Thursday, May 22, 2014

The Fraud of Fractional Reserve Banking?

(Note: I have written on this subject before.  It might be worth a read, as the three cases help to paint a picture, I believe.  Some of this will be repetitive, but I will now touch on a few points in this post that I did not address in the previous one.)

Fraud is an interesting concept.  Unlike a violation of property or person – usually a relatively cut-and-dry standard – fraud involves shades of gray: is advertising for make-up or cosmetic surgery fraud?  The Marlboro Man?  Lying?  It can be rather subjective.

Fraud Defined

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

This is a pretty subjective definition, perhaps difficult to put into practice.

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.

This definition offers more objectivity (a false representation of a matter of fact…that deceives and is intended to deceive).  A somewhat more subjective component is also included (by concealment of what should have been disclosed – how is should decided?). 

The intentional use of deceit, a trick or some dishonest means to deprive another of his/her/its money, property or a legal right.

“Intentional” is again mentioned; also tying it to deprivation of money and property. 

Fraud is a broad term that refers to a variety of offenses involving dishonesty or "fraudulent acts". In essence, fraud is the intentional deception of a person or entity by another made for monetary or personal gain.

Fraud offenses always include some sort of false statement, misrepresentation, or deceitful conduct.

To my understanding, “fraud” remains an open issue in the libertarian community.  Stephan Kinsella offers one libertarian view:

If one has a coherent understanding of the nature of contract (a title-transfer theory along the Evers-Rothbard line) and property rights, then one has to understand fraud as some kind of misrepresentation that vitiates the consent needed for a title transfer to be effective.

More from Kinsella:

…it is clear that for there to be fraud–at least of the type that counts as aggression–there must be some victim who did not give genuine consent for the defrauder to use or take his property.

Fraud Applied

With this as background, I turn to a detailed examination of the key passage from the key (and from my reading, the first) proponent of the concept of fractional-reserve-banking-as-fraud:

The Mystery of Banking, Chapter VII: Deposit Banking

Rothbard begins with a description of the earliest days of deposit banking – where an owner of gold bullion (or coins) would deposit his holdings with a warehouse for safekeeping.  In return, he would receive a receipt for the goods. 

Rothbard describes this as similar to a safe-deposit box; it seems to me something more – with a safe-deposit box, there is no receipt for the contents.  Instead, it is more like a vault service, where a receipt is provided for the itemized goods deposited. 

He then goes on to explain that such receipts began trading in place of the underlying gold – in other words, instead of going to the vault, withdrawing the gold, and then making payment, the holder of the receipt would hand the receipt over for payment.  This was more likely to be accepted for warehouses that were trusted.  The warehouse would charge for the storage of the gold; a storage fee was paid.

This also maintained the feature that the total supply of money was not artificially increased.

The warehouse would not record the gold on its balance sheet – it was not an asset of the warehouse.  The warehouse also did not record a liability on its balance sheet – it did not take legal ownership of the gold; it did not owe a debt; it had no legal liability – beyond, of course, as a warehouse.  There was no transfer of title.  The relationship was a bailment.

A dishonest warehouseman might be tempted to borrow some gold – unbeknownst to the depositor – and use it for his own purposes.  Eventually, the warehouseman figured out that he could merely print more receipts (based on his estimate of the actual demand for withdrawal of gold – a reserve requirement), and never remove the physical gold.  Rothbard describes this as embezzlement.  It is certainly a violation of the terms of the deposit, as the depositor is paying a fee for storage and the warehouse owner agreed to store the gold. 

During the nineteenth century, courts in England decided that the contract should be interpreted actually as a loan as opposed to a bailment – as the deposited gold was not segregated one depositor from another (one gold coin being the same as the next gold coin, if you will).  In other words, the depositor did not place his gold in a sealed bag with his name on it.  This gave the banks legal cover to do as they wished with the deposited gold – regardless of the contractual terms.

One can argue that the court made law, as opposed to interpreted contract; however, this is irrelevant for understanding banking in the modern era (the last 80 years, more or less).

Thus, the deposit became an asset of the bank, with a corresponding liability for that which was due to the depositor.  Herein is the root of fractional reserve banking.

The irresistible temptation now emerges for the goldsmith or other deposit banker to commit fraud and inflation: to engage, in short, in fractional reserve banking, where total cash reserves are lower, by some fraction, than the warehouse receipts outstanding.

In short, the deposit banker has suddenly become a loan banker

Here is where I will part ways with Rothbard.  There is no more deposit banker.  Assuming the banks conformed their contracts to the court decision, the bank is not claiming to act as a warehouse – there is no fraud.  If the contracts were not conformed, then I would concur (it seems difficult to argue that a court decision over-rides a valid contract, certainly for a libertarian) – but this is one of the foundations of my position: today’s deposit contract conforms to this decision (or, at minimum, does not state that the deposit will be held as a bailment).

…the original depositor thinks that his warehouse receipts are represented by money available at any time he wishes to cash them in.

Why does the depositor think this?  Can he not read the contract?  Does he hand his valuables over to the warehouseman without some agreement defining their relationship?

It should be clear that modern fractional reserve banking is a shell game, a Ponzi scheme, a fraud….

It is a shell game; it might be described as a Ponzi scheme (I guess until the reserve fraction gets to zero).  However, if the contract conforms, can the act be labeled as fraud?

As to the inflation?  A non-event from a contract / fraud perspective.  Until an Austrian / libertarian can turn Böhm-Bawerk on his head, and convincingly argue that value is objective, it is irrelevant.  We have the right to our property.  We have no right to the value of our property.  The notes are still in your pocket; the digits are still in the bank’s computer in your account.

Where did the money come from? It came—and this is the most important single thing to know about modern banking—it came out of thin air…. Essentially they do it in the same way as counterfeiters. Counterfeiters, too, create money out of thin air by printing something masquerading as money or as a warehouse receipt for money.

But it is not masquerading as a warehouse receipt for money.  Under the new deposit contract, it is no claim on anything other than the banks’ ability to honor it.  The claim is nothing more than what it is – a piece of paper with pictures on it (or digits on some hard drive).

The original is no longer a warehouse receipt for gold (or for anything else) – so how can the bank counterfeit for a warehouse receipt for gold if the original is not a warehouse receipt for gold?  It is a claim against the bank to make good.  Nothing more.

Another way of looking at the essential and inherent unsoundness of fractional reserve banking is to note a crucial rule of sound financial management—one that is observed everywhere except in the banking business. Namely, that the time structure of the firm’s assets should be no longer than the time structure of its liabilities.

This may be a poor business practice, but it is nothing more.  A free market will provide the discipline necessary to regulate this practice.  Not any concern for an Austrian as Austrian, or a libertarian as libertarian.

But why not equate the banker to the bridge builder?  Rothbard does just this:

The builder of a bridge estimates approximately how many people will be using it from day to day; he doesn’t attempt the absurd task of building a bridge big enough to accommodate every resident of the area should he or she wish to travel on the bridge at the same time. But if the bridge builder may act on estimates of the small fraction of citizens who will use the bridge at any one time, why may not a banker likewise estimate what percentage of his deposits will be redeemed at any one time, and keep no more than the required fraction? The problem with this analogy is that citizens in no sense have a legal claim to be able to cross the bridge at any given time.

But holders of warehouse receipts to money emphatically do have such a claim, even in modern banking law, to their own property any time they choose to redeem it.

Holders of warehouse receipts can legitimately be emphatic on this point.  Holders of today’s modern deposit account?  Show me where it says this in the contract; if they are so emphatic, might they not have ensured it was in the contract?  The depositor’s only legal claim – more specifically, the legal agreement between the depositor and the bank – is that the funds will be made available.  There is no contract that the funds will be stored as in a warehouse.

And the reality is, since the 1930s in the US and in most of the developed world as well, that funds demanded were virtually always delivered on demand (in recent times, only Iceland and Cyprus come to mind as exceptions).  I cannot think of a business with a higher rate of success in meeting the contractual demands of its deposit customers than modern banking.  The requirement of availability has been met, and by any reasonable expectation in any other business, exceeded.


So, let’s revisit the key statements from the above definitions and apply these to my view of Rothbard’s argument (all in the context of depriving someone of money or property):

…concealment of what should have been disclosed
…intentional use of deceit
…the intentional deception
…false statement, misrepresentation, or deceitful conduct.
…some kind of misrepresentation that vitiates the consent needed
…did not give genuine consent

There are three concepts from the above list that could be argued are damaging to my position that there is not fraud in the current deposit contract: intentional use of deceit, concealment of what should have been disclosed, and misrepresentation such that genuine consent is not given.  Ultimately, the behavior must be shown to deprive the rightful owner of money or property.

Is there intentional use of deceit?

…the act or practice of deceiving; concealment or distortion of the truth for the purpose of misleading; duplicity; fraud; cheating:

This, to me, is little more than a statement regarding the next two.  So I will move on to the next two.

Should it be disclosed that the bank is not holding your money? 

The contract discloses that the bank will make your deposited funds available to you on demand, with certain exceptions.  The bank is disclosing what it will do; must it also disclose what it will not do?  I suspect some will argue yes, as many people believe it to be the case that the bank is, in fact, acting as a warehouse.

Believe….  This is an interesting term (Rothbard uses the term “thinks”).  It is the only applicable one (I guess “wishes” could also be inserted), as the plain language of the contract gives no reason for the depositor to believe that the bank is acting as a warehouse.

The closest I can come to this term “believe” (or think or wish) in contract law is the concept of “meeting of the minds.” 

Almost everyone knows that in order for there to be a binding contract there must be a "meeting of the minds."

It is well established that courts will determine the intent of the parties by looking primarily to the plain meaning of the written words, and a judge will only hear testimony about what parties now say they intended if the words are ambiguous.

If the words are clear, there is no cause.  Only if the words are ambiguous will a judge consider trying to probe the minds of those doing the meeting.

In determining whether there is an ambiguity, the ordinary usage of a term will be employed in the sense that an ordinary and reasonable person would understand it.

Is there ambiguity to the word “available”?  Does “available” necessarily mean “storage”?  

Available: readily obtainable.
Storage: the act of storing; state or fact of being stored.

It seems “no” and “no” are appropriate answers.

As a promise of storage is not contained, this seems like a losing proposition for those who want to rely on “believe.”

And it is almost always insufficient for a party to contend that he or she did not read the clause in question or did not have it explained to them.

I guess if someone doesn’t understand “available,” they could ask for clarification.

The “plain meaning of the written words” is that the bank will make funds available, with certain specific (but in some cases, not minor) exceptions. In the US and much of the developed world since the 1930s (outside of countries ravaged by war), this requirement has been met with a success rate approximating 99.99% (I am only guessing, but I am probably not far off).  Other than the recent (and notable) exceptions of Iceland and Cyprus, I can think of no other meaningful failures in this.

The terms are not ambiguous – for example, available means available (it doesn’t mean storage). The funds will be made available. The funds have virtually always been made available. An ordinary person would understand this, it seems.  Or should….

So I conclude, no; the bank does not need to disclose that it is not acting as a warehouse.

But what if you don’t buy what I am selling?  I will play along: If yes, could this be considered a material misrepresentation, therefore vitiating genuine consent?

It is difficult for me to see how it is “material” misrepresentation if the success rate is 99.99% (or something like this).  The bank honors its obligations virtually every time – 0.01% is not very material.

So, no; it is not material.

But you still want to disagree – you insist it is material.  OK, I’ll bite: If yes, could the contract be written such that it eliminates the concerns of ambiguity?

This one is simple.  I dare you to disagree: Yes.

So even if it is…confusing (this is about the worst I can say about it from a contract perspective; but confusing isn’t a violation of NAP), well, this can be clarified with a simple sentence or two.

Ultimately: Was property or money deprived?

I revert to the overwhelmingly high success rate of meeting the demand for availability of funds.

No, property or money was not deprived.


There is no fraud in the modern deposit contract.  Even if my arguments on this are not convincing, it seems simple enough to add a sentence or two to the existing regulations to eliminate even this tiny, almost invisible, shade of gray.


  1. You say "I cannot think of a modern business with a higher record of meeting the contractual demands of its customers than modern banking"

    Well, I can tell you that the entire private banking system in Ireland went belly up. It was only because of a massive bail-out by taxpayers that bank creditors got protected. It cost the tiny economy of Ireland more than 60 billion Euros to meet the banker liabilities

    1. They would all go belly-up without government backing (as they should).

      What does this have to do with my point?

  2. OK, you're saying they have a great record of returning the deposits back to their customers because of the government backing!

    Well, we can agree on that!

    1. Yes, the reason the current banking system works so well is that it is virtually guaranteed by the central bank.

      So, the bank can commit to make funds available (even though it has loaned out almost all of the deposits), knowing it has this backstop.

    2. Thus, banks rely on the welfare of the state.

  3. "Banks rely on the welfare of the state"

    Banking is the most heavily subsidised industry in Europe. 200 billion Euros per year in a hidden subsidy.

  4. BM, your assertion that the banks honor their obligations 99.99 % of the time, is predicated upon, what?

    Does your assertion include the following:

    (1) all of the money lost by depositors of banks which failed (and, yes, for purposes of our discussion, FDIC bailouts do not offset the losses);

    (2) all of the bank imposed delays suffered by depositors before they were able to access their money;

    (3) all of the monies lost by depositors via bank capitulation to IRS levies and seizures;

    (4) all of the monies lost by depositors via bank capitulation to the levies and seizures of the department of revenue of the fifty little leviathans;

    (5) all of the monies lost by depositors via bank capitulation to the levies and demands of all other governmental thugs;

    (6) all of the monies lost by depositors via bank capitulation to the Patriot Act;

    (7) all of the monies lost by depositors via bank capitulation to the labyrinthine money laundering regulations; and

    (8) all of the monies lost by depositors through the bank's imposition of various fees and service charges to which the depositor did not specifically furnish his consent.

    1. I picked 99.99% out of the air.

      To your questions:

      Item 1: Do you know the number? I don’t. Out of countless billions in transactions, my guess is the number is small.

      Item 2: the depositor got the money.

      Items 3 – 7: SOMEONE got the money. That it may or may not have been the rightful owner is a legal question, and irrelevant to my point.

      Item 8: Change banks if you don’t like the fees.

      So the only relevant item from your list is item 1.

      Back to the 99.99%. Unless you have a better number, I will bet the number is well over 99%, as opposed to anything meaningfully less. My proof is in the economy – we live in a marvelously significant international division-of-labor economy, none of which would be possible without financial institutions being able to deliver.

    2. Thank you for your reply.

      Of course, I do not know the percentage of time the bank honors its obligations. I do not disagree with your basic position that the number is quite high.

      However, given that you asked, "was money or property deprived", you can not so easily dismiss Items 2-8. Item 2 is legitimate as depositors have been unable to access, I would guess, literally, billions, if only temporarily. That depositors have been unable to access all of their funds WHEN they want to, necessarily means that "money was deprived".

      Items 3-7 are everyday realities. To dismiss those concerns as "irrelevant to my point" is no argument at all as, once again, you set the standard, "was money or property deprived". Have you ever read a deposit contract that specifies that the bank will deprive you of your money should uncle come calling?

      Item 8: Yes, in a truly free market, that would be a real option; not so much in our economy.

    3. The deposit contract and regulations spell out the conditions for the possible delay of a withdrawal. Therefore, the contract seems to satisfy item 2; I will assume that where the denial was in violation of the contract an appropriate claim claim could be made.

      I stand by my statement for the remainder. These instances of "being deprived " are of a legal nature and not of a banking nature. You nor I have to like the laws or the ways they are prosecuted, but this is an entirely different subject.

      You are ignoring the context of the entire post by insisting on your interpretation of "deprived."