Robert Arvanitis wrote this wonderful essay, and gave me permission to reprint it here:
This begins with the historical merchant banks. These were firms that helped fund the Age of Exploration, and grew along with their clients during the Industrial Revolution.
A merchant banker was knowledgeable in one or more lines of business, put his own money into investments, and gathered more investors based on his own reputation. A merchant banker was the finance department for his clients. He not only lent and invested, he advised on markets, delivered correspondent services, knew the broader economy, and participated in the risks.
That was a lot of hard work, and a lot of sincere risk taking, and the merchant bankers were well-respected.
As banks grew, they drifted from their client focus. Commercial banks took retail deposits and lent more on credit analysis and less on a partnership perspective. Loans were still on the banks’ balance sheets, so they were at risk for defaults as well as liquidity, not the depositors. This meant that commercial banks needed ever-increasing capital to support those risks.
Meanwhile, as government grew, it had a baleful impact on banking. Government imposed increasing regulation, it set ever more complex tax schemes, and it used capital markets for its own deficit financing. The classic “elephant in the bath tub” of economic distortions.