Friday, March 29, 2013

Fractional Reserve Banking: Is it Fraud?

I will begin with my answer: maybe.  It depends on the contract.  Allow me to explain….
Fractional reserve banking is labeled by some as a fraudulent practice.  Murray Rothbard devotes a chapter to this in his book, “The Mystery of Banking.”

First, it is appropriate to define the term fraud.  I offer the following definitions from three different sources; the first from a common dictionary, and the latter two from two different law dictionaries:

Fraud: deceit, trickery, sharp practice, or breach of confidence, perpetrated for profit or to gain some unfair or dishonest advantage.

Fraud: A false representation of a matter of fact—whether by words or by conduct, by false or misleading allegations, or by concealment of what should have been disclosed—that deceives and is intended to deceive another so that the individual will act upon it to her or his legal injury.

Fraud: the intentional use of deceit, a trick or some dishonest means to deprive another of his/her/its money, property or a legal right…. Inherent in fraud is an unjust advantage over another which injures that person or entity.

Fraud is a difficult term to apply to real-world situations – one of those “I will know it when I see it” terms.  I will offer what I see.  I would like to examine the application of the term “fraud” to various aspects of money and banking.

It is also helpful to define what is meant by fractional reserve banking:

Fractional-reserve banking is the practice whereby a bank retains funds equal to only a portion of the amount of its customers' deposits as readily available reserves (currency on hand at the bank plus deposit accounts for that bank at the central bank) from which to satisfy demands for payment. The remainder of customer-deposited funds is used to fund investments or loans that the bank makes to other customers.

Fair enough.  Now, is it fraud?  I offer three cases to assist in answering this:

Case 1

Let’s start with what began as deposit banking:

I take one ounce of your gold in deposit and provide a receipt for your gold.  I will hold your gold for you in storage.  I will charge you a fee to do so.  I will deliver your gold upon demand and presentation of the valid receipt. 

Assuming I do exactly as I state – warehouse your gold for you – there is clearly no fraud. 

However, as warehouse operator, I decide to surreptitiously make a little extra income on the side.  Without changing any of the terms of our agreement, thus leaving you in the dark, I change my action:

I then lend out some of your gold, in order to make an additional profit.  I hope that I am able to meet your withdrawal demands.

This, to me, is the cleanest example of fractional reserve banking.  Is there a fraud here?  It seems to me that whether or not I am always successful in meeting withdrawal demand, there is a fraud.  The clearest issue is that I am charging you for a service that I am not performing.  A secondary issue is that there are two receipts for the same good, providing each receipt holder with the belief that he has immediate claim on the goods.

Case 2

In this case, consider the following terms:

I take one ounce of your gold in deposit and provide a receipt for your gold.  I do not charge you a storage fee; I may or may not pay you interest on your deposit.  I give you a receipt stating that I will deliver to you an ounce of gold upon demand and presentation of the valid receipt. 

Note: I do not state I will store your gold.  I charge you no fee for storage.  In fact, I even find a way to pay you interest on your gold.  This seems to me to be a perfectly valid arrangement, to the extent there are willing participants.

Within the confines of our agreement, I find a contractually-acceptable way to make a little extra income on the side:

I then lend out some of your gold, in order to make an additional profit.  I hope that I am able to meet your withdrawal demands.

Is there fraud here?  I never said I would store your gold, and I do not charge you in any case.  Are there two receipts for the same gold?  Yes, but the receipts have conditional claims.  My receipt to the depositor is clear that I am not storing the gold.  As long as the receipts were properly noted, I see no fraud here.

Case 3

Let’s go one step further:

I take one ounce of your gold in deposit.  I do not charge you a storage fee, although there may be other administrative fees associated with your account; I may or may not pay you interest on your deposit.  As reflected in our contract, the gold becomes part of my capital base, allowing me to do with it what I will.  I offer you a receipt stating that I will make best efforts to return an ounce of gold to you upon demand and presentation of the valid receipt. 

This also could be a valid arrangement, given willing participants.  Again, within the terms of our agreement, I utilize this capital to make additional income on the side:

I then lend out some of my gold (as it is now part of my capital base) in order to make an additional profit.  I hope that I am able to meet your withdrawal demands.

Again, there is no fraud here.  There certainly are not two claims on the same gold – the gold is mine, not yours, at least in terms of priority.

Case 3 describes, in very basic terms, the current banking system.  The end of deposit banking came through a few court decisions in England in the early 1800s.  To make a long story short, it was ruled that deposits made at the bank became property of the bank; the bank is bound to pay a similar amount in return when demanded.  From Lord Cottenham’s decision in the ultimate case, decided in 1848.  From Murray Rothbard, “The Mystery of Banking”:

The money placed in the custody of a 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 a hazardous speculation; he is not bound to keep it or deal with it as the property of his principal; but he is, of course, answerable for the amount, because he has contracted.

One doesn’t have to like the decision, but law in regards to deposit banking seems to have been built on this foundation ever since.  What is interesting to me is why traditional deposit banks did not immediately spring up again, in a different form.  I guess, to say it differently, why have not / cannot private contracts reestablish such a practice?

What are some common objections to these observations?

There are two or more receipts for the same ounce of gold / it is counterfeiting.

Case 1: This is essentially correct.

Case 2: I suggest not.  There are two receipts, but the receipts are conditional.  My receipt to you, the depositor, merely obliges me to make a best effort to meet your withdrawal demand – I am “answerable for the amount”, but there is “no breach of trust”.  If I am unable to meet the demand for withdrawal, there may be room for a civil action, governed by bankruptcy laws.  But bankruptcy is not necessarily fraud.

Case 3: This is clearly not true.  Even setting aside that there is no gold backing today, there are not two or more receipts for the same good.  The depositor has given capital to the bank.  The bank has first claim on the deposited goods, and in default other senior creditors might have priority over the depositor.  Again, the various claims will be resolved via bankruptcy.

This is precisely what is unfolding before our eyes in Cyprus.  Depositors are getting a real-world lesson in the reality of their deposits.

And specifically to counterfeiting, the Treasury is printing that which it has authority to print.  The Fed is creating digits for that which it is authorized.  These entities are not attempting to pass off an imitation of an original – they are authorized to make the original, as many as they desire!

It is Inflationary

Inflation is a tricky matter.  Monetary inflation has proven difficult to measure.  I know Rothbard has developed what is called the “True Money Supply.”  Other economists, Austrian and non-Austrian alike, hold different views as to what should be included or excluded.

Measuring the money supply is not so simple.  In a world where new and different forms of credit instruments and digital currency units are created regularly, determining and agreeing on how to measure the growth as a numeric value is inherently subjective, it seems to me.

My view is rather simple – even simplistic.  In a reasonably free market for money, credit, and banking, I am not sure we would bother with the concern about inflation any more than we would bother with every other business decision we make.  If market participants are not artificially limited as to options, it seems to me that the choice of currency unit will be no different that the choice of a grade of steel to a manufacturer – one more business decision that will have an impact to the P&L and cash flow of the firm.  A good choice will result in higher profits; a bad choice, lower.

So now I return to the objection regarding inflation: the simple answer is yes, it is inflationary.  However, I find the solution to this problem to be found in eliminating the monopoly, and not in outlawing otherwise legitimate practices (legitimate, as is true for Cases 2 & 3).

It is an Unstable System

All systems governing mans’ interactions with other men are by definition unstable.  The issue is: which system offers the likelihood of the least instability?  Some suggest that a 100% gold-backed system is the most stable system.  I will suggest that a system developed and maintained in a free market will be the most stable.

Ensuring a 100% gold-backed system will require enforcement.  It is also an artificial construct.  To put it bluntly, it is a centrally planned system. 

Where on earth is a centrally planned system, one that inherently requires force to ensure the plan is obeyed, more stable than a system that is derived by the market, where market forces ensure that the choices of all market participants are respected and where errors are quickly found and rooted out?

The answer is obvious for automobiles, or lemons, or housing.  Why not for money and credit?

Rothbard and Mises both have identified the self-correcting feedback of the market on limiting expansionary credit.  Inherently, they admit inflation, but they find the free-market system quite effective in policing the credit expansion.

When a market serves nicely as the enforcing mechanism, what is the justification to introduce non-market based force?

The Depositor is too Dumb to Understand Today’s Deposit Contract

This may be true.  It is certainly irrelevant.  Free markets mean free markets.  If this is true for what I put in my body, or my choice of clothes, it must be true in my choice of financial matters.  It is also not my obligation to think for another, nor my right to dictate to another.

There is No Choice but to Accept the Current Banking Contract

This is mostly, but not completely true.  To the extent it is true does not excuse the person entering into the contract.  There is certainly limited choice, but there isn’t fraud in today’s deposit contract.  In any case, there is a choice.  Transact with cash.  Difficult, though not impossible.


I feel this post is incomplete without noting the following, for which I am forever in the debt of Joe Salerno:

Daily Bell: Do you believe in private fractional banking or should it be illegal?

Dr. Joseph Salerno: I am neither a philosopher nor a legal theorist, but I believe in the absolute right of individuals to enter into any voluntary contract that they choose. But a contract must be meaningful to be enforceable. If I pay you for a promise to paint my house red and [at the same time also] green all over, this is not a contract but an absurdity. Likewise if I pay you (or even if you pay me) to store my motorcycle in your garage so that it is always available for me to use it and I grant you the freedom to rent it out at will. My point is that the deposit contract as modern free bankers conceive it, is a meaningless fiction. It implies that a sum of money can be both maintained on deposit for instantaneous withdrawal by the depositor and lent out to a borrower.

Now I am not saying that a free banking deposit contract can never be formulated in a meaningful way. But then it would not be a "deposit" contract at all, but a short-term credit transaction.

Thus to answer the question you posed: I do not believe that "private fractional-reserve banking," as it is commonly understood in debates among libertarians and Austrians today, should be illegal. It is a self-contradictory concept that could never be formulated into a meaningful contract on a free market.

I used to maintain that fractional reserve banking, if developed in the free market, would be acceptable.  Salerno changed my mind, although I was not able to fully grasp it when I first read this statement.  The problem is that there can be no fractional reserve banking in a free market, because such a contract (two people have equal claim to the same asset at the same time) cannot be written.  It is not meaningful; it is a physical impossibility.

I conclude that the only way to have true fractional reserve banking is through the fraud of the warehouseman – by fraud, I mean that the warehouseman has agreed to one set of terms to store the assets, yet is acting in a wholly different manner in regards to the assets in his trust. 

In today’s banking world, we do not have true fractional reserve banking.  I may not like today’s deposit contract, but there is no fraud in it.  What we have today is a monopoly in money, credit, and banking – a monopoly that has virtually, but not completely, disallowed the market-cleansing role suggested by both Rothbard and Mises.  The delay and prolongation enabled by this monopoly power has ensured that the bust will be a whopper.

The cause is not fractional reserve banking, but the monopoly.  The proper objection is simple: eliminate the monopoly.

End the Fed.

(Note: The introduction was modified on 31-Mar-2013)


  1. If there were no Fed, then market forces would moderate the excess expansion of credit created by deposit banking. Given that loans are created first and deposits are created out of thin air, is there any difference or does it only insure a greater bust?

    1. I am not sure what you mean precisely by your question, so forgive me if I am not answering it directly...

      Absent backing by the state, bank busts would occur, but without the system-wide risks brought on due to the current monopoly system.

      Both booms and busts are much larger under a monopoly cartel than would be true under free-banking, it seems reasonable to surmise.

  2. You described Case 3 as basically our current banking system. I have a question though about the receipt in Case 3. What is this receipt?

    I am asking because when I open a deposit account, I receive a checkbook. Are you simplifying these actual details by saying that a "receipt" is given by the Bank for the deposit?

    Another reason I am asking about Case 3 is that I still believe that it creates an injustice because this banking system creates more claims to the gold deposit than are necessary. The depositor has his claims to that money. The bank lends part of that deposit so the bank's loan customer has his claims. The same one amount of gold but now with multiple claims against it.

    1. “…when I open a deposit account, I receive a checkbook. Are you simplifying these actual details by saying that a "receipt" is given by the Bank for the deposit?”

      You receive a receipt for the deposit; you also have a checkbook.

      “Another reason I am asking about Case 3 is that I still believe that it creates an injustice because this banking system creates more claims to the gold deposit than are necessary.”

      What does “necessary” have to do with anything?

      “The depositor has his claims to that money. The bank lends part of that deposit so the bank's loan customer has his claims. The same one amount of gold but now with multiple claims against it.”

      The nature of the claims is different. If you read what I wrote in case 3, this should be apparent.

    2. It is still confusing. I'll have to study this Case more.