In a world where many of us use bank accounts every day, it’s easy to take money and banking for granted. But what gives money its value, and what roles do different banks play?

To answer that, this article – the third in our Finance 101 series – looks at how money has evolved and explains different types of banks and their distinctive characteristics.

Historically, banks played an important role in storing gold safely. Under the “gold standard”, the value of a country’s currency was tied to a fixed quantity of gold. In theory, every paper bank note could at any point be exchanged for its value in gold.

As economies grew, the amount of money needed to support trade and spending also grew. A country’s supply of money relied on a country’s supply of gold. But when a currency was tied to gold, governments had less flexibility to expand the money supply. This limited their ability to respond to economic downturns and other pressures, making the gold standard increasingly difficult to maintain.

Countries moved away from the gold standard at different times. A major turning point came in 1971, when the United States decided to formally end the gold standard. As a result, foreign central banks could not exchange the US dollar for gold.

Today, most countries use the fiat currency system. A currency’s value is not tied to a fixed amount of gold; instead, it is supported by public confidence and government authority.

That does not mean gold reserves are now useless. Rather, countries still hold gold as a reliable asset and a store of value, although its market price can rise or fall. Furthermore, it is also used to great effect in international trade between countries. Currently, the Bank of England holds more than 400,000 gold bars, in total worth well over £200bn, on behalf of the UK government, commercial banks and other central banks.

There are three main types of bank: central banks, retail/commercial banks and investment banks.

 

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Central banks

A central bank controls a country’s monetary policy and regulates its banking system. It is not a bank for ordinary people. Examples include the European Central Bank (ECB) and the Federal Reserve (Fed). The ECB serves the countries in the European Union that use the euro, while the Fed serves the United States.

Most central banks operate independently from the country’s government, but operate under legal frameworks and work alongside the government to support economic stability.

They usually have a few goals they aim to achieve. The Fed, for example, has a dual mandate, set by Congress: maximum employment and stable prices. For the latter, it targets annual inflation of 2% over the long run.

Retail and commercial banks

Retail banks (also known as consumer or personal banks) provide the high-street services that ordinary people use: current accounts, saving accounts, debit cards, mortgages, personal loans. Commercial banks offer similar services to businesses, such as business accounts, loans and payment services.

Examples in the UK include Barclays, NatWest and Santander, which serve both individuals and businesses. In the US, examples include JP Morgan Chase, Wells Fargo and Bank of America.

They make money mainly from the gap between the interest they pay on deposits and the interest they charge on loans.

Investment banks

Working in an investment bank is a dream for many people working in finance. The industry is often associated with extortionate salaries and bonuses, but many people are less familiar with what an investment bank actually does.