Before the Gramm-Leach-Billey Act (Financial Services Modernization Act) of 1999, the merger of investment banks and commercial banks (the name given to normal banks to differentiate them from investment banks) was forbidden under the Glass-Stegall Act of 1933. After 1999, commercial banks and investment banks were allowed to merge, blurring the distinction between bank types. While problems with the banking industry can bring financial crisis (such banking crisis of 2008-2009), commercial banks are an important and necessary part of the economy, for several reasons.
Accepting Deposits, Cashing Checks
Commercial banks have evolved from a long tradition, dating back at least to Italian moneylenders and merchants in the 12th century, of accepting deposits and writing checks. Checks allow cheaper transaction costs, by reducing costs associated with transporting money for long-distance commerce, and by reducing risks of money theft. By accepting deposits, offering interest on savings accounts, and offering inexpensive checking, banks lure customers to supply funds to drive their revenue-creating activities. Bank customers also receive an economic bonus: the security of the bank's vault for their savings.
Financial Hubs that Lower Cost
Banks reduce transaction costs in the economy by aggregating settlement of payments among multiple parties, as those parties (bank customers, other banks and third parties) engage in financial transactions. Interbank systems help banks collect payments from multiple sources easier. Banks not only acquire business due to their convenience, but they also serve to reduce the average cost of settlement between parties. The globalization and integration of the economy is likely to only make this effect more pronounced.
Lending and Credit
When banks accept personal deposits and aggregate them, they typically only keep a low percentage of deposits on-hand and lend out as much as possible. Loans earn the bank money in interest payments, but they also help the economic system function by increasing the availability of capital and allowing business to use debt to expand. Banks are important sources of typically high-quality credit, especially when compared to other agents in the economy. Even though some percentage of issued debt will go bad, the bank can (generally) still meet all of its obligations to depositors by using the revenues from diversified earnings.
Fractional-Reserve Banking and Money Creation
Banks are highly important for the economy because by engaging in their activities, they actually create money. The fractional-reserve system, universal in modern banking, means that banks only hold a certain percentage of deposits on-site. The fractional amount held is large enough to cover day-to-day withdrawals from accounts, but not enough to cover all claims by depositors. For example, if the reserve requirement is 10 percent and the bank receives a deposit of $100, it could loan out $90, for a total money supply $190. If the loaned $90 is deposited again, the bank will loan out about $81, and total money is $271. Even though the bank never prints money, fractional-reserve banking creates real money.
Convience of Modern Banking
Besides the esoteric arguments about the money supply, commercial banks are also important because they reduce transaction costs using modern technology. For example, electronic money transfer reduces costs for sending money in many cases, both in shipping and security costs as well as risks of theft. ATMs allow citizens with everyday access to accounts, and the rise of drive-through banking has made using bank services even faster. As banks increasingly reach out to the Internet to connect with customers, this factor of convenience (which saves time and money) will only increase.
- Economics: Private & Public Choice, 11th Ed.; Gwartney, Stroup, Sobel, and MacPherson; Thomson South-Western, 2006
- NewYorkFed.Org: Reserve Requirements
- Federal Deposit Insurance Corporation. "Your Insured Deposits." Accessed Sept. 17, 2020.
- Federal Deposit Insurance Corporation. "BankFind Suite: Find Annual Historical Bank Data." Accessed Sept. 17, 2020.
- U.S. Congress. "H.R.4173 - Dodd-Frank Wall Street Reform and Consumer Protection Act." Accessed Sept. 17, 2020.
Collin Fitzsimmons has been writing professionally since 2007, specializing in finance and the stock market. He serves as a financial analyst at AMF Bowling Centers, Inc. Fitzsimmons earned a bachelor's degree in economics from the University of Virginia.