Alright, settle in. Let's talk about something everyone's familiar with, but few truly understand: banks.
Our economies are utterly reliant on banks. Even Antarctica has ATMs! The word "bank" itself has been buzzing this year, hasn't it?
Banking might seem simple on the surface, but it's constantly and rapidly evolving behind the scenes. The banks of today are a far cry from those of ten, twenty, fifty, or even a hundred years ago. Moreover, different countries, like China and the US, have evolved entirely different banking systems, each shaping its economic landscape and intricately intertwining with its government.
Let's delve into the fundamental rules of this banking game and explore the distinct banking systems that China and the US have cultivated.
The Genesis of Banking
Back in the 11th century, Europe was a hodgepodge of currencies. Merchants would gather on outdoor benches, called "Banco" in Italian, to trade these currencies. Over time, "Banco" morphed into "Bank."
The generally accepted birthplace of the modern bank is 15th century Italy. One bank from that era, Banca Monte dei Paschi di Siena, established in 1472, still operates today. With 551 years under its belt, it's the oldest surviving bank and a significant player, employing over 20,000 people.
These early banks had a crucial distinction from today's commercial banks: they could issue banknotes. These banknotes were used for transactions. In essence, these banks leveraged their credit to print money, much like the ancient Chinese "Qian Zhuang" or Shanxi banks that issued their silver notes.
Having the power to print money didn't mean these banks went on a printing spree. On the contrary, they valued their credit above all else. Why? Because people chose to use their banknotes for transactions based on trust that they could exchange them for gold at any time.
The Evolution of Banking
Eventually, central banks took over the task of printing money, simplifying the banks' business model to three core functions.
First, they acquire money, primarily through deposits. Second, they use this money for lending or investments. Profit is generated from the interest rate differential, often measured by the "Net Interest Margin."
Lastly, they offer financial services like payments, fund trading, and asset management, for which they charge fees. So don't be fooled by banks' dazzling array of products and services; it boils down to moving money around, buying low and selling high, or collecting fees. They are essentially intermediaries, specifically for money.
The Importance of Banks
You might wonder, if they're just intermediaries, why are banks considered so crucial?
Their importance lies in this very intermediation. Let's imagine I, Xiao Lin, am a bubble tea prodigy. Without a bank loan, I'd be stuck working odd jobs to save up, and by the time I could open my dream shop, I'd be old!
However, if a bank recognizes my potential and grants me a loan, I can open my shop sooner. If it's successful, I profit, the bank profits, and people get to enjoy delicious bubble tea.
This is the essence of banking. It's about allocating resources to unlock a society's production and consumption potential. Have you noticed how money seems to spur rapid development in any sector it flows into? It's because the flow of money drives the flow of all other resources.
And who controls the flow of money? While investment firms and hedge funds seem to dominate the headlines, banks are the true giants. When a bank decides to lend to a particular sector, trillions of dollars are mobilized. They may not directly create value, but they indirectly fuel productivity and efficiency, unleashing an economy's full potential.
Therefore, a bank's most significant contribution lies not in attracting deposits, but in disbursing loans. Loans dictate where the money goes. While banks primarily aim to profit from the interest rate differential, they inadvertently activate the entire economy through lending.
Debt as a Measure of Economic Activity
One indicator of a country's debt is the "Private Debt to GDP Ratio." For example, a ratio of 200% indicates that all private debt in a country equals twice its annual GDP. Comparing the 2021 data from the World Bank and IMF reveals a positive correlation: countries with higher private debt ratios tend to have higher GDP per capita.
The US hovers around 220%, Germany at 180%, Japan approximately 250%, and China has risen from under 100% in 1994 to 180% in 2022. This is a broad comparison, and higher debt doesn't automatically translate to a better economy. The efficiency of the financial market and how the money is lent also play critical roles.
Ideally, governments and central banks aim for a system where banks lend to creditworthy individuals and businesses. As long as borrowers can repay, the more loans extended, the better for the economy. This has led countries like the US, with its sophisticated financial system, to push the boundaries. Their focus is on maximizing lending, even if it means the central bank needs to step in to backstop deposits.
Banks and the Creation of Money
Here's a little secret: most money in an economy isn't printed by the central bank, but by commercial banks. Each time a bank issues a loan, it essentially creates new money.
Many finance students are familiar with the "Money Multiplier" theory. Central banks require commercial banks to hold a percentage of their deposits, say 10%, as reserves to ensure liquidity.
For instance, if someone deposits $100, the bank keeps $10 with the central bank and lends out the remaining $90. This money circulates and eventually returns to the bank. They deposit $9 with the central bank and lend out $81, and so forth.
Through this process, the initial $100 becomes $1,000. The bank essentially printed an extra $900. The reserve requirement ratio has a significant impact on the total money supply in an economy.
China's reserve requirement ratio currently stands at 10.75%. In the US? It's zero! This extreme approach is not unique to the US. Europe has a 1% reserve requirement, Japan 0.84%, and Canada, the UK, and Australia have all abolished it. Their message is clear: lend as much as you can, don't let the money sit idle at the central bank.
The reserve requirement ratio has become less relevant in the West. Instead, a metric called the "Capital Adequacy Ratio," based on overall risk, dictates how much liquid assets a bank must hold. But that's a discussion for another time. The takeaway here is that in the US, Europe, and Japan, it's not deposit inflows or reserve requirements that constrain lending; it's the banks' willingness to lend. And this willingness directly influences the amount of money circulating in the economy.
The Double-Edged Sword of Banking
Banks, therefore, are not only intermediaries of resources but also gatekeepers of money supply, making them the central hub of resource allocation. The more extensive and interconnected a sector's reach within an economy, the greater the ripple effect when problems arise. It's like a malfunctioning traffic light at a busy intersection. While it's just one light, its failure throws the entire traffic system into chaos, unlike a regular streetlight going out.
Furthermore, banks are highly cyclical. During economic booms, they readily lend and reap profits. However, when the economy sours, lending dries up, bad debts increase, and banks face difficult times. Looking at the number of bank failures in US history clearly indicates the years of major recessions.
This combination of importance and cyclicality makes banks prone to systemic risks, necessitating government regulation and support.
Regulating banks is a delicate balancing act for governments and regulatory bodies. The goal is to maximize the benefits of banking while minimizing risks. Different countries adopt different approaches to control and guide their banking systems, much like pruning a tree to encourage growth in desired directions. Ultimately, due to varying pruning styles, each country cultivates a unique "tree," its banking system, which in turn shapes its economic model.
Two Trees: China and US Banking Systems
Let's examine two contrasting examples, China and the US, to understand how their banking systems have evolved.
China's banking sector has undergone a dramatic transformation, condensing centuries of evolution into a few decades. Under the planned economy post-1949, intermediaries were unnecessary. The government dictated resource allocation, individuals had limited savings, and businesses rarely sought loans outside the national plan.
While banks existed, their primary role was implementation. Two institutions dominated: the People's Bank of China (PBOC) and the Bank of China. The latter handled foreign exchange and trade, while the PBOC, under the Ministry of Finance, managed everything else, including printing money and theoretically handling commercial banking like deposits and loans for individuals and businesses, though actual activity remained minimal.
With the 1978 reforms and China's shift towards a market economy, the PBOC's role needed reassessment. It gained independence from the Ministry of Finance, assuming responsibility for printing money and monetary policy. Lending shifted to specialized banks, leading to the "Big Four": Industrial and Commercial Bank of China (ICBC), China Construction Bank (CCB), Bank of China (BOC), and Agricultural Bank of China (ABC).
True to their names, each bank had its designated domain. ICBC handled commerce, CCB infrastructure, BOC continued managing foreign exchange, and ABC oversaw agriculture. The government would approach the corresponding bank for any sector-specific needs. They could also participate in the market within their designated areas.
This division of labor brought clarity but stifled competition. None lacked deposits, unlike today's banks vying for customers with gifts and incentives. Loan applications were met with bureaucratic hurdles. While resource allocation existed, efficiency remained a concern. This led to excessive lending and ultimately contributed to the massive bad debts crisis of 1998.
The government realized the need to foster competition and introduced twelve new joint-stock banks, including China Minsheng Bank, China Guangfa Bank, and China Merchants Bank. They also merged numerous small urban and rural credit cooperatives into urban and rural commercial banks. The "Big Four" were pushed to compete in the market, shedding their sector-specific roles. You could now approach the Agricultural Bank for construction loans or the Construction Bank for agricultural loans. They transitioned from specialized banks to state-owned commercial banks.
The "Big Four" expanded to the "Big Six," and policy-related tasks like railway construction and infrastructure development were carved out, leading to the establishment of the China Development Bank, the Agricultural Development Bank of China, and the Export-Import Bank of China. They focused solely on policy-driven lending.
Commercial banks were now responsible for attracting deposits, setting interest rates, and deciding whom to lend to, all within a competitive landscape. However, the original "Big Four" remain dominant. Did you know their asset size ranks them among the top four globally?
Despite introducing market competition, the Chinese government retained its ability to exert precise control through specialized loans. For instance, if the central bank decides to support a particular industry, it can direct the "Big Six" to increase lending to that sector, providing the necessary funds.
This targeted approach, known as "Special Re-lending," has been employed extensively. Recent examples include billions in loans to support the real estate sector, loans for carbon emission reduction, and initiatives in areas like technological innovation, elderly care, and financial inclusion. The ongoing supply-side structural reforms also rely heavily on this mechanism.
This explains why banks occupy a unique and dominant position in China's financial system. Bank assets account for over 85% of the total financial system's assets.
In conclusion, China's banking sector, through half a century of evolution, has developed into a diverse system with state-owned commercial banks at its core, complemented by joint-stock banks, city commercial banks, and private banks.
The American Approach: From Laissez-Faire to Crisis and Back
The US presents a stark contrast, a story of extreme freedom and gradual tightening, eventually resulting in a highly securitized and market-driven banking system.
In the 18th century, after the Revolutionary War, the newly formed United States functioned more like thirteen states loosely collaborating, each printing its own currency with no central bank. Small banks operated within states with minimal government oversight. The system was chaotic, with everyone free to issue banknotes.
By the early 20th century, the US had a staggering 20,000 banks, four times the current number despite having only a quarter of the current population. And almost all of them could print money.
There were attempts to establish a central bank and national banks – the First Bank of the United States and the Second Bank of the United States. However, both were dissolved within twenty years due to resistance from states wary of centralized power. It wasn't until after the Civil War that the US finally unified its currency.
The banking sector remained a free-for-all, plagued by recurring bank runs in 1866, 1893, and 1907. The 1907 panic forced the government to turn to the legendary financier J.P. Morgan, who rallied the entire banking industry to avert disaster.
This prompted the government to realize the need for intervention to prevent future crises. Finally, in 1913, the Federal Reserve (Fed) was established as the central bank.
This marked a shift from extreme freedom to gradual tightening. However, the Great Depression of 1929 brought about the most significant bank run in US history, with 9,000 banks collapsing as people lost faith in the system.
The situation was so dire that President Roosevelt resorted to temporarily shutting down banks to prevent further runs. Following the Great Depression, further reforms led to the creation of the Federal Deposit Insurance Corporation (FDIC), insuring deposits up to $25,000, restoring confidence and discouraging bank runs.
Throughout the 20th century, US banks operated in a relatively relaxed regulatory environment. This, coupled with the well-established securities market (Wall Street has been trading since 1792), allowed businesses to raise capital without relying solely on banks. Bonds, stocks, and later, a vast derivatives market emerged.
For instance, the US mortgage market saw the rise of Fannie Mae and Freddie Mac, packaging mortgages into securities and selling them on the secondary market. This securitization, while not without risks, enabled capital to flow quickly to sectors with the highest potential returns, not just domestically, but globally. This ability to swiftly allocate capital, while commonplace now, was unique to the US.
This fueled the growth of Wall Street banks. In the 1990s and early 2000s, a Wall Street job guaranteed a hefty bonus, often exceeding a million dollars for top performers.
This era of deregulation culminated in the 2008 financial crisis, a complex event largely attributed to excessive lending, leverage, poor risk management, and other contributing factors.
The Aftermath of 2008 and the Future of Banking
The 2008 crisis led to another wave of tightening. The US government passed the Dodd-Frank Act, and central banks globally agreed on the Basel III Accord. These measures aimed to regulate large banks, controlling their size, risk exposure, and business scope. Proprietary trading was restricted, forcing banks to focus on intermediation.
However, not all banks were subjected to the same level of scrutiny. Only those with assets exceeding $500 billion faced strict supervision. In 2018, under pressure from smaller banks, the Trump administration raised the threshold to $2500 billion, exempting numerous mid-sized banks, including Silicon Valley Bank, First Republic Bank, and Signature Bank, from rigorous stress tests.
These three banks collapsed in 2023, becoming the second, third, and fourth largest bank failures in US history. While it's tempting to blame deregulation, these banks had their own internal issues. However, it highlights the vulnerability of banks during economic downturns, especially with the recent erosion of trust in smaller institutions.
The US government, having learned from past crises, responded swiftly and decisively. The FDIC took over Silicon Valley Bank within 48 hours, guaranteeing all deposits. The First Republic Bank situation prompted immediate action, urging a sale to JPMorgan Chase, which acquired the assets at a discount after wiping out all debts.
While this acquisition violates the Dodd-Frank Act's 10% limit on any single bank's share of national deposits (JPMorgan Chase now holds 17.6%), addressing the immediate crisis took precedence over concerns about monopolies and moral hazard. The Swiss government similarly facilitated UBS's acquisition of Credit Suisse.
These emergency measures prioritized stabilizing confidence. Issues like monopolies and excessive guarantees were put on hold. This latest crisis will likely trigger another round of introspection and tightening regulations in the US.
We've focused on the contrasting approaches of China and the US. Japan also presents a unique case, with its Keiretsu system, where massive banks are intertwined with and support their respective conglomerates.
Ultimately, each country adopts its own methods to regulate banks and, by extension, manage its economy. The US follows a cycle of loosening and tightening, driven by the market, while China leans towards policy-driven control over lending.
However, as some countries push the boundaries of their banking systems, it becomes increasingly apparent that excessive credit expansion, money printing, and lowering reserve requirements beyond a certain point leads to diminishing returns...