Definition
Banking is the practice of accepting deposits and issuing notes or loans, which together substitute paper claims for the actual gold and silver that would otherwise be needed for transactions. Smith devotes a long topic to the Scottish banks of his day, treating banking as one of the great productive institutions when properly disciplined and as a source of recurring crises when not.
The core trick is that depositors do not all withdraw at once. A bank can hold a small reserve of specie and use the rest to lend, so the same metal supports several times its volume in active credit. The economy gains the productive use of capital that would otherwise lie idle.
Why it matters
How it works
In Smith's account, when a bank lends a merchant a bill of credit, the merchant pays workers and suppliers with it; those parties either deposit the bill at the bank or spend it onward, so the same bill circulates many times. The bank earns interest on the loan, the merchant gets working capital, the workers get wages, and the underlying gold sits quietly in the vault. The system creates real economic activity from what would otherwise be inert metal.
The fragility is also structural. If depositors lose confidence and demand specie, the bank cannot redeem all the claims at once. The crisis that follows is not a calculation error; it is the inevitable other face of the same mechanism that produced the prosperity. Smith's prescription is prudential — banks must lend only against real, short-term commercial bills (the "real bills doctrine"), maintain ample reserves, and submit to a regime of prompt convertibility. These rules limit the upside in good times in exchange for surviving the inevitable bad ones.
The modern banking system runs on the same arithmetic. Fractional reserves, central-bank backstops, deposit insurance, and capital requirements are all later inventions designed to address the failure mode Smith identified — the same mechanism that creates credit also creates runs. Every bank crisis in the centuries since fits the pattern he laid out.