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Wednesday, August 3, 2022

Fractional Reserve Banking And "Fraud"

Although I like the title of my banking primer “Fractional Reserve Banking and its Discontents,” the problem is that I need to deal with some really loopy theories.

The economist Robert Solow provided us with a very good quote regarding the dilemma of such discussions.

Suppose someone sits down where you are sitting right now and announces to me that he is Napoleon Bonaparte. The last thing I want to do with him is to get involved in a technical discussion of cavalry tactics at the Battle of Austerlitz. If I do that, I'm getting tacitly drawn into the game that he is Napoleon Bonaparte. 

In the area of banking disputes, we run into internet Austrians who argue that fractional reserve banking is “fraudulent” based on alleged historical arguments. I have done my best to blank this nonsense out of my skull, but I will run through what I believe was the logic.

The “History”

The argument is that in Ye Olde Days (typically in a non-specified country, with dates also not specified), we had an economy that relied on metal coins for commerce. As every Dungeons & Dragons™️ player knows, holding lots of gold coins attracts the attention of bandits (if not dragons). So people who were used to guarding a gold hoard — goldsmiths — allegedly would take gold coins into their vaults for safe keeping.

The goldsmith would hand out a receipt for the gold which could then be redeemed (like a coat check). At which point the customers realised that they could transfer the receipt to another person in lieu of going to the goldsmith, redeeming the gold, and then transferring the gold. These receipts then partly replaced gold coins within commerce.

Then, some of those dastardly goldsmiths figured out that they had lots of gold coins lying around all day. They then could loan out gold to people, who then tended to leave the gold for a receipt — which means that there were more receipts in circulation than underlying gold. So long as not everybody wants to redeem their receipts at the same time, the goldsmith earns safekeeping fees as well as interest on gold. These “goldsmiths” allegedly turned into banks.

Napoleon Time

The Napoleon issue comes up because any attempt to debate this issue using the framing of its proponents: we have ended up discussing cavalry tactics.

The proper way to phrase this issue: does fractional reserve banking as it exists now in {insert country of choice} qualify as being fraudulent within said legal jurisdiction? Since it is safe to say that there is no case law suggesting this (since banks are legally operating on a fractional reserve basis in all major jurisdictions), we could look into the question whether banks have some special exception to the principles of fraud case law.

I am not a jurist, but it is abundantly clear that if there were a legal argument that fractional reserve banking was fraudulent, we would have something more concrete to discuss than alleged goldsmiths.

The ugly reality is that the people pushing this narrative have nothing resembling a legal argument, so they want to change the discussion to the behaviour of alleged goldsmiths in Ye Olde Days.

“Fraud” Just Means Stuff I Don’t Like

One potential excuse for this dubious line of argument is that people who write “fractional reserve banking is fraudulent” do not believe that it qualifies as fraud as the term is defined in law, rather that the practice is misleading. People believe that bank accounts are a form of safekeeping, not realising that they are a credit relationship (I discuss this distinction below).

Although such people might be surprised by this, it is very hard to see how this is anything other than their own personal problem.

Back to Cavalry Tactics

If we made the mistake of wanting to debate this using the preferred framing of the “
fractional reserve banking is fraud” crowd, we would end up in two quagmires.

  1. The alleged history of goldsmiths or whatever.

  2. The alleged history of the law around deposits. From what I have seen, this involved arguments about some alleged precedents in English law.

Alleged History

Almost every account of this topic I have seen was extremely vague about the dates and locations of these alleged goldsmiths. (That said, I believe it is possible to get more specifics from some sources.) Perhaps I am too cynical, but I tend to not pay attention to “histories” that omit things like dates.

But even if a date and location is specified, we still face a basic problem of history: there is a lot of history. There are a lot of different societies, and even what we view as the same society changes over time.

If we are discussing the history of laws within European society, our starting point needs to be the Romans. Roman law, and the canonical law of the Christian Church provided a unified starting point — although one might need to go back even further to other societies that influenced the Romans and Christianity, such as the Greeks, Egyptians, and the Jews.

(This runs into the issue of other historical roots, such as Islamic countries as well as Asian countries.)

As the Roman state withered, the forms of economic activity changed. Feudal relations quite often relied upon payment in kind. This allows a less complex financial system.

So even if someone can point to a particular backwater of Europe having goldsmiths that operate as the fable alleges, it does not tell us about the origin of fractional reserve banking — since the Romans had the economic equivalent of such banks. (I base this upon the essays in The Monetary Systems of the Greeks and Romans, by W.V. Harris. It was less clear whether the classical Greek trapeza would qualify.) Please note that these “banks” had institutional practices that varied from later banks — and thus some might argue that they are not “true banks” — but they worked on the economic equivalent of fractional reserve banking (they even had panics).

The reason why the above statements might be surprising is that the crackpots writing comic book history about banks relied on 19th century historians who believed that all transactions in Roman society were intermediated by coins. (Since coins were the easiest piece of archaeological evidence to dig up, they were studied intensely.) This ignores the documentary evidence of cheques being used, as well as the obvious logistical concerns with coin payment that large commercial transactions would imply. Although the articles I have seen hawking this view were happy to recent economists, modern historians were absent.

As I will discuss elsewhere, “fractional reserve banking” is an financial structure that is extremely efficient within a credit-based economy. The forms will vary, the economic incentives push towards a particular structure. Even if a banking structure did evolve from goldsmiths in a particular location, that is just telling us that financial complexity can flow back and forth over time.

Deposits Versus Safekeeping

Before getting into the legal arguments, I will offer a simplified introduction to the issue.

There is a distinction between what I call safekeeping and a bank deposit. (Since I have an international audience, I am not going to attempt to pretend that I am offering the legal details.) Banks do offer “safekeeping” services — safety deposit boxes.

If you go to a bank and rent out a safety deposit box, you might be able to place a $100 bill in the box. (In practice, depositing cash is discouraged or even outright banned by the bank’s contract — as noted in this online primer by Welch Law: If one wanted to stretch things, one could use the same vague description that could be used for a bank deposit — “leaving $100 at the bank for safety.”

The problem is that any knowledge of how safety deposit boxes tell us that they are different than bank deposits. The bank endeavours to keep the contents of the box safe, but they generally do not offer any guarantees about the item’s value. The items within the box remain your property, and they are particular goods — the bank will not substitute them for similar items. Meanwhile, they have no power to transfer the contents to other people as part of a commercial transaction.

One of the few real world examples I can think of that resembles the alleged gold smith situation is a coat check, where you are given a receipt for your coat. You can exchange that receipt with someone. Normally, this is done when one person in a group goes to pick up everyone’s coats, but you could hypothetically sell the receipt to someone if they wanted your coat.

However, it is clear that “fractional coat check receipt banking” is not going to happen.

  • Specific coats are not uniform. A counterparty has no idea as to the condition of the underlying coat based on its receipt.

  • Lending out coats presents obvious risks of damage, and doing so would be viewed as a breach of (implicit) contract. Since the coat is a particular item, the coat check owner cannot substitute another coat.

Replacing “coats” with “money” appears to solve some of the previous problems, but we still have problems — what happens if the “money” is counterfeit (or light weight in in the case of commodity money)?

If we return to bank deposits, it is clear that the original deposited instruments are not held by the bank. Although deposited cash remains at the teller’s till, most deposits are either electronic transfers or cheques. (Historically, cheques would have to be sent to the originating bank for clearing, but in Canada at least, cheques can be deposited via the customer taking photos of the cheque — and so it never enters the bank’s possession.) Deposits certainly do not represent a claim on the specific instrument used to make a deposit.

(I defer to the appendix how a scheme similar to the alleged goldsmith one would have to work.)

Legal History

We can now return to the issue of the alleged history of the legal reasoning as to why fractional reserve banking is fraudulent. The premise is the confusion between a safekeeping relationship (again, my term) and the deposit relationship.

This is a pointless rabbit hole to descent into, since the distinction between “safekeeping” and a deposit is a principle in Roman law — and these principles allowed for the legal operation of entities acting like fractional reserve banks. If one wants to delve into the history of the Roman “banks,” feel free to knock yourself out, but it is extremely likely that there is no documentary evidence of their origins. Almost by definition, they would have started small, and so the number of records of the origin would also not be numerous — and thus unlikely to have survived.

Concluding Remarks

The only things one needs to know about this “debate” is the following.

  1. Fractional reserve banking follows laws and regulations that have been in place for a long time, and no functioning adult views the mechanisms as being misleading or fraudulent.

  2. Any discussion of the origin of banks in the context of Western societies needs to focus on Roman law and financial practices (if not Greek).

  3. “Full reserve” financial intermediation is possible, but as I will discuss in later articles, has a different economic structure than banking.

Appendix: What About Goldsmiths?

In principle, I see no insurmountable legal wall that blocks someone from setting up a “full reserve gold bank” that works on a “safekeeping” basis in most jurisdictions. Such an effort would likely run into counterfeiting laws, securities laws, and possibly banking regulations, but even in the worst case, politicians could carve out exceptions in the regulations. One need only look at the crypto currency mania — crypto firms openly ran schemes that would have resulted in charges for a financial firm, but forbearance was given (at least until the time of writing) since crypto assets were not classified as securities.

The “safekeeping” firm would have standardised units of gold (coins, presumably) which it holds under guard. It then issues receipts for particular coins to owners, and those receipts would be bearer instruments — transferrable to other people.

To be useful, the receipts need uniformity. The firm issuing them would have to have a contingent liability to ensure the gold weight of the coins. A person cannot just stroll up with a coin and automatically get a receipt — the firm would effectively have to ensure that the coin is legitimate. Even if the coin is technically owned by someone else (and thus off the balance sheet of the receipt issuer), the acceptance of the contingent liability means that the transaction is economically equivalent to purchasing the coin at the face value of the receipt.

If the underlying “coins” are electronic instead of physical, the need for manual validation of the assets is eliminated (which is of course of interest to crypto fans). However, it raises an interesting question: why exactly does someone need an entity to hold an electronic entry in “safekeeping”? If the client can send the electronic entry (somehow) to the firm, why not just send the electronic entry to others and skip the overhead? We can look at the real world and see such relationships popping up due to the inability to transact in the underlying financial market, but it is clear that this “safekeeper” is acting as an intermediary between two sets of circulating financial claims. For example, customers could send Canadian dollars via the banking system to RomanchukBank to buy BrianCoins, and then RomanchukBank would hold the BrianCoins on behalf of the customers, who then trade them amongst themselves on the RomanchukBank electronic platform.

We then need to ask why we do not see such businesses popping up, since there is allegedly a demand for it. The answer is: how does the firm make money? Since the safekeeping “bank” is always accepting/redeeming receipts at par value, it makes no money off transactions. And even if it did charge a fee on acceptance/redemption, the receipt could hypothetically circulate forever. This generates no revenue for the “bank,” which has continuous recurring expenses associated with offering its services.

It obviously needs to charge a storage fee. However, if the receipt was a bearer paper instrument, the “bank” has no idea who to charge. In this case, the only sensible way to ensure a steady income stream to match expenses is to have the receipts expire, and either impose penalty fees or seize the asset if not paid in time. The implicit need for an expiry date (or similar mechanism) would mean that such bearer instruments would be far more annoying to deal with than most paper monies. (Paper money with expirations are one of the Big Ideas loved by certain types of economists, but they do not have much traction in the real world.)

Such a billing scheme is obviously more suited to an electronic entry format. However, if one thinks about the structure, such a scheme ends up looking like the economic equivalent to a mutual fund.

In upcoming articles, I will be discussing the economics of leveraged financial institutions, and see how the financial logic of a “fully reserved fund” is different than a bank. In the real world, both types of institutions co-exist, but they are not direct replacements for each other.

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(c) Brian Romanchuk 2022


  1. To what extent is this entire "controversy" a nonsense dependent upon the notion that money is an object (ie. gold or coins) rather than a system of obligations recorded upon ledgers? I take the latter to be the origin of money as exemplified by the Bronze Age palace economies where the ledger of obligations predates writing, let alone coinage.

    1. The people involved think of money as claims on gold, and can’t advance beyond it. The more “serious” legal arguments get into mumbo-jumbo about the laws around money (which is fairly complex), but the core problem is a generic credit claim versus a claim on specific coins.

  2. This comment has been removed by a blog administrator.

  3. A welcome contribution to this debate. I debunk the claim that English goldsmiths defrauded their depositors here: There is also a very large literature by myself and others countering other "Austrian" claims on this topic. Happy to point you to it, just write me at gselgin at cato dot org.

    1. Thanks. I will be re-writing this article at some point, and I will have a references section added. I had another article that discussed this debate, and it may have linked to that particular paper.

      Although I can get more specific, I really do not want to get drawn into arguments about cases in English law, for reasons I outlined - not my expertise, nor does it really matter.

  4. This comment has been removed by a blog administrator.

  5. Nice article. The concern of the moment for me is the fact that "fractional banking" is backed by nothing. No coins. No hard assets. No agreed values. Nothing.

    1. Oops, this comment disappeared in the spam folder for a couple of months.

  6. I don't see any argument to counter theirs?!

    1. (This is Brian.) Not clear to me who you are responding to. If it is to myself, this is too vague a statement to respond to.

  7. This comment has been removed by a blog administrator.

  8. It is fraud in that banks are not only lending money that isn't theirs, but that doesn't really exist since money lent can be 90% more than the reserves. Furthermore, banks are collecting interest on that money that doesn't belong to the bank and doesn't even exist. Just because it was legalized (no doubt a corrupt law that was likely leveraged by the fraudulent wealth by bankers on politicians), doesn't make it any less fraudulent. Nobody in society is allowed to lend out anything that doesn't belong to them and then charge for it. Modern society has been built on a fraudulent scheme

    1. (This is Brian.) Thanks for illustrating my point. Please learn something about capitalism and contract law. As soon as you transfer money to a bank, it is theirs, they just owe you a debt (the deposit).


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