Fractional reserve banking

In a loan contract, the availability of money is transferred to the borrower, who must return in at the end of the term and pay the interest. The borrower is free to use in in any way. In a deposit contract, the money is in custody and the depositor can withdraw it on demand, it is available to him at all times. The borrower - the bank - must keep a 100% cash reserve, if the reserve is smaller it is known as fractional reserve banking. (This is sometimes shortened to FRB for convenience.)

Properties of FRB

Anything less than 100 percent reserve deposit banking involves what one might call a legal impossibility. In employing its excess reserves for the granting of credit, the bank actually transfers temporary ownership of them to some borrower, while the depositors, entitled as they are to instant redemption, retain their ownership over the same funds. But it is impossible that for some time depositor and borrower are entitled to exclusive control over the same resources. Two individuals cannot be the exclusive owner of one and the same thing at the same time. Accordingly, any bank pretending otherwise-in assuming demand liabilities in excess of actual reserves-must be considered as acting fraudulently. Its contractual obligations cannot be fulfilled. From the outset, the bank must be regarded as inherently bankrupt-as revealed by the fact that it could not, contrary to its own presumption, withstand a possible bank run.

Technically, fractional reserve banking is embezzlement, but it is considered legal now. The bank is insolvent, because it cannot honor its commitments. But unless the customers demand too much money at once – or too many loans fail – it can continue running, without the customers ever noticing that their money was gone. If the bank's customers lose confidence in the chances of the bank's repayment, they can decide, en masse, to cash the deposits in. This loss of confidence, if it spreads from a few to a large number of bank depositors is called a bank run. It is always fatal, because, by the very nature of FRB, the bank cannot honor all of its contracts.

Banking cartels

If a lone bank engages in FRB, it can be ruined by a bank run, or people, who are not its customers, or other banks, demanding redemption of their receipts. A group of banks can agree to accept each other's receipts and not call for their redemption. This would limit the weaknesses of FRB, but in turn introduce the problems of cartels. The banks would need to expand in proportion, otherwise some will enjoy greater profit, while the rest will pay for it. Regional and seasonal differences may also come into play. The difficulty of coordination rises with the number of banks in a cartel.

However, cooperation in a cartel is much easier if the members are forced to it by law. A Central bank can enable all the banks to expand together so that one set of banks doesn't lose reserves to another and is forced to contract sharply or go under. A central bank is the lender of the last resort, bailing out the banks if necessary – this also increases the trust of the public in the system.

Legal aspects

Roman law recognized that bankers were often tempted to use the deposits for themselves. To penalize these actions, they should be not only charged with theft, but to pay interest "so that, in fear of these penalties, men will cease to make evil, foolish and perverse use of deposits".

In early medieval Europe, the bankers preserved their deposits fully at first, but later began to use them for their own purposes, creating deposits and granting credits out of nowhere. Since the canonical law banned the charging of interest on loans, bankers would instead pay "penalties" for "delays" in payment and in effect pay interest on a disguised loan, and justified any misappropriations on this basis. This practice was defended by some scholars, while others wanted to expose all hidden loans and equated all deposit contracts for loans. As a result, the distinction between them was obscured. Experts failed to clear up the resulting legal chaos until the end of the nineteenth century.

The authorities failed to enforce sound banking practices, and often granted banks a government license to operate with a fractional reserve, while taking advantage of easy loans to finance governments and public officials. Some rulers created government banks to reap the profits. But banks were still required to guarantee deposits.

As late as twentieth century, court decisions in Europe have upheld the demand for a 100-percent reserve requirement. In 1927, the Court of Paris convicted a banker for the crime of misappropriation for having used the funds deposited with him by a client, confirmed in 1934. After the failure of the Bank of Barcelona the Spanish Supreme Court also pronounced, that "the depositary does not acquire the right to use the deposit for his own purposes".

Fractional reserve banks never informed their depositors that some or all of their deposits would actually be loaned out and so could not possibly be ready for redemption at any time. (Even if the bank were to pay interest on deposit accounts, and hence it should have been clear that the bank must loan out deposits, this does not imply that any of the depositors actually understand this fact. Indeed, it is safe to say that few if any do, even among those who are not economic illiterates.) Nor did fractional reserve banks inform their borrowers that some or all of the credit granted to them had been created out of thin air and was subject to being recalled at any time.

Legalization

The landmark decisions came in Britain in the first half of the nineteenth century. In the first important case, Carr v. Carr, in 1811, the British judge, Sir William Grant, ruled that since the money paid into a bank deposit had been paid generally, and not earmarked in a sealed bag (i.e., as a "specific deposit") that the transaction had become a loan rather than a bailment. Five years later, in the key follow-up case of Devaynes v. Noble, one of the counsel argued correctly that "a banker is rather a bailee of his customer's fund than his debtor,. . . because the money in . . . [his] hands is rather a deposit than a debt, and may therefore be instantly demanded and taken up." But the same Judge Grant again insisted that "money paid into a banker's becomes immediately a part of his general assets; and he is merely a debtor for the amount." In the final culminating case, Foley v. Hill and Others, decided by the House of Lords in 1848, Lord Cottenham, repeating the reasoning of the previous cases:

The money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with 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.

These decisions were taken over by the American courts and so was FRB legalized. However, an interesting development occurred in grain warehouse law, which has developed in precisely the opposite direction, despite the conditions of depositing fungible goods were exactly the same, and grain was a general deposit and not an earmarked bundle.

In the history of the U. S. grain market, grain elevators several times fell prey to this temptation, spurred by a lack of clarity in bailment law. Grain elevators issued fake warehouse receipts in grain during the 1860s, lent them to speculators in the Chicago wheat market, and caused dislocations in wheat prices and bankruptcies in the wheat market. Only a tightening of bailment law, ensuring that any issue of fake warehouse receipts is treated as fraudulent and illegal, finally put an end to this clearly practice. Fractional-reserve grain warehousing, that is, the issuing of warehouse receipts for non-existent goods, was clearly seen as a fraud.

See also: History of Money and Banking

Securitization

Known since 18th century, securitization as it is known today was created in 1970, when the Government National Mortgage Association (Ginnie Mae) issued a mortgage-backed security (MBS) in the form of a pass through. Securitization has had an exponential growth since.

Economic actors can obtain rights to future payments of money - for instance, a car dealer that sells his cars on credit for five years in exchange of his cars. Such credits are relatively illiquid because their characteristics tend to be sector and client specific. Their owners may prefer to exchange them for an amount of money that is available now. Each of these claims can be passed to an economic actor that has the opposite preferences. Or, relatively similar claims, possibly coming from different owners, could be grouped together within a single holding entity that could then create standardized claims to be sold to investors on the financial markets. This process of putting together relatively illiquid assets and using them is called securitization - "... the process of pooling and repacking loans into securities that are then sold to investors."

Securitization allows FRBs to withdraw from the market the credit they have created and lent out. It reduces the money supply by the amount of liquid assets used to purchase the asset-backed securities. Therefore, it hides the increase in the money supply, i.e., inflation. It makes the economic environment appear less inflationary than it should be, given individuals' growing indebtedness to banks. Securitization portrays a bank-credit driven boom as noninflationary, savings driven growth. Also, securitization insulates lending activity of banks from the central bank's monetary policy. It contributes to the widespread illusion that more factors of production are available than in reality, and so becomes a factor in the generation of the boom-bust cycle.

External links

• Fractional-reserve banking on Wikipedia
• "Legal Tender Laws and Fractiona-Reserve Banking"(pdf) by Jörg Guido Hülsmann
• Fractional Reserve banking and boom-bust cycles by Frank Shostak
• The Fractional-Reserve Banking Question by Robert P. Murphy, June 2010
• The Form of Saving Matters by Robert P. Murphy, August 2010