Conventional banking

What Is Conventional Banking?

Conventional banking refers to the traditional operations of financial institutions that primarily accept deposits from the public and use these funds to provide loans. It forms a core component of the broader financial services sector, serving as an intermediary between savers and borrowers. These institutions are typically profit-making entities, generating income from the difference between the interest earned on loans and the interest paid on deposits. Conventional banking is what most people visualize when they think of a "bank," often involving physical branch locations alongside digital platforms.

History and Origin

The roots of banking can be traced back to ancient civilizations, with early forms involving merchants in Mesopotamia around 2000 BCE, who provided grain loans to farmers and traders²⁶, ²⁷. Temples in ancient Greece and Rome later expanded these activities, accepting deposits and exchanging currency, effectively serving as the earliest banks²⁵. The emergence of modern banking practices is often attributed to medieval and Renaissance Italy, particularly in cities like Florence, Venice, and Genoa, where merchant families like the Medicis established sophisticated banking operations²⁴.

The formalization of banking spread throughout Europe, with significant innovations occurring in Amsterdam during the 17th century and London in the 18th century²³. In the United States, the first commercial bank, the Bank of North America, was established in Philadelphia on January 7, 1782, following the American Revolutionary War to help stabilize the fledgling nation's finances²¹, ²². This institution played a crucial role in supporting economic growth by providing loans to both public and private sectors¹⁹, ²⁰. The 19th and early 20th centuries saw the expansion of state-chartered banks and the eventual creation of the Federal Reserve System in 1913, which aimed to bring greater stability to the financial system after a series of panics¹⁷, ¹⁸. A critical development came with the Banking Act of 1933, enacted during the Great Depression, which established the Federal Deposit Insurance Corporation (FDIC) to insure deposits and restore public confidence in banks.¹⁵, ¹⁶.

Key Takeaways

• Conventional banking primarily involves accepting deposits and extending loans to individuals, businesses, and governments.
• Banks earn profit from the interest rate differential between loans and deposits.
• Key functions include facilitating payments, offering wealth management services, and providing safe custody for valuables.
• The industry is heavily regulated to ensure financial stability and protect consumers.
• Conventional banking constantly evolves, integrating technology to offer services through various channels while maintaining its core purpose.

Interpreting Conventional Banking

In practice, conventional banking is interpreted through the range of services it provides and its adherence to regulatory standards. For individual consumers, it represents a secure place to save money, access funds through checking and savings accounts, and obtain consumer loans like mortgages or auto loans. For businesses, conventional banking offers essential services such as commercial loans, credit lines, and cash management solutions vital for operations and expansion¹⁴.

The health and stability of conventional banking institutions are often evaluated by regulatory bodies and market participants through metrics such as capital requirements, asset quality, management effectiveness, earnings stability, and liquidity. These measures provide insights into a bank's capacity to withstand economic shocks and fulfill its role in the economy.

Hypothetical Example

Imagine Sarah, a small business owner, needs to purchase new equipment for her catering company. She approaches her local conventional bank, "First Community Bank," where she has maintained a checking account and a savings account for years.

First Community Bank reviews Sarah's business plan, her financial history, and the collateral she can offer. Based on their assessment, the bank approves a five-year, $50,000 business loan with a fixed interest rate. Sarah uses the funds to buy the equipment, which helps her expand her catering services and increase her revenue. The bank earns interest on the loan, while Sarah benefits from the capital infusion needed for her business growth. This transaction exemplifies the fundamental role of conventional banking in facilitating economic activity by allocating capital.

Practical Applications

Conventional banking is deeply integrated into the daily lives of individuals and the operations of businesses. Its practical applications are extensive:

• Retail Banking: Provides services to individual consumers, including checking accounts, savings accounts, credit cards, mortgages, and personal loans. These services enable individuals to manage their money, save for the future, and finance significant purchases.
• Commercial Lending: Offers a range of loan products and financial solutions to small and medium-sized businesses, and large corporations. This includes working capital loans, equipment financing, and real estate loans, which are crucial for business operations, expansion, and job creation¹², ¹³.
• Payment Systems: Facilitates various payment methods, from traditional checks and debit cards to modern electronic fund transfers and online bill payments¹¹. This ensures smooth transactions within the economy.
• Wealth Management: Many conventional banks offer wealth management services, assisting clients with investments, financial planning, and retirement planning¹⁰.
• Trade Finance: Supports international trade through services like letters of credit and foreign exchange, enabling businesses to conduct transactions across borders.

Regulatory frameworks, such as the Basel Accords, play a crucial role in ensuring that banks maintain adequate capital reserves and manage risk effectively, thereby contributing to the stability of the global financial system. The Basel III framework, for instance, introduced measures to strengthen bank capital, liquidity, and leverage ratios, particularly in response to the 2008 financial crisis.⁹.

Limitations and Criticisms

While conventional banking is vital for economic function, it faces several limitations and criticisms:

• Risk Exposure: Banks are inherently exposed to various risks, including credit risk (borrowers defaulting), liquidity risk (inability to meet short-term obligations), and operational risk. Systemic risks, where the failure of one institution could trigger a cascade, have led to calls for stringent financial regulation⁷, ⁸. The 2008 financial crisis highlighted how interconnected the global banking system is, leading to widespread economic disruption when the US housing market collapsed..
• Regulatory Burden: Post-crisis regulations, such as the Dodd-Frank Act in the United States and the Basel Accords internationally, have significantly increased the regulatory burden on conventional banks. While intended to enhance stability, some argue that these regulations can constrain lending and economic growth⁶.
• Technological Lag: Historically, conventional banks have been slower to adopt new technologies compared to FinTech firms, potentially leading to less efficient services or higher operating costs⁵. This has spurred a race to modernize, but legacy systems can be a hindrance.
• Access and Inclusion: Traditional banking models, with physical branches and stricter credit criteria, may limit access for underserved populations or small businesses, raising concerns about financial inclusion.

These limitations underscore the ongoing challenge for conventional banking to balance profitability, risk management, and its role as a public utility within a dynamic economic landscape.

Conventional Banking vs. Digital Banking

Conventional banking is often contrasted with digital banking, although the lines between the two are increasingly blurred.

While conventional banking originated with physical presence and direct human interaction, the evolution of payment systems and the rise of the internet have pushed conventional banks to integrate digital services extensively. Today, most large conventional banks offer comprehensive online and mobile banking platforms, blurring the distinction with purely digital or "neobanks." However, conventional banks often retain a wider array of services, including complex investment banking or specialized corporate finance, and a more extensive physical footprint.

FAQs

What are the main services offered by a conventional bank?

A conventional bank typically offers deposit accounts (checking, savings, certificates of deposit), various types of loans (personal loans, mortgages, auto loans, business loans), credit cards, debit cards, money transfers, and often safe deposit boxes. Many also provide wealth management and investment services.

Is my money safe in a conventional bank?

In many countries, deposits in conventional banks are insured by government agencies up to a certain limit. For example, in the United States, the Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000 per depositor, per insured bank, for each ownership category. This protection helps maintain public confidence and prevents bank runs.³, ⁴.

How do conventional banks make money?

Conventional banks primarily make money through net interest margin, which is the difference between the interest they earn on the loans they issue and the interest they pay on the deposits they receive. They also generate income from various fees for services, such as overdraft fees, ATM fees, and account maintenance charges.

What is the role of regulation in conventional banking?

Regulation in conventional banking aims to ensure the safety and soundness of individual banks and the stability of the entire financial system. Regulators establish rules for risk management, capital adequacy, consumer protection, and anti-money laundering. Key international regulatory frameworks include the Basel Accords, which set global standards for bank capital and liquidity.¹, ².