Demystifying Banking: Understanding Money and Credit

The global banking system is a puzzle. With over 30,000 distinct banks worldwide, they possess astonishing amounts of assets. The top 10 banks alone represent around 25 trillion US dollars. Although banking may appear complex today, its initial purpose was to simplify life. Italy, the hub of European trading in the 11th century, brought merchants from all corners of the continent together to exchange goods. However, a challenge arose: the multitude of currencies in use. In Pisa, for instance, merchants had to manage seven different types of coins and continually exchange their money. This exchange process, often conducted on outdoor benches, gave rise to the term "bank," derived from the Italian word "banco," meaning "bench." The risks of travel, counterfeit currency, and obtaining loans led to a demand for a new business model. Home brokers began offering credit to entrepreneurs, while Genevan merchants introduced cashless payment methods.

Banks spread across Europe, providing credit to various institutions, including the church and European monarchs. How do banks operate today? In essence, they manage risk. Here's a simplified explanation of their operations. People deposit their money in banks and earn a small amount of interest. The banks then lend this money at much higher interest rates, acknowledging that some borrowers will default on their loans. This process is vital for our economic system, as it supplies resources for people to purchase items like homes or for industries to expand their businesses and grow. In short, banks transform unused funds from savers into capital that society can use for various purposes. Additional income sources for banks include accepting savings deposits, engaging in the credit card business, trading currencies, offering custodian services, and managing cash.

The primary issue with banks today is that many have strayed from their traditional roles as providers of long-term financial products, opting instead for short-term gains that carry much higher risks. During the financial boom, most major banks embraced complex financial instruments that were difficult to understand and engaged in their own trading practices to make quick profits, resulting in millions in bonuses for their executives and traders. This behavior was akin to gambling and caused significant harm to entire economies and societies.

For instance, in 2008, banks like Lehman Brothers provided credit to virtually anyone looking to buy a house, placing the bank in a highly precarious risk position. This led to the collapse of the housing market in the US and parts of Europe, causing stock prices to nosedive and ultimately triggering a global banking crisis—one of the largest financial crises in history. Hundreds of billions of dollars vanished, millions of people lost their jobs, and countless individuals lost substantial amounts of money. Most major banks had to pay billions in fines, and bankers became some of the least trusted professionals. To prevent banks from going bankrupt, the US government and the European Union assembled massive bailout packages to purchase bad assets.

New regulations were introduced to oversee the banking industry, and mandatory bank emergency funds were established to absorb shocks in case of another financial crisis. However, the banking lobby successfully blocked some of the more stringent legislation. Today, alternative financing models are quickly gaining traction. Examples include new investment banks that charge an annual fee and do not earn commissions on sales, thereby motivating them to act in the best interests of their clients. Another alternative is credit unions, cooperative initiatives established in the 19th century to bypass loan sharks. In essence, they offer the same financial services as traditional banks, but their focus is on shared value rather than profit maximization.

The self-proclaimed goal of credit unions is to help members create opportunities such as starting small businesses, expanding farms, or building family homes while investing back into communities. These unions are controlled by their members, who democratically elect the board of directors. Worldwide, credit union systems vary significantly, ranging from a handful of members to organizations with several billion US dollars and hundreds of thousands of members. Their focus on member benefits influences the level of risk credit unions are willing to take, which explains why credit unions, although also affected, weathered the last financial crisis far better than traditional banks. Additionally, the recent surge in crowdfunding cannot be overlooked.

Aside from making incredible video games possible, platforms have emerged that enable people to secure loans from large groups of small investors, bypassing the bank as a middleman. This approach also works for industry – numerous new technology companies began on Kickstarter or Indiegogo. Individual funders gain the satisfaction of being part of something bigger and can invest in ideas they believe in while spreading the risk so widely that if the project fails, the damage is limited. Last but not least, microcredits play a significant role. These are many small loans, primarily distributed in developing countries, that help people escape poverty. Previously, these individuals couldn't access the funds they needed to start a business because they weren't considered worth the time. Today, granting microcredits has evolved into a multi-billion dollar industry. So, while banking may not be everyone's cup of tea, the role banks play in providing funds to people and businesses is essential for our society. How this function will be carried out in the future is up to us to determine.