Capitalism Resources

Banking

In a capitalist economy, banks facilitate and foster economic activity. Like money, banks existed before capitalism, but only perform their vital functions fully and best under a system of individual rights and capitalism.

A bank is simply a business that provides financial services for its clients. The earliest banks began as warehouses for gold deposits, which could be relied upon to store and protect an individual's assets. These warehouses issued receipts to depositors for their gold. Over time, these deposit receipts circulated as a stand-in for actual currency. Since the receipts—which in legal form were a contract for storage and disbursement of the gold—could be taken to the warehouse and exchanged for gold, they served as a convenient circulating currency.

As banking became more sophisticated, the gold warehouses undertook to make loans at interest from their gold deposits. In return for the risk incurred by the depositor as well as the inconvenience of not having immediate access to his gold on demand, the gold on deposit would earn interest. Banking thus served a specialized role in a division of labor economy. Productive individuals with large capital reserves might wish to lend some of their money at interest, and entrepreneurial individuals with new ideas might require borrowing capital to start their businesses. The interaction of these parties might take place on an individual basis in a free economy to the extent that strangers might be able to gauge the risk of new ventures and to the extent that strangers can persuade others to offer them capital for untried ideas. The banking business serves as a specialized actor in this regard, taking on the burden of making all the decisions about risk and cost, thereby leaving entrepreneurs and capitalists to remain specialized at their own occupations.

By balancing the rates of interest and taking into account the other costs of operating a bank, the managers of a bank earn a return—a profit—by successfully operating their enterprise. In a capitalist economy, banks compete for customers just as any other business does, by offering the best products (credit products, stable and dependable currency, etc.).

Under a capitalist system, just as the supply and use of money would be determined by the market, so too would the size, complexity, and operations of the banking industry. In such a system, a central bank that directs interest rates and currency policy by legislative authority would be as strange to us as a central automotive agency that directed the production of automobiles by legally controlling how many auto makers could exist, what types of cars they made, what color they would be, and the prices they could charge. In a free banking system, which largely existed in the United States in the years prior to the Civil War, banks operated in the same manner as other businesses. To the extent that they offer economic value to those to whom they offer their products, they succeed. To the extent that they mismanage depositors' assets or overextend their loan portfolio, they fail.