How bank runs come to be?

A look at the 'black box' called a bank

From Tuomas Malinen’s Forecasting Newsletter.

Issues contributed:

• What are bank runs and how they come to be?

• The difference between commercial and shadow banks, and how they contribute to the current crisis.

• Credit crunch is getting worse.

Since the start of the current crisis, or its second wave, I have received quite a few inquiries on the banking system. There are so many misconceptions regarding to it that I decided to explain it in more detail in this entry. First, some history.

The foundations of banking practices were developed in Ancient Greece in the harbor city of Piraeus, where the local bankers, or trapezitai, took deposits and provided loans.¹ The first known banks that truly resembled modern banks operated in Imperial Rome, which also brought first banking crises. It has actually been said that Rome's financial system was so sophisticated that it was matched only by the banking sector created in during the Industrial Revolution.²

The order of the Knights Templar created a system, where pilgrims could deposit money with the order in Europe and withdraw it in the Holy Land in the 12th century.³ This created a financial system of long-distance remittance. Simple merchant banks, usually in the service of the rulers, appeared to Europe in the 14th century. They were concentrated in financing production and trade of commodities.

The first payment systems resembling the modern ones appeared in the 16th century. They arose from merchant fairs where commodity trades were settled.⁴ By 1555, the merchant fair of Lyons had become a clearing house for credit and debit balances of merchant houses across the continent. The merchants realized that the trustworthiness of well-known international merchants could be used to pass their I-Owe-Yous (IOU, i.e. a promise to pay back at agreed future) to not so well-known local merchants. This created a credit system, where bilateral promises (IOU:s to pay and receive) between local and international merchants were used as liquid liabilities. These could be assigned from creditor to creditor and, in essence, create money (credit) through building a leverage against the original claim from the well-known merchant. This, basically, created the fractional reserve banking system, where only fraction of money (credit) in circulation holds collateral. This system is at the heart of many banking problems, but essentially the special nature of banks subjects them to runs.

Banking is a business of trust, and it has been broken during the current crisis in a spectacular fashion, as shown by the failures of Silicon Valley Bank (SVB), Signature Bank, First Republic Bank in the U.S., and with the failure of Credit Suisse in Europe. To understand the failures and the modern banking system, we need to understand who sets their rules, how money is created and how the banking system operates. I will also update the situation with the credit crunch intensifying in the U.S.

The commercial and ‘shadowy’ side of banking