Ms. Divya Jain, MBA – Faculty (Finance)
Ms. Mamta, M.Sc. – Faculty (IT)
ICFAI National College,
Ph: 0120 – 2830165/ 2850058
Concluding the topic of the paper E-banking has become the necessity these days. The technology and security standards are of prime importance as the entire base of Internet banking rests on it. Also the competition has increased to such an extent that the one who is not compatible with the changing environment is not able to survive for long. E-banking comprises of Internet Banking, Smart Cards, Debit Cards, Credit Cards, Automated Teller Machines, and Charge Cards etc. Now-a-days, foreign banks are also entering into the Indian Banking Market. They are serving a hard and severe competition to nationalize and private sector banks. Introduction of these techniques have made the transactions and activities of businesses very effective and smooth. Many people are having access to Internet and Mobile Connections. But everything has two aspects – good and bad. The adoption and switch over to Electronic banking will also raise certain legal issues and disputes in the future which have to be anticipated and remedial measures for the same need to be adopted. Further, these issues should also be compatible with the existing laws, particularly the Information Technology Act, 2000. Further, all these e-banking transactions are being supervised and regulated by the guidelines of RBI. Such as, all banks that are providing Internet Banking are required to have prior approval from RBI.
- Technology used in E-banking
- Current Usage of Technology in Banks
- Advantages of the Technology
- Challenges of the Technology
- Supervisory Issues as per RBI
- Legal Issues - IT Act, 2000
A sound and effective banking system is the backbone of an economy. The economy of a country can function smoothly and without many hassles if the banking system backing it is not only flexible but also capable of meeting the new challenges posed by the technology and other external as well as internal factors. The importance and role of information technology for achieving this benign objective cannot be undermined. There is an urgent need for not only technology up gradation but also its integration with the general way of functioning of banks to give them an edge in respect of services provided to the customers, better housekeeping, optimizing the use of funds and building up of management information system for decision making. The technology has the potential to change methods of marketing, advertising, designing, pricing and distributing financial products and services and cost savings in the form of an electronic, self-service product-delivery channel. The technology holds the key to the future success of Indian Banks. Thus, “Electronic Banking” is the need of the hour, which cannot be lost sight of except at the cost of elimination from the competition. The existence of Electronic banking also becomes inevitable due to the standards required to be matched at the international level. Thus, the domestic as well as the international standards mandates the adoption of Electronic banking at the earliest possible moment.
In India, from the early I990's, electronic banking is gaining in popularity as an important distribution channel to provide banking services. This direction is being taken by the batiks to differentiate their services to the consumers to gain their loyalty. The strategies adopted by the Indian banks to survive the increased competition are the focus of this study.
Technology is enabling banks to provide the convenience of anytime-anywhere-banking. Banks are now reengineering the way in which their services can be reached to their customers by bringing in flexibility in their "distribution channels". The earlier brick-and-monar branch is no longer sufficient; technology is now taking banks to the homes or offices, 24 hours a day, 365 days a year through ATMs, phone banking and PC banking. The financial supply chain is undergoing a fundamental strategic change
What is Non-Branch-Banking?
Traditionally, consumers could do their banking only by coming to the bank branch. The brick-and-mortar building of the bank branch defined the periphery of service delivery of banking products.
The trend of Non-Branch-Service Delivery in banking started with the growing popularity of electronic payment services. It started with Electronic Funds Transfers (EFT). Then credit cards came. ATMs and smart cards were next in the evolutionary history. Gradually, with the advance of computing technology, telephone banking and Computer Telephony Integration (CTI) became a powerful medium of delivering banking services. The latest product is Electronic banking, where the technology and other issues are still under evolution.
These new technologies have broken the paradigm of branch banking. Customers, whether individual consumers or business corporate, are no longer required to go to the bank to do their business. It can be done from home, using the PC or the telephone, or at the shopping markets, using plastic money.
Some banks have now also started door to door delivery of services. As a result, it is now possible to order cash or demand drafts to be delivered at home. Consumers wishing to open accounts with banks or to apply for durable loans can call up Direct Sales Associates (DSAs) of banks and their representatives will complete the necessary documentation at the customer's convenience, at his desired place und time. These are the elements of the new flexible financial supply chain.
TECHNOLOGY USED IN E-BANKING
The Electronic Fund Transfer (EFT): This facility offers you to make payments to account holders of other banks in an efficient and fast manner. As against the physical clearing, where the cheques are cleared on presentment of the physical instrument at the clearing house, in EFT the transactions are settled electronically. EFT also provides you with an opportunity to move your collections to an electronic platform, whereby you can instruct your Dealers to pay through EFT, thus reducing the time for realization of funds. At present the electronic fund transfer facility is available in two modes and you can avail either of the following modes to transfer your funds:
National Electronic Fund Transfer (NEFT): This is the faster mode of fund transfer in which the funds are credited to the beneficiary’s account on the same day. It is offered by computerized branches of certain banks.
EFT: This is the normal electronic fund transfer facility offered by the banks. It is similar to NEFT in all respects with the exception of the transaction cycle time – an EFT transaction takes a minimum of 3 working days to be credited to the beneficiary’s account whereas in NEFT, the amount is credited on the same day of the transaction. The end to end transaction can be done through our Corporate Electronic banking wherein the request can be submitted online, either as a single transaction or through a file uploads. The key features that are common to both EFT and NEFT are:
EFT/NEFT clearing is conducted by Reserve Bank of India (RBI) and it takes place thrice a day during Monday to Friday and twice on Saturdays.
The payment instruction can be given through the Corporate Electronic banking. Alternatively the instructions can also be sent to the designated branches.
Presently offered at more than 125 locations, which covers all the major cities of the country
Automated Teller Machines: The Automated Teller Machines are installed, now-a-days, at every nook and corner in most of the towns & cities. These are meant for balance enquiries, cash withdrawals and many other facilities depending upon the policies of the bank. This requires a valid Customer Id and password to log in and is therefore safe to be used. Despite of using ATM cards, Debit cards can also be used in the ATMs.
Debit Cards: Debit Cards is another advanced technology of the electronic banking, now-a-days. These cards are the multi-purpose cards and can be used in ATMs for balance enquiry and cash withdrawal or can be used for easy shopping at various counters. Debit Cards ensure the automatic deduction of amount from the account just by scratching it on the machine. It makes it easier for the consumers to go for shopping with and even carrying cash with them.
Credit Cards: Credit Cards, unlike debit cards, provide credit to the consumers. A credit card system is a type of retail transaction settlement and credit system, named after the small plastic card issued to users of the system. A credit card is different from a debit card in that it does not remove money from the user's account after every transaction. In the case of credit cards, the issuer lends money to the consumer (or the user). It is also different from a charge card (though this name is sometimes used by the public to describe credit cards), which requires the balance to be paid in full each month. In contrast, a credit card allows the consumer to 'revolve' their balance, at the cost of having interest charged. Most credit cards are the same shape and size, as specified by the ISO 7810 standard.
Charge Cards: A charge card is a means of obtaining a very short term (usually around 1 month) loan for a purchase. It is similar to a credit card, except that the contract with the card issuer requires that the cardholder must each month pay charges made to it in full -- there is no "minimum payment" other than the full balance. Since there is no loan, there is no official interest. A partial payment (or no payment) results in a severe late fee (as much as 5% of the balance) and the possible restriction of future transactions or even cancellation of the card.
Smart Cards: A card that is used for storing and retrieving personal information, normally the size of a credit card and contains contains electronic memory and possibly an embedded integrated circuit. The card can be used to do many tasks:
Will verify the carrier of that card in order to access systems.
Storing a patient's medical records
Storing digital cash
To use a smart card, either to pull information from it or add data to it, you need a smart card reader, a small device into which you insert the smart card.
Payment and Settlement Systems and Information Technology: The development of payment and settlement systems conforming to the best international standards has been a key objective of the Reserve Bank. A milestone was crossed during 2003-04 with the commencement of the Real Time Gross Settlement (RTGS) as a facility available for quick, safe and secure electronic mode of funds transfer. Preparation of the draft legislation relating to payment and settlement systems was another important development. The legislation aims at providing a sound legal basis to various payment and settlement systems operating in India and empowers the Reserve Bank to regulate and supervise such systems. It profiles the significant expansion of activity in the payment systems in India and the key drivers – retail payments and the rising popularity of card-based transactions, large value payments propelled by rising turnover in the inter-bank clearing, Negotiated Dealing System (NDS) and foreign exchange clearing segments. Noteworthy landmarks in the evolution of payment systems highlighted in this Section are the implementation of Real Time Gross Settlement (RTGS) system, the Special Electronic Funds Transfer (SEFT) system and the foundation being laid for the constitution of a Board for Payment and Settlement Systems as an apex regulatory authority. Reviewing developments in the settlement systems in India in 2003-04, the Section highlights the continuing preponderance of paper-based (cheque) clearing and the preparatory steps being taken to introduce cheque truncation to improve the speed and efficiency of paper-based settlement systems. The implementation of Online Tax Accounting System (OLTAS) to IT-enable tax payment as well as tax administration is brought out in this Section along with developments relating to the Indian Financial Network (INFINET) and Structured Financial Messaging Solution (SFMS). The role of central counter parties (CCPs) in minimizing settlement risks is underscored. The Section concludes with a review of the growing role of information technology (IT) within the Reserve Bank and the special emphasis being laid on information security and disaster recovery management.
Range of Services Offered by Transactional Internet Banks
(Percentage of transactional banks offering selected services)
ADVANTAGES OF THE TECHNOLOGY
The benefits and advantages of information technology for the smooth and efficient functioning of the banking business cannot be disregarded and sidelined. Its proper and methodical use can bring the following advantages:
An electronic delivery system brings an integrated trade services and cash management system to your desktop. This system delivers continuously updated information on your trade and cash account transactions.
Information can be retrieved by one office, multiple offices or from a regional office monitoring your group's receivables.
Export LCs issued in your favour, receipt of import bills and notification of discrepant documents, status of your import and export bills, credit and debit advices, and copies of schedules and tracers are electronically transmitted to your own systems for updating or further analysis.
Letters of credit initiation and amendments are easily handled as well as initiating direct collection letters and applications for export bills.
Instructions are easily prepared with customized templates, and databases that allow you to create, store and insert frequently used clauses, correspondent addresses and international commercial terms.
To complete your trade settlements, local and cross-border payments can be executed through the system.
All transactions are handled with a host of internationally approved security measures and transactions are processed efficiently, with minimal manual intervention.
It brings trade services to your desktop, with solutions for you to maximize the efficiency of your trade activities.
It ensures a Sound Payment System without any disruption in the flow of money supply in the economy. The payments in India are largely cash based although there are non-cash based payments as well. The various forms of electronic based payment, such as credit cards, Automated Teller Machines (ATMs), Debit Cards etc, are emerging at an incredible speed. Many banks have made initiatives aimed at electronic modes of funds movement.
The information technology revolution has significantly benefited the financial system. In particular, there are four key areas in which the financial system has experienced the benefits of the technology revolution:
Risk control and
It ensures effective Regulation and Supervision. The technology has brought alterations to decades old attitude and practices, in a more effective, economical and competitive manner.
It also ensures Monetary and Financial Stability. One of the critical activities undertaken by Central bank to ensure monetary and financial stability is to provide the banking sector with finality of settlement. The payment and settlement systems are the conduits through which monetary policy measures are transmitted to the financial and then the real economy. The information technology revolution has given rise to an extraordinary increase in financial activity across the globe. The progress of technology and the development of worldwide networks have significantly reduced the cost of global funds transfer.
CHALLENGES OF THE TECHNOLOGY
The information technology in itself is not a panacea and it has to be effectively utilized. The concept of Electronic banking cannot work unless and until we have a centralized body or institution, which can formulate guidelines, regulate, and monitor effectively the functioning of Electronic banking. The most important requirement for the successful working of Electronic banking is the adoption of the best security methods. This presupposes the existence of a uniform and the best available technological devices and methods to protect electronic banking transactions. In order for computerization to take care of the emerging needs, the recommendations of the Committee on Technology Up gradation in the Banking Sector (1999) may be considered. These are:
Need for standardization of hardware, operating systems, system software, application software to facilitate interconnectivity of systems across branches
Need for high levels of security
Communication and networking – use of networks which would facilitate centralized databases and distributed processing
Need for a technology plan with periodical up gradation
Need for business process re-engineering
Need to address the issue of human relations in a computerized environment
Need for sharing of technology experiences
Need of Payment systems which use information technology tools. The Reserve Bank of India has played a lead role in this sphere of activity - with the introduction of cheque clearing using the MICR (Magnetic Ink Character Recognition) technology in the late eighties.
Need for standardization – across hardware, operating systems, system software, application software to facilitate inter-connectivity of systems across branches.
Need for high levels of security – in an environment which requires high levels of confidentiality, security is an important requirement.
Once both the above are achieved, the next logical approach would be towards communication and networking – use of networks which would facilitate centralized databases and distributed processing. Exploitation of computer networks by banks would result in savings in cost and increase in efficiency.
Need for a technology plan which has to be periodically monitored and also upgraded consequent upon changes in technology itself.
Need for business process re-engineering with the large scale usage of computers – the objective is not to merely mechanize activities but to result in holistic benefits of computerization for both the customer and the staff at branches.
Need to address the issue of Human Relations in a computerized environment especially from the point of Human Resources Development.
Sharing of technology experiences and expertise so as to reap the benefits of technology implementation across a wider community.
REGULATORY AND SUPERVISORY ISSUES
The banks operating in real space are regulated and supervised by the RBI on regular basis. This regulation and supervision is required to be extended to Electronic banking as well. Thus, the RBI has issued the following guidelines in this regard:-
Only such banks which are licensed and supervised in India and have a physical presence in India will be permitted to offer Electronic banking products to residents of India. Thus, both banks and virtual banks incorporated outside the country and having no physical presence in India will not, for the present, be permitted to offer Electronic banking services to Indian residents.
The products should be restricted to account holders only and should not be offered in other jurisdictions.
The services should only include local currency products.
The ‘in-out’ scenario where customers in cross border jurisdictions are offered banking services by Indian banks (or branches of foreign banks in India) and the ‘out-in’ scenario where Indian residents are offered banking services by banks operating in cross-border jurisdictions are generally not permitted and this approach will apply to Internet banking also. The existing exceptions for limited purposes under FEMA i.e. where resident Indians have been permitted to continue to maintain their accounts with overseas banks etc. will, however, are permitted.
Overseas branches of Indian banks will be permitted to offer Electronic banking services to their overseas customers subject to their satisfying, in addition to the host supervisor, the home supervisor.
Given the regulatory approach as above, banks are advised to follow the following instructions:-
All banks, who propose to offer transactional services on the Internet, should obtain prior approval from RBI. Bank’s application for such permission should indicate its business plan, analysis of cost and benefit, operational arrangements like technology adopted, business partners, third party service providers and systems and control procedures the bank proposes to adopt for managing risks. The bank should also submit a security policy covering recommendations made in this circular and a certificate from an independent auditor that the minimum requirements prescribed have been met. After the initial approval the banks will be obliged to inform RBI any material changes in the services / products offered by them. (Para 8.4.1, 8.4.2)
Banks will report to RBI every breach or failure of security systems and procedure and the latter, at its discretion, may decide to commission special audit / inspection of such banks. (Para 8.4.3)
The guidelines issued by RBI on ‘Risks and Controls in Computers and Telecommunications’ vide circular DBS.CO.ITC.BC. 10/ 31.09.001/ 97-98 dated 4th February 1998 will equally apply to Internet banking. The RBI as supervisor will cover the entire risks associated with electronic banking as a part of its regular inspections of banks. (Para 8.4.4, 8.4.5)
Banks should develop outsourcing guidelines to manage risks arising out of third party service providers, such as, disruption in service, defective services and personnel of service providers gaining intimate knowledge of banks’ systems and misutilizing the same, etc., effectively. (Para 8.4.7)
With the increasing popularity of e-commerce, it has become necessary to set up ‘Inter-bank Payment Gateways’ for settlement of such transactions. The protocol for transactions between the customer, the bank and the portal and the framework for setting up of payment gateways as recommended by the Group should be adopted. (Para 8.4.7, 18.104.22.168 – 22.214.171.124)
Only institutions who are members of the cheque clearing system in the country will be permitted to participate in Inter-bank payment gateways for Internet payment. Each gateway must nominate a bank as the clearing bank to settle all transactions. Payments effected using credit cards, payments arising out of cross border e-commerce transactions and all intra-bank payments (i.e., transactions involving only one bank) should be excluded for settlement through an inter-bank payment gateway. (Para 8.4.7)
Inter-bank payment gateways must have capabilities for both net and gross settlement. All settlement should be intra-day and as far as possible, in real time. (Para 8.4.7)
Connectivity between the gateway and the computer system of the member bank should be achieved using a leased line network (not through Internet) with appropriate data encryption standard. All transactions must be authenticated. Once, the regulatory framework is in place, the transactions should be digitally certified by any licensed certifying agency. SSL / 128 bit encryption must be used as minimum level of security. Reserve Bank may get the security of the entire infrastructure both at the payment gateway’s end and the participating institutions’ end certified prior to making the facility available for customers use. (Para 8.4.7)
Bilateral contracts between the payee and payee’s bank, the participating banks and service provider and the banks themselves will form the legal basis for such transactions. The rights and obligations of each party must be clearly defined and should be valid in a court of law. (Para 8.4.7)
Banks must make mandatory disclosures of risks, responsibilities and liabilities of the customers in doing business through Internet through a disclosure template. The banks should also provide their latest published financial results over the net. (Para 8.4.8)
Hyperlinks from banks’ websites often raise the issue of reputation risk. Such links should not mislead the customers into believing that banks sponsor any particular product or any business unrelated to banking. Hyperlinks from banks’ websites should be confined to only those portals with which they have a payment arrangement or sites of their subsidiaries or principals. Hyperlinks to banks’ websites from other portals are normally meant for passing on information relating to purchases made by banks’ customers in the portal. Banks must follow the minimum recommended security precautions while dealing with request received from other websites, relating to customers’ purchases. (Para 8.4.9)
Thus, the guidelines issued by the RBI have taken care of the challenges to be faced by the Electronic banking. The Reserve Bank of India has directed that all banks offering Electronic banking services, with immediate effect, should adopt the Group’s recommendations. Even though the recommendations have been made in the context of Internet banking, these are applicable, in general, to all forms of electronic banking and banks offering any form of electronic banking should adopt the same to the extent relevant. Further, all banks offering Electronic banking are advised to make a review of their systems in the light of these guidelines and report to Reserve Bank the types of services offered, extent of their compliance with the recommendations, deviations and their proposal indicating a time frame for compliance. The first such report must reach the RBI within one month from 14-06-2001. The banks not offering any kind of I-banking may submit a ‘nil’ report. The banks who are already offering any kind of transactional service are advised to report, in addition to those mentioned in paragraph above, their business models with projections of cost / benefits etc. and seek RBI’s post-facto approval.
LEGAL ISSUES - IT ACT, 2000
The Internet banking cannot operate properly unless it is in conformity with the Information Technology Act. 2000 (hereinafter referred to as Act). A holistic approach should be adopted, the purpose of which should be to bring uniformity and harmony between the provisions of the Act on the one hand and the guidelines issued by the RBI on the other. It must be appreciated that in case of conflict between the provisions of the Act and the guidelines, the former would prevail.
The following provisions of the Act have a direct bearing on the functioning of Internet banking in India:
The authentication of electronic records for the purposes of Internet banking should be in accordance with the provisions of the Act.
The electronic records duly maintained for the purposes of Internet banking would be recognized as legally valid and admissible.
The digital signature affixed in a proper manner would satisfy the requirement of signing of a document for the purposes of Internet banking.
Any kind of paper work, which is required to be filed in the government offices or its agencies, would be deemed to be duly filed if it is filed in the prescribed electronic form. Thus the paper formalities can be effectively substituted with electronic filings for Internet banking purposes.
The banking business requires certain documents or records to be retained for a fixed period. In Internet banking such documents or records can be retained in an electronic form.
The rules, regulations, order, bye-law, notification or any other matter pertaining to Internet banking can be published in the Official Gazette or Electronic Gazette, as the case may be.
The Internet banking presupposes the existence of attribution and certainty. If any electronic record is sent by the originator himself, by his agent, or by an information system programmed by or on behalf of the originator to operate automatically, then the electronic shall be attributed to the originator.
The requirement of acknowledgement of documents sent for the purposes of Internet banking is adequately safeguarded by the Act.
The Internet banking may require to determine the time and place of dispatch and receipt of electronic records. This problem can be easily solved by applying the provisions of the Act.
The Internet banking would require the secured electronic records for its proper working. Where any security procedure has been applied to an electronic record at a specific point of time, then such record shall be deemed to be a secure electronic record from such point of time to the time of verification.
A digital signature meeting the specified requirements would be deemed to be a secured digital signature for carrying out Internet banking transactions.
The Central Government has the power to prescribe the security procedures to give effect to the provisions of the Act, having regard to the commercial circumstances prevailing at the time when the procedure was used. Thus, the Central Government can specify safety measures and security procedures for Internet banking under the provisions of the Act.
The Controller of Certifying Authorities (CCA) can issues licenses to the Certification Authority under the IT Act, 2000. The Certifying Authority is assisted by the Registration Authority, which is created at the level of the organizations subscribing to the services of the Certifying Authority .The Reserve Bank would function as a Registration Authority (RA) for the proper functioning of Internet banking.
Thus, the information Technology Act, 2000 has laid down the basic legal framework conducive to the Internet banking in India. In case of any doubt or legal problem, the provisions of the Act can be safely relied upon. It must be noted that the object of the Act is to facilitate e-commerce and e-governance, which are essential for the functioning of Internet banking in India. There may be challenges of Internet banking which cannot be tackled appropriately with the existing legal framework. To meet such challenge appropriate amendments can be made either to the Act itself or a separate new law dealing specifically with the Internet banking can be enacted.
With the exception of the extremely wealthy, very few people buy their homes in all-cash transactions. Most of us need a mortgage, or some form of credit, to make such a large purchase. In fact, many people use credit in the form of credit cards to pay for everyday items.
The world as we know it wouldn't run smoothly without credit — or without banks to issue credit. Below, we'll explore the birth of these two now-flourishing industries.
Tutorial: Introduction to Banking and Saving
Banks have been around since the first currencies were minted — perhaps even before that, in some form or another. Currency, particularly the use of coins, grew out of taxation.
In the early days of ancient empires, a tax of one healthy pig per year might be reasonable, but as empires expanded, this type of payment became less desirable. Additionally, empires began to need a way to pay for foreign goods and services, with something that could be exchanged more easily. Coins of varying sizes and metals served in the place of fragile, impermanent paper bills. (To read more about the origins of money, see What Is Money?, Cold Hard Cash Wars and From Barter to Banknotes.)
Flipping a Coin
These coins, however, needed to be kept in a safe place. Ancient homes didn't have the benefit of a steel safe, therefore, most wealthy people held accounts at their temples. Numerous people, like priests or temple workers whom one hoped were both devout and honest, always occupied the temples, adding a sense of security.
There are records from Greece, Rome, Egypt and Ancient Babylon that suggest temples loaned money out, in addition to keeping it safe. The fact that most temples were also the financial centers of their cities is the major reason that they were ransacked during wars.
Coins could be hoarded more easily than other commodities, such as 300-pound pigs, so there emerged a class of wealthy merchants that took to lending these coins, with interest, to people in need. Temples generally handled large loans, as well as loans to various sovereigns, and these new money lenders took up the rest.
The First Bank
The Romans, great builders and administrators in their own right, took banking out of the temples and formalized it within distinct buildings. During this time, moneylenders still profited, as loan sharks do today, but most legitimate commerce — and almost all governmental spending — involved the use of an institutional bank.
Julius Caesar, in one of the edicts changing Roman law after his takeover, gives the first example of allowing bankers to confiscate land in lieu of loan payments. This was a monumental shift of power in the relationship of creditor and debtor, as landed noblemen were untouchable through most of history, passing debts off to descendants until either the creditor's or debtor's lineage died out.
The Roman Empire eventually crumbled, but some of its banking institutions lived on in the form of the papal bankers that emerged in the Holy Roman Empire, and with the Knights Templar during the Crusades. Small-time moneylenders that competed with the church were often denounced for usury.
Eventually, the various monarchs that reigned over Europe noted the strengths of banking institutions. As banks existed by the grace, and occasionally explicit charters and contracts, of the ruling sovereign, the royal powers began to take loans to make up for hard times at the royal treasury, often on the king's terms. This easy finance led kings into unnecessary extravagances, costly wars, and an arms race with neighboring kingdoms that would often lead to crushing debt.
In 1557, Phillip II of Spain managed to burden his kingdom with so much debt (as the result of several pointless wars) that he caused the world's first national bankruptcy — as well as the world's second, third and fourth, in rapid succession. This occurred because 40% of the country's gross national product (GNP) was going toward servicing the debt. The trend of turning a blind eye to the creditworthiness of big customers, continues to haunt banks up into this day and age.
Adam Smith and Modern Banking
Banking was already well established in the British Empire when Adam Smith came along in 1776 with his "invisible hand" theory. Empowered by his views of a self-regulated economy, moneylenders and bankers managed to limit the state's involvement in the banking sector and the economy as a whole. This free market capitalism and competitive banking found fertile ground in the New World, where the United States of America was getting ready to emerge. (To learn more, read Economics Basics.)
In the beginning, Smith's ideas did not benefit the American banking industry. The average life for an American bank was five years, after which most bank notes from the defaulted banks became worthless. These state-chartered banks could, after all, only issue bank notes against gold and silver coins they had in reserve.
A bank robbery meant a lot more then than it does now, in our age of deposit insurance and the Federal Deposit Insurance Corporation (FDIC). Compounding these risks was the cyclical cash crunch in America. (To learn more, read Are Your Bank Deposits Insured?)
Alexander Hamilton, the secretary of the Treasury, established a national bank that would accept member bank notes at par, thus floating banks through difficult times. This national bank, after a few stops, starts, cancellations and resurrections, created a uniform national currency and set up a system by which national banks backed their notes by purchasing Treasury securities, thus creating a liquid market. Through the imposition of taxes on the relatively lawless state banks, the national banks pushed out the competition.
The damage had been done already, however, as average Americans had already grown to distrust banks and bankers in general. This feeling would lead the state of Texas to actually outlaw bankers — a law that stood until 1904.
Most of the economic duties that would have been handled by the national banking system, in addition to regular banking business like loans and corporate finance, fell into the hands of large merchant banks, because the national banking system was so sporadic. During this period of unrest that lasted until the 1920s, these merchant banks parlayed their international connections into both political and financial power.
These banks included Goldman and Sachs, Kuhn, Loeb, and J.P. Morgan and Company. Originally, they relied heavily on commissions from foreign bond sales from Europe, with a small backflow of American bonds trading in Europe. This allowed them to build up their capital.
At that time, a bank was under no legal obligation to disclose its capital reserve amount, an indication of its ability to survive large, above-average loan losses. This mysterious practice meant that a bank's reputation and history mattered more than anything. While upstart banks came and went, these family-held merchant banks had long histories of successful transactions. As large industry emerged and created the need for corporate finance, the amounts of capital required could not be provided by any one bank, and so initial public offerings (IPOs) and bond offerings to the public became the only way to raise the needed capital.
The public in the U.S. and foreign investors in Europe knew very little about investing, due to the fact that disclosure was not legally enforced. For this reason, these issues were largely ignored, according to the public's perception of the underwriting banks. Consequently, successful offerings increased a bank's reputation and put it in a position to ask for more to underwrite an offer. By the late 1800s, many banks demanded a position on the boards of the companies seeking capital, and if the management proved lacking, they ran the companies themselves.
Morgan and Monopoly
J.P. Morgan and Company emerged at the head of the merchant banks during the late 1800s. It was connected directly to London, then the financial center of the world, and had considerable political clout in the United States. Morgan and Co. created U.S. Steel, AT&T and International Harvester, as well as duopolies and near-monopolies in the railroad and shipping industries, through the revolutionary use of trusts and a disdain for the Sherman Anti-Trust Act. (To find out more about this subject, read Antitrust Defined.)
Although the dawn of the 1900s had well-established merchant banks, it was difficult for the average American to get loans from them. These banks didn't advertise and they rarely extended credit to the "common" people. Racism was also widespread and, even though the Jewish and Anglo-American bankers had to work together on large issues, their customers were split along clear class and race lines. These banks left consumer loans to the lesser banks that were still failing at an alarming rate.
The Panic of 1907
The collapse in shares of a copper trust set off a panic that had people rushing to pull their money out of banks and investments, which caused shares to plummet. Without the Federal Reserve Bank to take action to calm people down, the task fell to J.P. Morgan to stop the panic, by using his considerable clout to gather all the major players on Wall Street to maneuver the credit and capital they controlled, just as the Fed would do today.
The End of an Era
Ironically, this show of supreme power in saving the U.S. economy ensured that no private banker would ever again wield that power. The fact that it took J.P. Morgan, a banker who was disliked by much of America for being one of the robber barons with Carnegie and Rockefeller, to do the job, prompted the government to form the Federal Reserve Bank, commonly referred to today as the Fed, in 1913. Although the merchant banks influenced the structure of the Fed, they were also pushed into the background by it. (To learn about robber barons and other unseemly financial entities, see Handcuffs and Smoking Guns: The Criminal Elements of Wall Street.)
Even with the establishment of the Federal Reserve, financial power and residual political power was concentrated in Wall Street. When World War I broke out, America became a global lender and replaced London as the center of the financial world by the end of the war. Unfortunately, a Republican administration put some unconventional handcuffs on the banking sector. The government insisted that all debtor nations must pay back their war loans, which traditionally were forgiven, especially in the case of allies, before any American institution would extend them further credit.
This slowed down world trade and caused many countries to become hostile toward American goods. When the stock market crashed on Black Tuesday in 1929, the already sluggish world economy was knocked out. The Federal Reserve couldn't contain the crash and refused to stop the depression; the aftermath had immediate consequences for all banks.
A clear line was drawn between being a bank and being an investor. In 1933, banks were no longer allowed to speculate with deposits and the FDIC regulations were enacted, to convince the public it was safe to come back. No one was fooled and the depression continued.
World War II Saves the Day
World War II may have saved the banking industry from complete destruction. WWII, and the industriousness it generated, lifted the U.S. and world economies back out of the downward spiral.
For the banks and the Federal Reserve, the war required financial maneuvers using billions of dollars. This massive financing operation created companies with huge credit needs that, in turn, spurred banks into mergers to meet the new needs. These huge banks spanned global markets.
More importantly, domestic banking in the United States had finally settled to the point where, with the advent of deposit insurance and mortgages, an individual would have reasonable access to credit.
The Bottom Line
Banks have come a long way from the temples of the ancient world, but their basic business practices have not changed. Banks issue credit to people who need it, but they demand interest on top of the repayment of the loan. Although history has altered the fine points of the business model, a bank's purpose is to make loans and protect depositors' money.
Even if the future takes banks completely off your street corner and onto the internet — or has you shopping for loans across the globe — banks will still exist to perform this primary function.