There was a time when banks acted as custodians of their customers’ money. Indeed, keeping a person’s money and using it as if it belonged to you without their agreement is fraud in common law. A banking license legally exempts banks from charges of criminality in pursuing the normal course of fractional reserve banking business, by making it clear that you, the customer, agree to being a creditor of the bank instead of the bank acting as custodian for your money.
Modern banking has its roots in England’s Bank Charter Act of 1844, which led to the practice of fractional reserve banking. Fractional reserve banking is defined as making loans and taking in customer deposits in quantities that are multiples of the bank’s own capital. Case law in the wake of the 1844 Act, having more regard to the status quo as established precedent than the fundaments of property law, ruled that irregular deposits (deposits for safekeeping) were no different from a loan. Judge Lord Cottenham’s judgment in Foley v. Hill (1848) 2 HLC 28 is a judicial decision relating to the fundamental nature of a bank which held in effect that:
“The money placed in the custody of the banker is to all intents and purposes, the money of the banker, to do with it as he pleases. He is guilty of no breach of trust in employing it. He is not answerable to the principal if he puts it into jeopardy, if he engages in haphazardous speculation...”i
This was probably the most important legal ruling of the last two centuries. Today, we know of nothing else other than legally confirmed fractional reserve banking. However, sound or honest banking had existed in the centuries before the 1844 Act.
It was probably with sound money and sound banking in mind that Goldmoney recently announced a tie-up with a British-based and regulated peer-to-peer lender, which enables owners of gold and silver bullion to use it as collateral to raise funds.ii The purpose of this article is to explain how honest banking worked before fractional reserve banking was devised. This is the logic behind the recently announced collaboration between Goldmoney and Lend & Borrow Trust Company Ltd. We will start by looking very briefly at the bones of the Goldmoney deal, before going on to explain how banking worked when money was sound, and the serious flaws behind fractional reserve banking.
The Goldmoney – LBT collaboration.
On 23rd May, Goldmoney announced an investment and collaboration in and with the UK-based peer-to-peer lending platform, Lend & Borrow Trust Company Ltd. LBT is unique, being the only peer-to-peer facility in Western financial markets that allows businesses and individuals to use their investment-grade physical bullion as collateral against loans, without the loan obligations and collateral being comingled with other customer business. For example, an individual might have gold stored for him by Goldmoney in an LBMA-recognised vault, and wishes to borrow money against it, utilising it as collateral. LBT’s platform permits lenders and borrowers to agree between themselves – without disclosing their names to each other - the duration and interest rate on loans under an agreement template provided by LBT, which administers the loans. Both the lender and borrower must comply with the terms laid down between them in a standardised LBT agreement.
At no time is LBT a principal in the transaction, so lenders and borrowers can agree an interest rate without having to take LBT’s creditworthiness into account, based solely on physical gold or silver as collateral. Furthermore, LBT is regulated by the Financial Conduct Authority to operate an online electronic system that facilitates peer-to-peer lending.
The logic of a collaboration between Goldmoney and LBT is obvious, in that it enables customers to raise finance using bullion. But there is an underlying sound-money logic as well. Between them, Goldmoney and LBT are the template for sound-money banking as it existed before fractional reserve banking became the standard banking model, after Britain’s Bank Charter Act of 1844.
It should be noted that neither Goldmoney nor LBT operate as banks. Banking licences are granted to banks specifically so they can take customers’ assets onto their balance sheets, exposing them to counterparty risk. In other words, you, the bank customer, become a creditor of the bank. Neither Goldmoney nor LBT have this relationship with their customers, both companies being non-banking regulated financial service providers in their relevant categories and jurisdictions.
The roots of banking
Throughout history, there have been two types of distinctly different financial activity, which today we call banking. The first was the safe storage of monetary deposits on behalf of merchants, safeguarding their money from the day-to-day risks and inconvenience of holding large sums in their possession. The development of coinage, in the form of fungible units of gold and silver, allowed banks to make payments on their customers’ instructions using coins that were not necessarily the original ones deposited. And because the basic business of merchants was transporting goods from one place to another, the ability to make payments drawn against a merchant’s funds became a natural extension of depository banking.
Deposits at the London goldsmiths enabled them to issue notes to their depository customers, representing their specific deposits in whole or part, and these notes began to circulate between merchants in lieu of physical payments. Possession of a depository note was evidence of ownership, and the circulation of these notes became the forerunner of today’s paper money.
The second activity was for a bank, using its own capital or capital it had collected from others specifically for this function, to make loans to farmers and merchants to facilitate the production and delivery of goods. There is an important distinction between holding deposits and lending money, the former was a custodial function, while the latter was loan finance.
Loan finance need not be a banking function. It was more normal for people to borrow money from their masters in Grecian and Roman times, their feudal superiors during the middle ages, or their family and friends. The primary banking function was therefore the custody of money and to expedite its use. But as is always the case with money and trust, the temptation to use deposited money for other purposes without the consent of the owner has recurred throughout the history of banking.
There was the simple fraud, where a banker took customer deposits and lent them out for his own personal gain. The profits made could be substantial, but the risk was a customer might request a large withdrawal that could not be met, and the banker would be found out. Banking fraud became more complex when governments latched on to the potential that banks offered for satisfying their own repeated need for money. Therefore, governments pushed bankers into lending money to the state. They gave bankers privileges, insulating them from the legal consequences of fraudulent conduct. From time to time repeated government bankruptcies caused bankers to reform their behaviour, returning to sound money practices. But this was never to last, the relationship between law-creating governments and the banks they permitted to operate fluctuating between honesty and deceit.
The 1844 Bank Charter Act was the foundation of today’s government-sponsored banking system. The note-issuing facility was gradually transferred from private banks to the Bank of England, which ceased its commercial activities. The Act placed strict controls on the Bank of England’s note issue, requiring every extra pound sterling to be backed by gold.
At that time, the expansion of bank credit was not regarded as an increase in the quantity of money, this only being widely understood by the consensus of monetary economists much later. Consequently, there was no credible challenge to banks issuing credit unbacked by gold, unlike the gold restriction on the Bank of England’s note issues, so sound and unsound money existed side by side with little distinction. Therefore, based on ignorance and precedence, fractional reserve banking became the operational standard for Britain and its empire. Since Britain dominated international trade in the second half of the nineteenth century, it also became the international standard for the world’s banking industry, and remains so to this day.
The important point that has become lost in modern banking is taking deposits is a fundamentally different function from making loans, and for sound-money banking to apply, there must be separation between these two functions, a separation that was lost following the 1844 Act.
Legal versus economic treatment of deposits
The precedent having been created, fractional reserve banking is today incorporated in law in all jurisdictions. Without it, modern economics, grounded on financing both private sector and government debt, could not exist. From an accounting point of view, it means deposits must be included in bank balance sheets as a liability to offset against loans, which are recorded as a bank’s assets. There is no distinction made between a currency deposit, that is one that originates from a note-issuing central bank, and a deposit whose origin is the expansion of bank credit.
Bank credit and customer deposits are therefore inextricably linked for accounting purposes, confirmed by government laws and banking regulation. Depositors are creditors of their bank, and their deposits are at risk. That is undoubtedly the position from a bank’s point of view, but we must also look at it from the depositor’s perspective. The depositor is assumed to be in no doubt where he or she stands in law, but most depositors regard deposits at the bank as their own money, a misconception that the banks and their licensing authorities would rather not challenge. Central banks bail out commercial banks, and governments operate depositor protection schemes for this reason.iii
Regardless whether bail-outs and protection schemes are deliberately designed to mislead the public as to their true position, depositors are generally unaware that their deposits can be used by the bank for anything the bank choses, as ruled in Foley v. Hill, quoted above. They hold the bank responsible for the safe-keeping of their money, which implies the bank must keep it safe and sound, available for instant withdrawal. And here we must make an economic distinction, between a deposit (including cash, current or checking accounts and instant-access deposits) that can be withdrawn at no notice, and a deposit that requires notice for its conditions to be fulfilled.
A deposit that can be withdrawn with no notice is a demand deposit. In modern-day banking law, there is no difference between a demand deposit and a time deposit, except a demand deposit can be withdrawn at any time, while in a time deposit, money is deposited for a specific time. But this was not always the case. The forerunner of the demand deposit was the irregular deposit. Going back to U.S. bank law of the late nineteenth century, an irregular deposit, in the days when physical gold and coin were deposited in a bank was defined as:
“a deposit in which the depositee is not to return the specific money deposited, but he is to return an equal sum to the depositor. In an irregular deposit, money is deposited in a bank for safe keeping, and the depositor receives in its place other money.”iv
The ruling effectively accommodated fungibility. Note the condition of safe keeping and how no time element is involved, the other money being received in this definition available instantaneously. A time deposit is different in these key respects.
There can no doubt that a time deposit is a loan to the bank and the depositor becomes a creditor. The basic conditions are the exchange of money for its present value, in return for its repayment for a future value, usually the sum of principal plus accrued interest agreed at the outset. However, if a deposit has no time-value, it cannot, strictly speaking, fulfil the conditions of a loan, because ownership is not clearly transferred, even though the bank pays overnight rates of interest on a demand deposit. In practice, possession is being confused with ownership.
It is no exaggeration to say that fractional reserve banking relies on duping the public into believing there’s no difference between an irregular (or demand) deposit and a time deposit. It is fundamental to modern banking, which is wholly unsound in this respect. There can be no doubt that if the average bank customer was aware that by depositing money, he is in law making a loan to the bank, he would hesitate. He would probably require some comfort as to the creditworthiness of the bank. From the bank’s point of view, it would be bad for business and at the very least restrict how the bank deploys the depositor’s money.
Does it really matter? Well, yes, particularly when all banks replace their true safekeeping obligations with the law of large numbers, because in the cycle of credit expansion and contraction, those large numbers of public depositors are almost certain to demand their money back from at least some of the banks when credit expansion grinds to a halt.
The return to sound-money banking
The problems faced by central banks have their roots in growing financial instability. Every cycle of bank credit expansion is followed by a bust, and at the present time every successive bust is greater than the last. Since the great financial crisis of 2007-09, the quantities of bank credit have increased massively. This writer estimates a rise in US interest rates of between one and two percent will be enough to trigger the next banking crisis, so large has the burden of debt become.
We can only assume that the return from fractional reserve to sound deposit banking will not be straightforward. Fractional reserve banking is so long established that the path to sound banking is unclear to all levels of the financial and regulatory establishment. Their current solution to the difficulties created is to ban cash, so ordinary citizens will have no alternative to depositing all their money in the banks. This is a stride into the last-chance saloon, and no one in the establishment understands what sound banking is anymore.
The next banking crisis is a tidal certainty, the consequence of the abuse of people’s money, which should be held for safekeeping. But there is unlikely to be an early acceptance that the problem is unsound money and unsound banking. Instead, we can expect an even greater expansion of central bank money to bail out the banks than we have ever seen before. If anything comes out of the next banking crisis, it is unlikely to be sound banking, at least initially.
The true separation of deposit banking from loan business must remain a long-term objective. History tells us it will return, but only after the final discreditation of fractionally reserved banks. Until now, the very few members of the banking public who understand this danger have only been able to stockpile physical gold and silver as the alternative to maintaining balances at the banks.
However, the use of sound money, replacing unsound fiat currency, is gradually becoming a practical alternative to conventional banking. The emerging nations in Asia have populations that never abandoned gold as money. Notably, in populous countries such as India and Indonesia, networks of pawn shops allow savers to finance capital spending using their gold as collateral. These are no longer backwaters in the global economy, and so long as they can resist the movement towards banning cash in favour of fractionalised bank accounts, they will have some protection from the end of the banking system as we know it.
Citizens in the advanced economies are the most exposed to the end of unsound money. They are the owners of the massive deposits that have grown so rapidly since the last financial crisis, being the consequence of the expansion of bank credit and not the accumulation of genuine wealth. The day central banks fail to prevent a global banking crisis is the day their deposits will turn into dust. And when the dust settles, there is a chance the world will return to sound money. It will require for its distribution a banking system based on the separation of safekeeping functions from the arrangement of loan finance.
The tie-up between Goldmoney and LBT is an early step in that direction.
iReported in Jesus Huerta de Soto’s Money, Bank Credit and Economic Cycles, Chapter 3 pp 125.
iiiThe regulatory and accounting distinction between deposits and loans is very different, being the means of delineating creditor rights and precedence in a bank liquidation. It has no bearing on this discourse.
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