The controversy on the legality of fractional reserve bank accounts is not settled. Walter Block’s recent blog raises the question yet again, in which he argues that fractional reserve banking is illicit because banks are fraudulently conveying multiple titles to the same property. I strongly disagree and have argued this at length in print. My thinking on it is presented in full here.
Prof. Block writes “In fractional reserve banking, A lends $100 to B, the bank. B gives A a demand deposit for that $100. B keeps a reserve of 10%. B lends out $90 to C. B gives C a demand deposit for that $90. Thus, both A and C are the ‘proper’ owners of that $90.” This argument is erroneous. The first sentence is correct: A lends $100 to B, the bank. A depositor is a lender, a creditor, and the bank is a borrower, a debtor.
The conditions of this loan are spelled out in a lengthy document that forms the agreement between lender A and borrower B. Bank of America’s Deposit Agreement and Disclosures reads “Our deposit relationship with you is that of debtor and creditor. This Agreement and the deposit relationship do not create a fiduciary, quasi-fiduciary or special relationship between us.” The “demand deposit” that is exchanged for the $100 promises many things, including redemption upon demand of $100, but it doesn’t stipulate that the depositor’s $100 will be kept in safekeeping or in trust with the bank acting as trustee (fiduciary). It states clearly that the bank takes possession of the $100 as any borrower would who issues a debt. The demand deposit is an account, a demand deposit account. It is not cash, that is, it is not $100 in bills or currency. It can be exchanged for cash by the depositor, but it is not cash. The conditions of exchange have many stipulations in the document, indicating strongly that a demand deposit account is not cash.
The lender now owns the account, a debt instrument. It is like owning any bill or bond, except that it’s redeemable in cash at the lender’s will. The lender does not have title to the $100 or $90 of it or any part of it. The lender has title to the debt instrument, which is the deposit account. The deposit account is not the same as the deposit made, which was $100 in cash. The exchange saw to that.
I have now explained the meaning of Prof. Block’s second sentence “B gives A a demand deposit for that $100.” The term “demand deposit” doesn’t mean that B gives A title to the $100 initially owned by A or that B holds the cash in trust for A or holds in a safety deposit location for A, awaiting a call to give it back intact. It means that B takes title to the cash in exchange for an account, a debt instrument, with certain features. A has title to the account, but not that $100. If the bank doesn’t issue a title to A’s cash, it cannot issue multiple claims to that cash either, as Prof. Block goes on to argue.
Naturally, banks attempt to meet the conditions of the account and provide cash upon demand. The understanding of the banking business and how they meet their obligations is beyond our scope. The main point about it is that there is a risk that a bank will not be able to deliver the cash it has promised to deliver, even if it never creates a new demand deposit, which we haven’t discussed yet but which forms part of the argument of Prof. Block. A bank might become insolvent and not be able to meet demands for cash, either immediately or with a delay while it liquidated assets. There is a risk of insolvency, as with any debt instrument. This is even before thinking about fractional reserves and credit expansion. Is risk of insolvency fraudulent? If it were, no one would be allowed legally to issue a debt. As long as lenders agree to the risk, there is no fraud. The creditors of banks, including demand depositors, agree to the risk when they agree to make the exchange. They know there is risk. Even in the old days, they knew there was risk. Bank runs occasionally made that risk really evident. Countless westerns display the risk when banks are robbed of their gold and the depositors left high and dry. We conclude that the risk of bank insolvency doesn’t condemn banks to be purveyors of fraudulent debt instruments.
The next part of Prof. Block’s argument begins “B keeps a reserve of 10%.” I will stipulate this premise too. It means that B keeps $10 in cash, ready to service redemption demands. We are thinking in a simplified but nonetheless useful way; actual banking practice will use a number of techniques that reduce the risk of insolvency to a negligible amount. I’ve already argued that negligible still means non-zero, but that non-zero is still legal under libertarian conditions of signing an agreement or its equivalent.
We are next told “B lends out $90 to C. B gives C a demand deposit for that $90.” There is no problem with these assumptions, except that they omit stating a very important consequence. They need to be unbundled. Think of the transactions in two steps. In step 1, the bank receives from C his promise to pay the bank $90 under the loan’s conditions; C issues a note or debt to the bank. C is a borrower and B a lender in this transaction. B, acting as creditor, holds the loan as an asset. The bank exchanges a newly-created demand deposit account for C’s note. The bank has therefore issued a new debt, which is this demand deposit account. We have already seen in detail that a demand deposit account is a debt instrument issued by a bank. In the first case I described earlier, the bank exchanged this debt (the demand deposit account) for cash. In the current case, it’s exchanging this debt (the demand deposit account) that it’s issuing in exchange for, not cash, but C’s note or debt. This is a point that needs to be understood. Banks often issue their own debt in exchange for the debts issued by borrowers. The debts issued by banks are their liabilities. The debts issued by the borrowers are assets of the bank.
This process of issuing a debt in exchange for a debt is legal under existing law and under libertarian law. There is no duplication of titles involved. There is no sale of the same thing to two different owners.
Step 2 occurs when C redeems cash from the demand deposit account. The bank will pay out cash. The bank has title to all its assets. They are a collection that the bank manages so as to be able to meet all demands for cash and not become insolvent. Success or failure at this depends on many factors including business acuity, but that’s another matter as I said earlier. A cash redemption causes a credit to the cash account, indicating a reduction in that asset. There is a simultaneous debit to C’s demand deposit account, indicating a reduction in the bank’s liability.
Prof. Block writes “Thus, both A and C are the ‘proper’ owners of that $90.” No, not at all. This conclusion does not follow from the assumptions. Person A gave up ownership of the $90. Bank B took title to it and pooled it with other cash and assets, all forming one collection designed to meet demands for cash, among other objectives. Person C has a newly-created claim on B for $90, that is true, but that claim is not on A’s cash, because A gave up that cash to B in exchange for a different claim, a demand deposit account. Furthermore, Prof. Block didn’t point out that B now owns a claim on C, which is the debt issued by C to B that the bank designates as a loan asset.
The exchange between B and C creates new debts and new liquidity, to the extent that people accept claims on B in lieu of cash or currency. This is the “thin air” money that’s often talked about as another avenue of criticism of banks. The currency that C attains in his demand deposit is coincident with the fact that B holds C’s note. None of this is illegal under libertarian or existing law. A discussion of bank laws and central banking is beyond the scope of this blog as is a discussion of the economic consequences of banking. The narrow point I’m making is that banking should not be criticized on the grounds of one of its basic business practices being illicit. There are other grounds for criticizing banking, bank laws, bank practices and central banking, but the argument that fractional reserve banking is illicit due to the issuance of multiple titles to the same thing is not one of them. Critics of banks should move on to other substantive criticisms and leave this discredited argument behind.
Finally, I will address Prof. Block’s correspondent, who is not wrong to see something of an analogy between overbooking and a demand deposit account.
A depositor gives up ownership of “funds”, exchanging that right for a different set of rights via ownership of the account. The analogy to a parking lot that overbooks is stretched but not altogether unreasonable. It’s stretched because banks are not known habitually to overbook and leave themselves unable to provide funds upon demand, whereas airlines and parking lots have greater rates of overbooking. Furthermore, banks have many techniques to avoid running out of cash. Leaving that important practical distinction aside, the exchange of funds for an account does in fact give the account owner an option to demand funds that may or may not be fulfilled just as the buyer of an airline ticket has an option to be accommodated by a seat or not. No one has a firm right to a seat, and no one has a firm right to get funds on demand. That’s the nature of these agreements, and there is no fraud or selling of multiple titles to the same asset in either case. Neither the bank nor the airline nor the parking lot agrees to provide you with a definite amount of funds at a definite place or time or a definite seat or a definite space. They are all providing contingent claims. If you want funds for certain, you find a safe place to store them, perhaps a safety deposit box or a hole in the ground. These will not provide the services offered by a bank account, again showing that a bank account is not simply your stored money to which you are entitled as an owner of such. You are entitled to a set of rights that include withdrawal of funds matching your deposited amount but only as a creditor demanding immediate redemption of a debt.
8:18 am on June 18, 2016
