Credit systems (banking)

The essence of modern banking is that banks do not act anymore as safekeepers of deposits. Instead, when money is “deposited” with a bank, the bank institution becomes the legal owner and is allowed to use the funds for its own purposes (up to certain limits, that will be explained in the legal sub-page). The customer has a legal claim towards the bank to pay money as recorded in an account, according to the arrangement between the customer and the bank (for instance, after a certain time, or on first demand). The customer has no right that is attached to the physical money anymore (provided that he would have deposited physical money in the first place – which is becoming very rare), so if the bank becomes insolvent then his theoretical claim becomes virtually worthless. Banks have become insolvent as long as they have existed – both because of making losses and because of having money tied up in longer term investments that cannot be timely realized to repay panicing customers in a bank run – and because this can have large secondary effects in an economy (certainly in today’s interconnected economy where claims on banks are seen as real money that can be wired to each other to discharge one’s paying obligations), this activity of taking money in return for a reclaimable obligation is subject to strict regulations and authorization requirements.

A bank, who is the legal owner of the amounts of money that are recorded on accounts of customers, can also have other sources of money than from customer’s “deposits”: they can also borrow on the capital markets and so forth. So-called investment banks might in some cases even obtain their money from proprietary trading or from financial or advisory services. From what sources and under what conditions that bank-licensed entities can take money is highly regulated (see the discussion in the subpage). With what activities that banks can get involved with their money in order to make more then they owe to their providers of money, is also highly regulated. Credit to commercial and private entities has been a traditional use to make money that covers the obligations that a bank owes to its sources of money – and to leave a profit margin over. Because of this traditional source of profit, banks are technically called “credit institutions” in European legal parlance. But other uses that generate money are also in use (limited by regulations).