DISCLAIMER: the following is a discussion of principles of banking and Roman jurisprudence. The author is not a qualified lawyer. This post is not intended or offered as a guide to banking or investment at the time of writing or in the future. For current legal advice on the status of different kinds of banking, please consult a qualified lawyer.
I am currently reading a sample of Money, Bank Credit, and Economic Cycles, by Jesus Huerta de Soto, a professor of Applied Economics at King Juan Carlos University, and a Senior Fellow of the Mises Institute. The book is fascinating, exploring the legal, moral, and economic understanding of different kinds of banking through the ages, beginning with an examination of Roman jurisprudence (which forms the basis of the civil law systems of Western Europe and South America). This book is a critique of fractional reserve banking from an Austrian economic point of view.
He begins by making a distinction between deposit banking and loan banking. In deposit banking, which can be split into two subcategories, regular and irregular, the depositary agrees to protect the deposit of the depositor, guaranteeing its availability to the depositor at any time upon request. In the regular version, a specific item is left (e.g. a painting), which can be reclaimed later. In the irregular version, fungible goods (e.g. money) are left, and the depositary guarantees to return, upon request, goods in the same amount of the same quality and value (but not the specific coins originally handed over), referred to in Latin as the tantundem qualitatis et bonitatis. The depositary, in running a business, will sometimes charge for this security and availability service. He must always keep the same amount of the given good as originally deposited, otherwise he will have be found to have misappropriated it. In some law systems, not only would such action give rise to criminal liability, but it would also create a right to interest on the part of the depositor, to compensate him for the time in which he did not have access to the full amount of his deposit.
Loan banking, on the other hand, works quite differently. In this instance, the lender agrees to forego access to an amount of money, for example, for a set term, on the understanding that he will receive the same amount back with additional interest at the end of the term. If the banker fails to meet these terms, he will be in breach of contract (and may be liable for misrepresentation, if he never had the intention of honouring his agreement). The speculative nature of this kind of banking entails a greater kind of risk, since the banker will use the money to generate the both or either capital or income in order to yield interest to the lender. Accordingly, in Roman jurisprudence, in the event of insolvency, depositors ranked higher in priority than creditors, since creditors were deemed to have accepted the risk that their investments might prove fruitless.
There are a number of dangers inherent in the existence of these two systems side-by-side. Firstly, there is the danger that a bank patron will choose the wrong service for his needs, either through ignorance on his part or as the result of miscommunication or deception. A person who thought he was a depositor, when in law he was a creditor, would be very angry in the event of his bank’s insolvency. Secondly, there is the danger that an unscrupulous banker will appropriate money from the deposit for use as a loan in the belief that he will have generated a return to pay back the loss before the depositor asks for his money back.
The latter danger is the essence of fractional reserve banking. A bank that operates in this manner gambles on the probability that at any one time, there will not be a demand for withdrawals that is greater than the sums held on reserve. Such a practice would be considered unethical in Roman jurisprudence, but is mainstream in Western banking today. The problem occurs when just such an unlikely scenario occurs, triggered by fears of bad investments in the commercial world or concerns about mismanagement by company officers or general adverse economic conditions.
In such an event, where a bank cannot meet the demands of its clients, it must be declared insolvent, unless it can be rescued. If the bank is allowed to go insolvent, this will be a great pain to the natural and non-natural persons who have left money with it. There will be some ripples from this as the missing funds will mean that some contracts and plans dependent on them cannot proceed. However, the overall effect will be contained.
How might the bank be “rescued”? Private individuals could try to make up the losses – but few would be willing to do this, and those who did will not be remunerated if their contributions are gifts. If they are loans, there is the possibility that the bank will not be able to repay them. If it does, this may come at someone else’s expense.
If the government decides to shore up the bank, it will have to find money of its own to do this: it can print more money at the central bank; it can take out a loan; it can raise taxes. If the government prints more money, it is likely that this will cause inflation because, chances are, demand for money will not increase proportionately. Inflation decreases the spending power of the national currency, so this measure effectively works out as a tax on citizens. If it also undermines international confidence in the country, this can have an impact on foreign investment.
If the government raises taxes, this imposes an additional burden on taxpayers but also creates further problems. It encourages other banks to behave as recklessly as the example above in the belief that the government will rescue them too. Furthermore, it creates ill feeling among the citizenry, because many will ask why they should have to pay for the misfeasance of others. Thirdly, if corporation tax is increased, this will encourage many businesses to move to countries with a lower rate.
Lastly, there is the loan option. This has the same problems as the tax example above, only the effects are deferred. The loan will eventually have to be repaid, especially if it is owed to a foreign creditor. The more loans the state has to take out, the greater the chance of a fall in confidence, which could encourage people to sell their stockpiles of that nation’s currency, decreasing its purchasing power on the foreign markets.
Given all of the above, one can understand why many would prefer for there to be a clear demarcation between deposit accounts and loan accounts in banks. A bank should maintain a 100% reserve at all times for its deposit accounts and charge a fee for its services (safeguarding, counting, paying bills), since it is doing this as a business. The more people who use the bank, the lower the fee will be, because the bank can make economies of scale. When someone opens an account, they should always have an adviser who explains in simple terms exactly what their options are and what the consequences of these options will be in the event of insolvency. Loan accounts could still be permitted under this scheme, because they are effectively investments. Provided that the risks are explained to the customer before he contracts with the bank, there will be no misrepresentation and he will be deemed to have accepted the risk. It will be fair to let him lose out by not having the government refund him if the investment proves bad. What should not happen, as has in the past, is the mixing of funds from loan and deposit accounts.