How Banks Work

After we posted the video about the SVB situation, a lot of you guys asked us to make a follow-up on how banks actually work. So here it is!

Now, before we get into the video, Alux as a company is safe and healthy. We're bootstrapped, which means we started this from the ground up with no investor money other than our own resources. We've been profitable for years. The app is doing great, which you can check out at alux.com/app. We've got enough cash flow to cover any type of crisis, and the SVB situation was really business as usual. Also, we're not investors in SVB but depositors. Now, if you don't know the difference between those two terms, you'll especially benefit from watching this video.

So here's how banks work. Welcome to Alux!

Let's start off with a brief history and timeline of banking because this wouldn't be a complete video without some historical background, now would it? It's important to understand where everything began. So here's the timeline:

Ancient Banking (2000 BCE to 100 CE)

The history of banking is almost as old as humanity itself. The first recorded evidence of banking activity dates back to ancient Mesopotamia, where merchants provided grain loans to farmers and traders. Temples and palaces in Babylon, Egypt, and Greece served as repositories for valuables and issued loans to citizens. One of the most famous legal codes from ancient Mesopotamia, the Code of Hammurabi, contains several laws related to financial transactions, property rights, and commercial activities. These laws provide insights into sophisticated financial systems and regulations. So yes, our ancestors were not as stupid as we like to believe.

Banking in Rome (100 BCE to about 500 CE)

Roman banks, known as mensai, were involved in currency exchange, deposit-taking, and lending. Individuals known as argentari (bankers or money changers) and fenetores (money lenders) played a significant role in the financial system. This provided various financial services such as money changing, lending, and deposit-taking, and these individuals often set up their businesses in the Forum, the center of commercial and political life in ancient Roman cities.

Medieval Banking (500 CE to about 1400 CE)

After the fall of the Roman Empire, banking activity decreased in Western Europe but continued in the Byzantine Empire and the Islamic world. The Knights Templar, a Christian military order, established an early form of international banking, allowing pilgrims to deposit and withdraw funds across their network of commentaries.

The Rise of Modern Banking (1400 CE to 1700 CE)

The Medici family, an influential banking dynasty in Renaissance Italy, developed the double-entry bookkeeping system. This period saw the establishment of central banks such as the Bank of Amsterdam in 1609, the Swedish Reichs Bank in 1668, and the Bank of England in 1694, which provided stability and regulation to banking systems. The Bank of Amsterdam was the first bank to issue paper money, and it became a model for other central banks that were established in Europe during the 18th and 19th centuries.

The Industrial Revolution (1700 CE to about 1900 CE)

The Industrial Revolution brought about rapid economic growth and increased demand for banking services. Joint stock banks emerged, allowing people to pool resources and invest in new ventures. Central banks began to issue bank notes and manage the money supply.

The 20th Century

During the late 19th and early 20th centuries, the gold standard became the dominant global monetary system. Participating countries pegged their currencies to gold, facilitating international trade and investment. The gold standard provided stability but restricted countries' abilities to manage economic fluctuations, leading to its eventual collapse during the Great Depression. This led to the creation of regulatory bodies and insurance schemes to protect depositors. The latter half of the century saw the rise of multinational banks, the automation of banking services, and the development of credit cards and electronic payment systems.

The 21st Century

The advent of the internet brought about the proliferation of online banking and digital currencies such as Bitcoin. The 2008 global financial crisis prompted renewed regulatory efforts such as the Dodd-Frank Wall Street reform and consumer protection act of 2010 in the United States, aimed at bolstering financial stability and consumer protection. But the 2008 financial crisis was never resolved, only delayed, and here we are now, still kicking that can down the road.

So now that you've got this context, let's discuss how banks worked in the past and the era of the gold standard. The gold standard was a monetary system in which the value of a country's currency is directly linked to a fixed quantity of gold. Under this system, central banks committed to exchanging their currencies for a specific amount of gold upon demand, thereby ensuring the currency's stability and facilitating international trade.

The origins of the gold standard can be traced back to the use of gold coins as a medium of exchange. Gradually, countries adopted the practice of issuing paper currency backed by gold reserves, allowing for the expansion of the money supply without the need for additional gold. By the late 19th century, the gold standard had gained widespread acceptance and it was adopted by many countries, including the United States and Great Britain.

However, the gold standard had inherent flaws. One of the primary reasons was its inflexibility in terms of economic crisis. Since the money supply was tied to gold reserves, it was difficult for governments to increase liquidity and stimulate economic growth during recessions or depressions. This inflexibility ultimately contributed to the severity of the Great Depression in the 1930s. Additionally, the gold standard required countries to maintain large reserves to back their currency, which led to the hoarding of a precious metal. This, in turn, resulted in a limited gold supply and slowed global economic growth.

Countries with trade deficits often had to deplete their gold reserves to settle their international obligations, causing further economic instability. The gold standard also led to speculative attacks on currencies. When investors perceived that a country's gold reserves were insufficient to maintain a currency's value, they would engage in a speculative attack, selling that country's currency in anticipation of its devaluation.

During the early 20th century, countries began to abandon the gold standard. In response, the outbreak of World War One prompted many countries to suspend the gold standard temporarily, as the need to finance war efforts outweighed concerns for currency stability. In the 1930s, the United States and other countries began to abandon the gold standard altogether in an attempt to combat the Great Depression.

In the aftermath of World War II, the Bretton Woods Agreement established a new international monetary system based on the U.S. dollar, which was itself pegged to gold. However, this arrangement proved unsustainable, as growing trade deficits and inflationary pressures forced the United States to abandon the gold convertibility of the dollar in 1971. This marked the end of the gold standard era and the beginning of the modern-day system, which uses fractional reserve banking.

So, fractional reserve banking is a financial system in which banks are required to hold only a fraction of their customers' deposits in reserve, while the remainder can be loaned out or invested. In some ways, it's the opposite of the gold standard. This practice forms the basis of modern banking, allowing banks to create credit and stimulate economic growth by facilitating lending and investment.

Under fractional reserve banking, when a customer deposits money, the bank is obliged to retain only a certain percentage of that deposit as reserves. The reserve requirement is typically mandated by a central bank or other regulatory authority. The bank can then use the remaining portion of the deposit to extend loans or make investments, generating income through interest and fees.

We've explained this system in more detail in our video on the Silicon Valley Bank collapse. Make sure to check that one out because massive knowledge bombs were dropped!

So needless to say, here are some advantages and disadvantages of fractional reserve banking. Let's be nice and first discuss the advantages.

First, economic growth. By lending out a portion of their customers' deposits, banks help to increase the money supply, fueling investment and consumption. This stimulates economic growth, encouraging the creation of new jobs and industries.

Second, profitability. Fractional reserve banking enables banks to generate income from interest and fees on loans and investments made with customer deposits. This income helps banks to maintain profitability, which can lead to increased shareholder value and further investment in the financial sector.

Third, financial intermediation. Banks play a crucial role in financial intermediation, connecting borrowers and savers in the economy. Fractional reserve banking allows banks to extend credit to borrowers, providing businesses and individuals with the capital they need to grow and innovate.

Now let's explore the disadvantages.

Well, first, bank runs. Fractional reserve banking can make banks vulnerable to bank runs, a situation in which a large number of customers choose to withdraw their deposits simultaneously due to concerns about the bank's solvency. Since banks only hold a fraction of their deposits in reserve, they may not have enough cash on hand to meet withdrawal demands, leading to a crisis of confidence and potential financial instability. You know, the sort of stuff we're hearing about these days.

Second, inflation. The process of creating new loans in a fractional reserve banking system can lead to an increase in the money supply. If the growth of the money supply outpaces the growth in economic output, it can result in inflation, eroding the purchasing power of money and potentially causing economic imbalances.

Third, excessive risk-taking. Fractional reserve banking can encourage excessive risk-taking by banks, as they seek to maximize profits through lending and investment. This can lead to the misallocation of resources and contribute to the formation of asset bubbles. In the event of a financial crisis, banks with high levels of risky loans and investments may face insolvency, necessitating government intervention or bailouts.

So it appears that since 2008, we've all seen these things in action, and by the looks of things, it seems like the pain has only just begun.

Now, let's explain the types of banks and services.

First up, we've got retail banks, also known as consumer banks. Retail banks primarily serve individual customers and small businesses. They offer a wide array of banking services such as checkings and savings accounts. Retail banks provide customers with deposit accounts that enable them to securely store their money while offering varying degrees of interest and accessibility.

These banks extend various types of loans, including personal loans, auto loans, and mortgages, to help customers finance their needs and goals. The cash that is deposited by the customer is lent out to other customers at a higher rate of interest than the depositor is paid. At the highest level, this is the process that keeps the economy humming: people deposit their money in banks, the bank then lends out the money for car loans, credit cards, mortgages, and business loans. The loan recipients spend the money they borrow, the bank earns interest on the loan, and the process keeps money moving through the system.

Remember, just like any other business, the goal of a bank is to earn a profit for its owners. For most banks, the owners are their shareholders. Banks do this by charging more interest on the loans and other debt issued to borrowers than they pay to the people who use their savings vehicles. For example, a bank might pay one percent interest on a savings account and charge six percent interest for its mortgage loans, earning a gross profit of five percent for its shareholders.

Credit Cards: These banks issue credit cards that enable customers to make purchases on credit and repay the balance at a later date, typically with interest.

Payment Services: Consumer banks facilitate various forms of payment processing, such as check clearing, electronic fund transfers, and bill payments.

Foreign Exchange: These banks also offer currency exchange services, assisting customers in converting one currency to another for travel or other purposes.

Second up, we've got commercial banks. These banks cater primarily to businesses, both small and large, providing a range of financial services to support their operations and growth.

Here you'll find business loans. Commercial banks provide businesses with loans and lines of credit to finance expansion, working capital, equipment purchases, and other needs.

Trade Finance: They offer trade finance services as well, such as letters of credit and guarantees to facilitate international trade and mitigate risks associated with cross-border transactions.

Treasury Management: Commercial banks provide cash management services, helping businesses optimize their cash flow, manage liquidity, and process payments efficiently, as well as foreign exchange and hedging. They offer foreign exchange services for businesses involved in international transactions, as well as hedging instruments to mitigate currency, interest rate, and commodity price risks.

Third up, we've got investment banks. These specialize in capital markets activities and advisory services, primarily serving large corporations, institutional investors, and governments.

They handle mergers and acquisitions advisory. Investment banks advise clients on corporate transactions such as mergers, acquisitions, and divestitures, providing strategic guidance and valuation expertise.

Underwriting: Investment banks assist clients in raising capital through debt and equity offerings, acting as intermediaries between issuers and investors and underwriting securities offerings.

Asset Management: These banks also manage portfolios of securities and other financial assets on behalf of institutional clients such as pension funds, mutual funds, and insurance companies.

Trading and Market Making: These banks engage in securities trading, acting as market makers by buying and selling securities to maintain liquidity and facilitate efficient price discovery in financial markets.

Fourth up, we've got central banks. Unlike the banks above, central banks do not deal directly with the public. A central bank is an independent institution authorized by a government to oversee the nation's money supply and its monetary policy. As such, central banks are responsible for the stability of the currency and the economic system as a whole. They also have a role in regulating the capital and reserve requirements of the nation's banks.

The primary tasks of a central bank are the following:

Monetary Policy: Central banks control the money supply and interest rates to achieve macroeconomic objectives such as stable inflation, economic growth, and low unemployment.

Lender of Last Resort: They act as a lender of last resort to commercial banks in times of financial distress, providing emergency liquidity to maintain the stability of the financial system.

Supervision and Regulation: They oversee the banking sector, establish prudential regulations, and monitor the solvency and risk management practices of banks to ensure their soundness and stability.

The U.S. Federal Reserve Bank is the central bank of the U.S. The European Central Bank, the Bank of England, the Bank of Japan, the Swiss National Bank, and the People's Bank of China are among its counterparts in other nations.

Some people love banks, while others despise them, especially when they're talking about central banks. But no matter your stance, banking, as mentioned at the beginning of the video, is as old as humanity itself. So as long as economics exists, banks are not going anywhere.

Now, this should cover most of the theory behind how banks work. This is a lot to unpack, but we hope you're left with a better understanding of how the current financial system works. Understanding banks means understanding the foundation upon which the entire economy is built.

So we really encourage you to watch this video as many times as you need to in order to make sure you can put together each piece of the puzzle.

And with that being said, it's time to wrap up this video, but not before we ask you the following: How do you think the future of banking will look in the coming years? Drop your answers in the comments below. We're always curious to hear your vision!

As always, thanks for watching Alux. We'll see you back here tomorrow.