by elmads

Introduction

Banking has been a crucial part of our society, their purpose is to provide financial security and confidence within an economy. Do you need a trusted and licensed custodian entity to hold your money? The banks are at your service. Not just that, they can also receive your deposits that they will pay interest on it as an incentive to you. They can give you credit when you need capital for your own personal endeavours, and they can also manage your money and grow it in your behalf.

Banks’ business model may seem complex most especially with the new products that they now offer to the public. But, the traditional banking of lending has been and will always be their core business model.

What is Money and Credit?

Do you trust the paper money that you have? or shall I say the digital numbers in your bank account? What do we actually trust in the money that we have now? The answer to that is this; We trust that our government will honour the paper money we have as a trustful piece of paper that holds value as an exchange for various products and services. That’s it, because the word money itself is built on trust. We could have been using stones or sea shells today as money and that’s is purely possible, as long as there is this mutual trust to honour those stones and sea shells as a means of exchange.

The idea and concept of money is old but still very relevant to our time. I’ve discussed this in my blog titled “The Evolution of Money”. Nevertheless, money itself is not the oldest form of trust, it actually is debt.

Debt and money has evolved hand in hand, overtime. The idea that we could rely on people to pay something that they have borrowed to us, at a future date is the rise and innovation of Credit.

Credit, also known as “Credo”, which is the Latin for “I Believe”.

Sure, debt has always been a double edged sword, either it is a leverage for success, or an amplifier of pain and sufferings. That being said, one thing is for certain with credit. Without it, the current economic growth that our world has achieved for centuries wouldn’t even be possible.

Lending

The rise of money lending started in 13th century Venice Italy. During those times, merchants came and went into the docks of Italy for trade, as it was one of the main trade cities in the very busy Mediterranean sea. Due to this, the business model of banking was created, it became an integral part in the trade network where it supplied merchants with the money they would need for their business endeavours.

Nevertheless, lending does not come without risk to the lenders. Risks such as the possibility of ships and boats to sink, leaving assets and money to go down the drain, and also the probability of merchants to run away from their debts. This was why interest payments and collaterals were required to be paid or given by merchants to their creditors as a risk management method. This is where interest payments were strongly practiced, and in turn became well known throughout the busy streets and ports of Italy. These transactions and deals of lending were done in benches, in old Italy it was called “Banco”, and over the years it evolved in what we know now as Banks.

Furthermore, this integration of the banking business model (lending with interests) was only done by the Jewish people who lived in Italy during those times. Why? because Christians in that time period, consider lending money with interest as a mortal sin called “Usury”, while the Jewish doesn’t (as long as they don’t do it with their Jewish brothers and sisters, this means that they can only do this lending with interest to Non-Jewish individuals that time). This is the reason why the Jews dominated the early banking business model.

Unfortunately, there was a downside for the Jews, they were the minority group in Italy. They were seen as sinners in the eyes of the Christians, which in turn pushed them into social exclusion.

Banking during that time was just at its infancy, we could say that it was only like a pawnshop. But infants don’t stay infants forever, they grow strong, wise and independent adults overtime.

The rise of true banking did not come not until the 15th century, in Florence Italy. Thanks to one family that forever changed banking, “The House of Medici”.

Banking Innovations and The House of Medici

Most people today know the strength, power and influence that the Rothschild family have brought into the banking system that we have now. While this is absolutely true, people forget that there is also this one family who brought the banking business model into greater heights, even before the Rothschild came into the picture, and this was the Medici family.

They were so powerful that they were considered to be the behind the scenes, major financiers of The Renaissance period. Do you remember, Leonardo da Vinci, Michaelangelo, Raphael, and Gallileo? The Medici family was said to be the ones who substantially financed these great artists’ endeavours and skill, which resulted to the legendary paintings and sculptures that we have now. Those were just some of the numerous artists that the Medici’s backed with money. That’s how great bankers and capital allocators they were.

How did they gain so much wealth to finance the Renaissance period? They innovated a lot of things, their greatest creation was basically the idea of “Holdings Company”. Plus, they were also able to get around the grey areas of the illegality of lending with interest via the “Bills of Exchange” (Remember what I wrote in this blog’s portion of “History of Lending”? where the Catholic church condemns lending with interest during those times? The Medici family was flexible and found ways around it).

Bills of Exchange (BoE) is like the modern day cheques. A specific type of draft that allows an account owner to order his/her bank to pay a third party on demand. The only difference with the bill of exchange is that one BoE can have a lot of instructions to pay more than one person or entity.

They used this method in international trades and make money from the Currency Exchange Rates. They let someone borrow money from them in a specified currency, with the promise that they will get paid at a later time in the future but in a different currency. The difference in the currency exchange rates were their profits. For example, we borrowed money in USD then promise to pay it after a year but via GBP.

The other way they made money from lending without interest is through “Late Payment Fines”. As what the name implies, they charge a fine to the late payees.

These are the few and most popular ingenious and strategical ways they did to get around the Christian laws of the medieval ages. They made a lot of innovations of making money through banking which I will be sharing in my upcoming blogs.

Below is a photograph of Nathan Mayer Rothschild and Lorenzo de’ Medici, who both substantially changed and impacted banking during their time periods. In my own humble opinion, they are the greatest bankers within their family lineage.

Lorenzo de’ Medici became an influential statesman and ruled Florence Italy, so basically he dabbled into politics. Nonetheless, he was still a magnificent banker of their family.

On the other hand, Nathan Mayer Rothschild was a pure banker and businessman. His cleverness, connection, and skills were top notch. Thanks to him, the Rothschilds secured a position as the preeminent investment bankers in Britain and Europe. His greatest contribution was, he almost single-handedly financed the British government and their war efforts during the Napoleonic wars.

He made a lot of money from that war. One of the ways he did it is through leveraging the price fluctuations/volatility of Bonds during that time. He also managed to maximize the arbitrage of Gold prices from different parts of Europe. An investment banker indeed.

Generally speaking, Nathan Rothschild grabbed the opportunities presented to him during a time of crisis.

How do Banks Make Money?

Traditional banking is a straightforward business model. They gain money through Deposits and Lending. Before I explain how, we first need to understand both Deposit and Lending.

DEPOSITS – Banks are custodian of money, they are the safekeeper of money that have been entrusted to them by their customers. They store money through vaults with large metal doors with locks and codes, just like what most movies portray. This storage of money are called the money reserves of a bank. The question is how do banks entice customers to place their hard earned money with them, what incentivizes people to do so? it’s through savings account with interest. Banks offer savings accounts that ensures an earned simple interest per month or per year.

For instance, a savings account with a 1% Annual Interest Rate. Let’s say you’ve opened an account with a certain bank and placed £3,000 with them. Every year you’ll be earning £30 in return, at the same time you are more certain that the money is safe with banks than other financial non-bank institutions. This incentivize people to place their hard-earned money into banks. This in mind, deposits are then considered as a liability for the banks, because they pay their customers a monthly or yearly interest for their trust to put their money with them.

LENDING – This is where banks make money. See, the deposits that people give to the banks? they lend out a portion of it and collect interest from the people who borrows that money. Basically that’s the gist of it, they receive deposits with a low interest rate that they pay, while lend out that deposit to other with a high interest rate for its loan.

For instance; 1% Annual Interest Rate for their Savings Account, while 10% for their Credit Card Loans. Subtract the two together, 10% – 1% = 9%. The difference is their income, it is specifically called as a bank’s “Interest Income”. This is their income directly from the difference of their loan interest rate income from their deposit interest payment.

Remember that the Deposits are liabilities for banks while Loans are Assets for banks.

COMMISSIONS – This is one of their income stream. This is broad, but generally it is all of their income that is not related to their interest income. Examples are their income from commission of foreign exchange rates, investment management fees, wealth management fees, and banking services fees. This segment is called the “Non-Interest Income”, straightforward isn’t it.

Why Banks are Important in Today’s World?

Banks are the intermediary of money, they take the unused money of savers and hold it in their behalf, while they turn those funds into an active money where society can use it to do stuff which helps the economy. These are the money used for lending to other people who will then utilize it to spur the economy through spending, and/or build businesses. This is why credit has been vital in the growth of the world economy, without it, the world would not achieve the current economic prosperity.

In short, banks are here to spur the economic growth of a country and the world.

Nonetheless, credit is also a double edged sword. For individuals and companies, like most banks, who knows how to leverage credit, It’ll be a positive sum game for them. But, for those who mismanages it, it’ll be most of the time a dreadful and painful experience.

To Sum It Up

Banks have been an essential part of our society, and it has been evolving continuously for more than 8 centuries now. Today, banks are yet again moving forward with technology, like the increasing popularity of the blockchain tech which could be seen as a threat to the dominance of the banking system, most especially with regard to their non-interest income segment. This is not just purely because of the cryptocurrencies, but also because of the Central Bank Digital Currency. This is a direct threat to their business model, because it might remove the need for commercial banks as intermediary, all of the deposits of the people will be and might be given to the Central Banks instead.

Nevertheless, with banks or not, banking will still always be around and essential. I’ll end my blog with a quote from Brett King.

“Banking has to work when and where you need it. The best advice and the best service in financial services happens in real time and is based on customer behaviour, using principles of Big Data, mobility and gamification.”

-Brett King

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.