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BirdsEye View

the role of banks in the economy

 Yuval Noah Harari wrote a fascinating book titled Sapiens Interestingly, the book talks about the importance of a banking system in economic development.  I thought his description was spot on, and can help any banker get a deeper understanding of the critical role banks play in any strong economy.

Our industry hasn’t done a great job explaining the crucial role we play in any economic development, both by facilitating the flow of funds from over-funded areas to those who need funds as well as by creating a multiplier effect that ripples through communities to expand individual wealth and help grow businesses which, in turn, create jobs.

Here is an example the book offers.

A contractor finishes his first big job, receiving payment in cash of $1 million.  He deposits the sum in the bank. The bank now has $1 million in capital.

In the meantime, an aspiring baker sees an opportunity to fill a void in a part of town that doesn’t have a bakery.  But the chef doesn’t have enough money to buy the equipment needed to launch the venture or renovate the space needed to produce the baked goods.  The baker goes to the bank, presents their business plan to the bank, and requests a loan to fund the enterprise.  The banker lends the necessary funds to the baker, $1 million.

The baker now hires the contractor to build the bakery.  His price for the construction is $1 million.  When he gets paid, the contractor again deposits the amount in the bank.

The bank now has $1 million in its safe ($1 million is on loan to the baker, which now has been paid to the contractor, and $1 million is in the bank, deposited by the contractor), and the contractor has $2 million in their account.  

The project experiences delays and cost overruns to the tune of an additional $1 million.  The baker borrows another $1 million from the bank and pays the contractor.  At this point the contractor has $3 million in the bank, and the bank still has a $1 million in their vault.

I’m sure you can see the multiplier effect at work here.  The bank facilitated the flow of funds from the contractor to the baker and then again back to the contractor, while funding both businesses.  These businesses, in turn, hire employees to get the work done, and pay them wages.  These wages go to buy goods and services for the employees and their families, which, in turn, create revenue for other businesses and additional deposits at the bank of those monies that have not been spent.

Current capital requirements allow banks to leverage a dollar of deposits more than 10 times.  In other words, the contractor could have up to $10 million in their account even though the bank still has only $1 million in the safe.  This is the multiplier effect in a nutshell.

Money has always been a key factor in economic growth, because it can be converted into all manner of goods and services.  Before the modern era it was very difficult to finance new enterprises, because there was no universally accepted currency, and there were no institutions that could fund new businesses or general purchases.  This imposed extreme limitations on growth.  One could only grow their wealth through their self-funded means.  The wealthy remained wealthy, and the poor, no matter how industrious or creative, could not find ways to finance their visions and make them come true.

Banks changed all that by creating and offering credit to a far broader audience than ever before.  In the past, credit was available, essentially only to those who really didn’t need it, but was not often used.  Economic reality was that wealth is finite and dwindling (as most wealthy people inherited their wealth and were consuming it without accreting meaningfully to their legacy), and therefore providing credit is a high-risk proposition.  Only the very rich, or people with clear economic propositions (such as merchant seamen) could obtain credit.  Major economic expansion by ordinary people through industry and wisdom couldn’t take place.  In past centuries, when credit was limited, so was new business formation, which resulted in general pessimism regarding business formation in general.  

If you think about it, credit is the difference between the current size of the economy and future economic expansion.  Assuming that individuals and companies will generate more earnings using the credit, and will therefore be able to repay it in the future, is the prerequisite to credit availability.  

Several factors converged to change the negative expectation about future earnings and ability to repay.

As science evolved and discoveries increased, so did the sum total of human production and wealth.  Innovation yielded efficiencies and broke old paradigms, including trade routes, transportation times and new product development.  As trust in a better future (and ability to repay) grew, so did credit availability and extension.  Banks were created, and, through them, idle funds were put to work.

This theory sounds reasonable, but it is still a theory.  Visiting countries which didn’t have strong banking systems showed me how true this theory is, and how little appreciation we have for the importance of our industry in creating individual wealth, jobs and overall R&D investments to improve all our lives.

The first time I visited Russia I was struck by the absence of locally-owned businesses and brands.  Most foreign luxury brands were present, but there were no locally owned cafes, clothing stores, convenience stores etc.  Jeans weren’t commonly seen on local people, and a dour atmosphere seemed to prevail.  The only locally own department store was G.U.M.  I was stunned when we returned a decade later to find a bustling local economy, where people would sip their coffee (or vodka) at street cafes at midnight, local brands for convenience store chains, clothing and restaurants were abound, and the overall feel of the place changed dramatically.  You already know what changed – the availability of credit dramatically broadened.

Similarly, we visited Bhutan, ostensibly the happiest place on earth.  This unique kingdom, 700,000 people strong, is nestled in the Himalayas.  It is an amazing place in many ways.  People are content, largely tilling their land and working extremely hard for meager returns. The first time we visited, there were no tall buildings in Bhutan.  Construction was limited to the local community gathering to help build a new house, made from tamped mud.  The women would tamp the mud while singing soft songs, and the men would use wood beams to build the frame.  It was a beautiful sight.  There was much commerce but no banks.  Commerce was barter-based as well as currency-based, and the King also supported the citizens financially on occasion.  When we visited we minimally used currency, and there were no ATMs or banks to be seen.  We had a similar experience in Myanmar.

Returning after a few years to both places was a stunning experience.  In Myanmar, ATMs, banks, buildings, stores etc. sprouted everywhere, as a banking system was stood up.  In Bhutan, the country was opened to tourism and, with it, foreign investment.  So, while locals still couldn’t get out of their poverty trap, new jobs were created by the inflow of foreign money into the land, and, with it, more jobs, alternative careers, and even the prospect of owning your own travel agency could become a reality.

These, as well as many other places I visited over the years, showed me how important our industry is to the well-being of a country and a community.  It’s not just the number of hours we donate to Habitat for Humanity or other excellent causes, not the fund-raising we do for United Way and other charities.  It is the very business we engage in that fuels economic prosperity, gives people credit to realize their dreams and improve their lives every day.  Without credit most of us couldn’t buy cars, dine out as often as we do, go on vacations, start businesses etc.  Credit removes many of the limitations society had in the past on improving one’s life and creating opportunities for many others through business formation.

As an industry, we didn’t tell our story well.  We should do so at every opportunity. Our business is making people’s dreams come true.  Banking is a noble profession, and we should never forget it.