase or installment credit, that is, loans to consumers, that are repaid in regular, equal monthly amounts. However in Britain, the USA and Japan there is a strict separation between commercial banks and banks that do stockbroking or bond dealing. Thus in Britain merchant banks specialise in raising funds for industry on the various financial markets, financing international trade, issuing and underwriting securities,

dealing with takeovers and mergers, issuing government bonds and so on. They also offer stockbroking and portfolio management services to rich corporate and individual clients. Investment banks in the USA are similar, but they can act only as intermediaries, offering advisory services, and do not offer loans themselves. But frankly speaking, the distinction between commercial and merchant or investment banks has become less clear in recent years.

Deregulation in the US and Britain is leading to the creation of “financial supermarkets” – conglomerates combining the services previously offered by stockbrokers, banks, insurance companies, etc. We can also speak about building societies that provide mortgages, for instance they lend money to home-buyers on the security of houses and flats and attract savers by paying higher interest than the banks. There are also supranational banks such as the

World Bank or the European Bank for Reconstruction and Development, which are generally concerned with economic development. How can a bank can profit? Of course, from the difference between the interest rate charged to borrowers and that paid to depositors also known as a margin or spread. Usually a country’s minimum interest rate is fixed by the central bank.

This is the discount rate at which the central bank makes secured loans to commercial banks. Banks lend to blue-chip borrowers (very safe large companies) at the base rate or the prime rate; all other borrowers pay more, depending on their credit standing (credit rating or creditworthiness): the lender’s estimation of their present and future solvency. Borrowers can get a lower interest rate if the loan is secured by some kind of asset, known as collateral.

These days many loans are made with floating or variable interest rates that change according to the supply and demand for money (sometimes there are arrangements limiting rates. The upper limit is called ceiling, the lower one – floor, and a collar is an arrangement that fixes both the upper and lower limits). What should I stress is that nowadays banking system is not the same it used to be. A lot of innovations, developments take place there and every year we can observe new

banking products. In the UK for example salary is usually paid directly into a low-interest current account. A person can withdraw money from automatic cash dispensers with a cash card. People can pay regular monthly bills by way of a standing order: the bank pays them according to the instructions of the client. Irregular bills are usually paid by cheques. One can have a credit card which is useful for ordering things by post or on the telephone, and for

travelling worldwide. While using credit card your bills usually come every month to be paid. There is very useful to have a deposit account in a building society if you wan to have a flat of your own. It pays higher interest than the current account at the bank, but has restrictions as to how and when you can withdraw your money. One can arrange an overdraft with the bank which means that you can occasionally withdraw more money than is actually in your account.

Interest is calculated daily in that case. Bank can also sell a private pension plan or offer investment advice bout shares, bonds, mutual funds and so on. Speaking about modern banking I should mention a clearing system – it’s 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 amount needed to balance inter-bank accounts.

One more innovation in banking sphere is the electronic funds transfer which transfers money from individuals to the bank, from bank to bank, from city to city through an electronic system. Large banks are installing automatic teller machines outside their buildings for customers to get cash, make loan payment or transfer money at any time of the day or night. Not all of these innovations are wide-spread in Russia but step-by-step we are getting closer to using

credit cards, cheques, etc. In most financial centres there are also branches of lots of foreign banks, largely doing Eurocurrency business. A eurocurrency is any currency held outside its country of origin, such as US$ in France, Yen in the US or Deautschmark in Japan. The name isn’t the bast one as Eurocurrencies do not necessarily have anything to do with Europe. The Euromarket developed during the Cold war in the early 1950s, when the

Russians who were afraid that the Americans might freeze their dollar accounts in New York, transferred them to Europe, particularly to banks in London and Euromarkets are still concentrated in this city as there are fewer governmental regulation there than in most other financial centres, plus the fact that the European time-zone is half-way between those of Japan and the

USA. Although a central bank can determine the minimum lending rate for its national currency it has no control over foreign currencies. Furthermore banks are not obliged to deposit any of the Eurocurrency assets at 0% interest with the central bank, which means that they can usually offer better rates for borrowers and depositors than in the home country. Nowadays the banking industry is becoming less regulated.

This process is stimulating the diversification of banks, and services and price competition. The competition results offering more an better services to the bank customers. Some banks even try to assign each of their major customers to a “personal banker”.