We continue our journey through the evolution of banking with the rise of the clearinghouse association. First, let’s review the evolution of economic development thus far. Imagine a world of scarcity where we have instantiated agents. These agents own property and take action according to their preferences. As agents interact, direct (barter) exchange arises. Each agent trades some good or goods that he owns for some other good or goods that he or she values more than the item or bundle given up. In each exchange, agents pays only as much for a good or goods as they are willing. Sometimes, a good desired by an agent can only be acquired by multiple exchanges. Imagine that agent A owns an apple, agent B owns an orange, and agent C owns an avocado. Agent A is willing to trade her apple for an avocado, but agent C will only trade her avocado for an orange. It just so happens that Agent B would like to trade his orange for an apple. Agent A, sensing an opportunity to attain her desired end, trades her apple for agent B’s orange. Then she trades the orange for an avocado. This is indirect exchange. Over time, some types of commodities, say oats, come into use for indirect exchange. The commodity used for indirect exchange comes to gain value for its use in indirect exchange. This value is its exchange value.
Eventually, one or several of these moneys comes to dominate markets of indirect exchange. Money has developed whose price tends to reflect its supply and demand. One interesting feature of a commodity money is that its quantity is, in the long run, dependent on its supply and demand. If money becomes dearer due to an increase in demand for it, its price will rise and thereby increase the quantity of money supplied. A fall in demand will allow the quantity supplied in a given time period to fall. Thus, the quantity of money stock is self-regulated with respect to changes in demand.
Commodity moneys are costly for agents carry. If the commodity money is not standardized, it may be difficult to measure. If it is heavy, like gold or silver, it may be costly, or even dangerous, to carry on one’s person. Owing, at least in part, to these reasons, agents find that they benefit from leaving their money entrusted to a third party at a secure location. The agent will likely receive a deposit slip in exchange which can be used as money. Thus we have the emergence of fiduciary currency. Eventually, the agent or firm entrusted with the gold realize that they might profit from lending out some portion of the existing deposits. This allows the latent media to earn a return. This return allows the agent or firm to pay interest on deposits. The cost of holding gold is no longer borne by the agent who owns the commodity. Fractional-reserve banking is born.
Any bank in operation chooses to keep on hand some commodities whose value is equal to a portion of its reserves. This is needed in the case that some depositors want to immediately withdraw their currency from the bank. If too many depositors attempt to withdraw from the bank simultaneously, the bank may risk being unable to make a repayment. Absent any institution designed to aid the bank in such a crisis, the bank will have to borrow from another bank in order to stave off hysteria. Of course, if no other bank is willing to lend to the bank, it will have to close until it can acquire the funds. This option is a last resort as it will certainly attract the attention of risk-averse depositors. Bankers realize that they have incentive to minimize the occurrence of this scenario as a wave of collapses may have repercussions for the entire economy. It so happens that a clearinghouse association is an organization in prime position to provide stability during a run.
A clearinghouse is the location at which multiple banks may hold some of their reserves and keep their records. By holding their reserves and records at a common location, banks can clear debits and credits between one another and use the reserves on hand to pay remaining debts between one another. The clearinghouse is also a nexus for information concerning the creditworthiness of borrowers, thus serving a role in risk mitigation. The clearinghouse might also mitigate risk by producing temporary currency during a crisis. The clearinghouse has plenty of reserves on hand. During a crisis the clearinghouse, ostensibly drawing from these reserves, can lend out emergency currency. This emergency currency allows banks that consider themselves to be at risk and that the clearinghouse deems to be only illiquid - not insolvent - to build up their reserves without depleting the supply of available credit. Since credit is employed predominantly for business, a net decrease in available credit typically diminishes the level of future production, and consequently, real income. Likewise, a collapse in the credit markets leads to a collapse in production until the collapse reverses (assuming it reverses). A wave of banking failures, like the one that occurred during the Great Depression, can turn an economic recession into a depression. For the sake of self-preservation, the clearinghouse has incentive to prevent such an extreme crisis.
Given the risk of a credit crisis, the clearinghouse also takes on a proactive role in regulating the positions of its member banks. If may, at random or on the suspicion of a bank’s malhealth, withdraw a large amount of funds from a member bank in order to test its capacity to handle adverse clearings. This serves to discourage excessive risk taking by member banks and represents yet another means of promoting the stability within the system.
Having mechanisms that promote stability does not suggest that the system is itself perfect. Every system has bugs. There will always be some banks that take on excessive risk. There will always be failures. Irresponsible banks must fail or else they corrupt the whole system. The significance of the clearinghouse system is not that it prevents any instability, but that it places bounds on that instability. Regulation and stability are themselves properties of the system as entrepreneurs earn profit by finding ways to mitigate risk.