Why Do Banks Exist?

Ivan Skladchikov
January 27, 2020
Why do banks exist article featured image

Today, banks are an important part of any adult’s life. Why do we need them? And why do banks still exist? These are two hot topics of modern economics.
To understand the present and predict the future of the banking system, let’s start with some history. 

History Of Banks: Milestones

  • It all might have started in 8000 BC. There is evidence that back then people used to make records of their trades in a log.
  • The prototypes of banks existed in Mesopotamia. In Babylon and some other cities, they used temples to deposit valuable assets, not necessarily money. Temples stored assets for free: the idea was to lend them out for interest and thus make a profit. A farmer could borrow some grain and pay this loan after harvest. There are records of similar banking activities in different parts of the ancient world. The Parthenon and the famous temple of Artemis were wealth storages, too.
  • The first ‘proper’ banks appeared in the Middle Ages. Mainly, they were merchant banks with a focus on crops and the Silk route expeditions. One of the earliest institutions of this kind started in Italy. In fact, the word ‘bank’ has Italian origin and means ‘banco’ (bench). The earliest bankruptcies took place there, too.
  • The time between the 17th and 19th centuries was very important. The basic concepts and principles connected with debts, deposits, etc. were shaped. Our modern system is still built around them.
    In this period, the goldsmiths of London provided their vaults for storing the money and gold of merchants. While these merchants were traveling overseas, the goldsmiths offered their money for loans and charged a commission.
  • Banknotes first appeared as promissory notes. You deposited your money in a bank and they gave you a hand-written note confirming this fact.
  • The banking system we are familiar with developed in the 20th century, after World War II. Many things we still use today, like cash machines or SWIFT network, appeared in this period.
The first ATM installed in 1967 by Barclays in one of its branches in London.
Image source: Shorthand Social

Why Do Banks Exist?

The shortest answer to this question “Why do banks exist?” would be “Banks exist to make money”. So, they are similar to any other business. But why our attitude towards banks is so controversial? Surveys show, that many people don’t trust these institutions and doubt they have their clients’ best interests in mind. Especially, if you ask about ‘banks in general’.

The infographics showing the attitude of respondents to banks.
Image source: Deloitte.

To understand this attitude better, it would be useful to know how the banking system makes money and what its pros and cons are.

Why Do Banks Exist And How Do They Make Money?

The number and variety of financial services a bank offers you may vary, but the core is always the same. Most banks provide:

  • Checking and savings accounts
    You store your money in a bank and receive interest accrued on your account balance regularly. 
  • Various types of loans
    Banks use your money for various loans, including house mortgages. The interest your bank collects on a loan is bigger than the percentage it pays to you. Thus, you have your slice of revenues and your bank pockets the rest. 
  • Money transfer
    If you need to send money to another person or business, located in your country or abroad, you use a bank. It moves your funds and charges a commission for it. The size of this commission may vary, depending on many factors.
  • Currency exchange
    You use banks to buy or sell foreign currencies, and it’s not free. A bank earns money by grabbing a fixed commission, or by setting a special exchange rate. Or both.  
  • Other
    Banks charge a service fee for your credit cards. It may charge a commission for using an ATM. They offer safe deposit boxes for storing your valuables, consult you on different financial issues, etc.

Pros Of Banks 

So far, it looks like the relationship between traditional banks and their customers is mutually beneficial. After all, they make our life easier in more than one way:

  1. Banks make money digital and more convenient to use
    Few people today carry cash in their wallets — almost all of us use credit cards, issued by our banks. It’s more convenient, fast and safe.
  2. Banks make managing your funds easier
    Due to mobile banking apps and online services we can settle our money issues without a visit or even a call to an office. Financial institutions harnessed the power of the internet to streamline many processes.
  3. Banks combine many services in one place
    Whatever you need — a checking or savings account, loan, certificate of deposit — most banks are ready to offer you anything you ask for, if you look like an eligible client.
  4. Banks offer cash deposits
    If you have to deal with large amounts of cash on a daily basis, an old-school bank is the best option for you. It would be safer to deposit this cash in your account instead of keeping it at home.

Cons Of Banks 

The benefits we listed make banks look like a perfect solution for everyone’s financial needs. But these institutions balance their pros with some serious cons. These cons are the main reason why people today don’t trust banks or dislike them.

Why do banks even exist if millions of adults lack access to banking?
The graph showing the number of unbanked people in different countries in 2017.
Image source Forbes Statista
  • High fees. Banks charge fees for everything because they can. The best example is cross-border transfers, with several correspondent banks charging their commission and applying unfavorable exchange rates. As a result, you may be surprised by the percentage you have to pay.
  • Delays
    If you move money within the same bank, it may be ok. But if you send funds abroad or to another bank, it may take up to several business days: such a transfer happens in steps and may involve other banks.
  • Banks are unavailable to some people. To open a bank account you have to provide a set of documents and be attractive as a customer. Today, about 1.7 billion people are unbanked (have no account). They may be too poor to pay for banking services or be located in an area where banks have no presence — for economic or political reasons.
  • Many people think banks triggered the financial crisis of 2008. It’s a controversial issue, but experts agree that big banks played one of the key roles in the subprime mortgage crisis, leading to the economic recession.
  • Banks have control over your personal info. Collecting your data help make you a personalized offer, but a bank is also free to share your info with their partners or government officials.
    Note, that your bank knows a lot about your shopping habits, major life events, travels, earnings, savings, problems, and plans. All this stuff is linked to your real identity and sits in a centralized database you don’t control.

Do We Still Need Banks?

Hopefully, we have answered the question “Why do banks exist?”

Now, let’s think if we still need them.

Ok, we all agree that most people need the services banks to provide them. It’s hard to imagine our daily life without a credit card of a payment app. We want to be able to send money with a click. We need a safe place to store our savings in.

Living without a bank account seems too stressful and challenging. So, why should we break our relationships with banks, even if these institutions cheat on us, occasionally?

Probably, the best answer to this question was given by Bill Gates back in 1994. He stated:

“We need banking, but we don’t need banks anymore”. 

Why blockchain can improve the existing concept of banks
Decentralized and centralized databases compared.
Image source: eLearning Industry

Cryptocurrency vs banks 

In 2009 Satoshi Nakamoto developed the Bitcoin (BTC), the first decentralized digital currency, based on blockchain technology. The primary purpose of this cryptocurrency was to disrupt the centralized financial system that had proved to be dysfunctional. It’s interesting, that Satoshi himself had a negative personal experience with banks. In 2005, they repeatedly denied him an account just because he had no permanent address in the United Kingdom. 

“ I felt like a failure and was humiliated by the banks so I made it my mission to invent something that would enable a common layperson to access money without involving the big banks.” 

As a result, he decided to develop a system that everyone would be able to access. Something like a self-regulating bank without borders and without any trusted central authority to manage customers’ money and data. 

The creation of BTC was just a start. In the 2010s hundreds of cryptocurrency projects appeared, seeking to disrupt the banking system or transform it beyond recognition. The great majority of their developers just made easy money and vanished. Fortunately, there were a few fintech startups that were more about value than hype.
Among the most famous of them are Ripple (XRP) and Stellar (XLM). To know more about them, read this article.

Why with blockchain banks don't have to exist anymore
Blockchain use-cases for banks: from interbank transactions to serving the unbanked.
Image source: Disruptor

Banks and blockchain 

The blockchain technology that makes cryptocurrencies possible is one of the most important topics in today’s financial industry. Many major banks are testing it to move with the times. Among them are JPMorgan, Santander, Bank of England, Bank of America, Citibank and Credit Suisse. The full list is available here.

Using blockchain is able to reduce the cost and increase the speed of transaction processing. It also allows to avoid many errors and eliminate a lot of reconciling work. The most obvious use-cases of blockchain are inter- and intra-bank cross-border transfers, that have always been absurdly expensive, complicated and slow.

Blockchain may look like the future of banking, but adopting the new technology means transforming the current infrastructure and retraining employees. So far, banks have been cautious to accept innovation. Rather, they are forming their blockchain strategy and starting to explore the opportunities it promises. 

Why Do Banks Exist: Conclusion

Will banks create their own cryptocurrencies that will displace Bitcoin and the likes of the market? Or will they disappear as ‘proper’ cryptocurrencies go mainstream? There are different opinions on that. 

Anyway, it would be interesting to watch them try ‘to centralize the decentralized’.

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