Many banking functions such as safeguarding funds, lending, guaranteeing loans, and exchanging money can be traced to the early days of recorded history. In medieval times the Knights Templar, an international military and religious order, not only stored valuables and granted loans but also arranged for the transfer of funds from one country to another. The great banking families of the Renaissance, such as the Medici in Florence, were involved in lending money and financing international trade. The first modern banks were established in the 17th century, notably the Riksbank in Sweden (1656) and the Bank of England (1694).
In the 17th century, English goldsmiths provided the model for contemporary banking. Gold was stored with these artisans for safe keeping, and was expected to be returned to the owners on demand. The goldsmiths soon discovered that the amount of gold actually removed by owners was only a fraction of the total stored. Thus, they could temporarily lend out some of this gold to others, obtaining a promissory note for principal and interest. In time, paper certificates redeemable in gold coin were circulated instead of gold. Consequently, the total value of these banknotes in circulation exceeded the value of the gold that was exchangeable for the notes.
Two characteristics of this fractional-reserve banking remain the basis for present-day operations. First, the banking system’s monetary liabilities exceed its reserves. This feature was responsible in part for Western industrialization, and it still remains important for economic expansion, though a risk of creating too much money is a rise in inflation. Second, liabilities of the banks (deposits and borrowed money) are more liquid—that is, more readily convertible to cash—than are the assets (loans and investments) included on the banks’ balance sheets. This characteristic enables consumers, businesses, and governments to finance activities that otherwise would be deferred or cancelled; at the same time, it opens banks to the risk of a liquidity crisis. When depositors en masse request payment, the inability of a bank to respond because it lacks sufficient liquidity means that it must either renege on its promises to pay or pay until it fails. A key role of the central bank in most countries is to regulate the commercial banking sector to minimize the likelihood of a run on a bank, which could undermine the entire banking system. The central bank will often stand prepared to act as lender of last resort to the banking system to provide the necessary liquidity in the event of a widespread withdrawal of funds. This does not equal a permanent safety net to save any bank from collapse, as was demonstrated by the Bank of England’s refusal to rescue the failed investment bank Barings in 1995.