Article Background:
Anyway, it got me thinking so I came up with a fictional story to describe how the whole thing got started. The purpose of the story is to get us thinking about our banking systems. And maybe get us asking some serious questions about our banks and how they make money. Could our banking systems be flawed? Has the global credit crisis exposed some of these flaws? What do you think?
The First Bank.
Once upon a time there was a man who stored gold in a cave. He locked it up behind a big steel reinforced wooden door. No one could get in without the key. And only he had the key. His name was Theo.
One day a man asked Theo, “I’ve got my gold at home and I’m afraid it may get stolen. Can I store my gold with you for safekeeping?”
Theo thought about it and said, “Sure, why not?” He charged the man a small daily fee for storing his gold. The man’s gold was safe and Theo was making a little money.
Before too long Theo’s cave was virtually full of other people’s gold. He spent a lot of time developing a record keeping system to track ownership of the gold. He earned a handsome profit by holding and protecting other people’s gold. But, it became tedious having to open the cave at all hours when people came by to retrieve their gold. There had to be a better way of doing business.
So, he decided to limit the hours customers could access their gold. He put up a sign saying, “Open from 9 to 4 Monday through Friday.” Theo now had the evenings and weekends off. If customers needed gold after hours, too bad, the cave bank was closed. They would have to wait.
This worked well for a time but then Theo got tired of lifting the heavy gold bars. Always looking for a ways to streamline his service, he pondered on how to get rid of this heavy lifting aspect of the job.
Then Theo had an idea. “I’ll just issue an official looking piece of paper – I’ll call it a note – verifying how much gold a person has stored with me. Then the person only has to carry around the note, not the bulky gold.”
So, his customers started using the notes. Before long, most people accepted the notes as if they were the gold itself. Everyone knew if they went to the cave with the note, Theo would hand over the equivalent gold. Since everyone knew this was the case, fewer and fewer people ever came to see Theo for their gold. The customers seemed to like the notes better too. It was a lot easier for them to carry around notes than it was to carry around a bunch of gold bars.
Then one day Theo accidentally stumbled across a way to make even more money from his “cave bank.” A man came up and asked to borrow some gold. Theo thought about it and asked, “Let me get this straight. You want me to lend you some gold? Now, why would I want to do that?”
“Because in two weeks time, I’ll give you back more gold than you let me borrow. Instead of the gold just sitting there, I’ll pay you to use it.” Replied the man with complete assurance.
Theo thought it sounded too good to be true. “So, if I let you borrow the gold, what do plan to do with it? And, how do I know you’ll pay me back?” he asked.
The man explained his enterprise, “I’m going to use the gold to buy tools to my grain production process more efficient. I’ve run the numbers, and in two weeks I can earn back the gold, pay you interest and make a profit. What do you say?”
“But, I’ll need more than your promise to pay me back. What have you got that I can keep if you don’t pay me back?” Theo wasn’t taking any chances.
The man thought for a moment and then replied, “I’ll sign my house over to you during the time I borrow the money. If I don’t pay you back with interest, you get my house. How can you refuse that deal?”
Theo had the man’s house valued. It was worth 15 times the amount of gold the man wanted to borrow. Theo thought about the deal. He couldn’t think of any downside. So, he instructed his lawyers to draw up the contract. Of course Theo charged the lawyer fees to the man borrowing the money.
Two weeks later the man paid back the gold plus interest plus the lawyer fees. Theo was amazed. “How easy was that? I couldn’t lose. If he didn’t pay me back then I got his house which is worth 15 times the gold I let him borrow!” Now Theo had another way to make money, let people borrow the gold.
At first Theo was only lending his personal gold. But, after a time he began to ask his gold storage customers if he could lend out their gold. He would be very careful to make only good loans; loans that would be paid back. And, he would make sure each loan was secured with tangible property such as a horse, wagon and/or house. That way, if the loan is not repaid, the bank gets property worth more than the borrowed gold. The bank can’t lose.
Theo went on to explain to his customers that they would earn interest on the borrowed gold. The interest would more than cover the rent they were paying to Theo. So, if they let Theo lend out their gold, the customers didn’t have to pay rent anymore and they got paid a small amount of interest. The customers liked this plan. They were more than happy to let Theo lend out their gold.
Of course, Theo didn’t tell them how much he was charging the borrowers for interest, so the bank gold depositors didn’t realize they were only getting a fraction of the interest earned. But, they didn’t care; it was a much better deal now than before when they had to pay to store their gold at Theo’s cave bank.
Theo started to make a lot of money by letting people borrow the gold. Of course the gold never left the cave; he just issued the paper notes. The borrowers preferred the paper notes anyway. That way they didn’t have to carry around those heavy gold bars. Everyone liked it.
After a while, all the gold was on loan.
Theo grew worried as he couldn’t lend more gold. He started thinking about ways to overcome this obstacle. His first idea was to get more people to deposit gold. This worked for a while, but after he got just about everyone to deposit their gold he hit the wall again. What to do? Then one day he discovered the answer. It was so simple. Why didn’t he think of it before?
He discovered the answer when a customer came to him desperately seeking a loan.
“I’m sorry, but we have no more gold left to lend. You’ll have to wait for someone to repay before I can lend you some.” Theo told the pleading customer the bad news.
“But, I must have the loan or they’ll take my house! You’re my last resort.” Replied the begging customer.
Theo felt sorry for the man. So, he thought about it. “Hmm. Let me see. How can I creatively lend this man some gold?” Theo stalled for time. Then, like a flash, the idea came to him. He had the answer.
“Sir, how much gold do you need?” Theo asked the man almost as an order.
The man was startled and surprised, “I thought you said you had no gold left?”
“I just remembered I’ve got some stored in a secret place. I’ll lend you this secret gold. Do you want it or not?” Theo was in charge.
The man left the cave with a paper note for the amount of gold he needed. The deal was done. Banking has never been the same since. Theo was a genius. He discovered the art of making money out of thin air.
Theo watched as the man left. The man left the bank with a spring in his step. He was happy. His home was safe now.
Two weeks later Theo watched again in amazement as the man returned and paid his debt back with interest. Everyone benefited. The bank earned interest and the man used the money to save his house from getting taken away. It was a win-win.
But, somehow Theo was having a challenge coming to terms with what he’d done to make it all happen. Yes, it had a happy ending. Yes, the man saved his home and the bank made money. But it all happened because Theo did something that he’d rather not tell anyone about.
“No one will find out anyway. So, why worry about it?” Theo thought to himself.
Over the next year or so, Theo kept using this “secret” stash of gold and lending to trustworthy and low risk customers. They always paid back and the bank was making a lot of money. After a while, the secret gold became a normal banking practice. He didn’t even call it secret gold anymore. It was just another loan like any other loan.
After a while, the amount of secret gold – which was no longer called secret – was 10 times larger than the normal gold. There was 10 times more lending on the secret stuff than on the regular stuff. And, it made the bank rich. The profits came flying in. Theo was a hero to the bank and the community. Until something happened.
“Get in line mister.” Yelled the man. “We’re all waiting for our gold too. Just wait your turn.”
The line stretched for several blocks. It was a long wait to get to the big wooden door at the cave. Everyone wanted their gold. There was only one problem. Theo had only a fraction of the gold required to pay everyone back. Truth be told, he had only one tenth of the gold required. He could only pay 10% of the people; one in 10 persons would get their gold. He was in big trouble. Everyone was going to find out about his secret gold.
When the people found out about the secret gold, they were furious.
“How could you lend gold you didn’t have? And, then have the audacity to charge interest on it?” Someone shouted.
“If we did that, we’d be arrested!” Another chimed in.
Once the people got over their initial anger, Theo worked a deal where he paid everyone 10% of their gold. That way they all got something up front. Then, he paid them back gradually until the entire debt was paid.
After a time, folks forgot about the bad thing that happened with the secret gold. As a matter of fact, they went back to it. Except this time everybody knew about it and now it was ok. Theo’s bank and other banks were free to lend gold they didn’t have. It was now legal as long as you were a bank.
And they all lived happily ever after!