The financial crisis has led to new interest in the ethics of financial markets. In this article, we further the debate on the nature of banking contracts by showing that the fundamental subjective purposes of loan and deposit contracts are irreconcilable. Any resultant mixture of the two contracts is a legal aberration. We consider a mutual fund as an important and legitimate alternative to the common demand deposit to provide high liquidity and some yield without offering full availability of a nominal sum. Besides being a close substitute for how many deposit accounts function today, the mutual fund has the additional benefit of satisfying all legal and ethical requirements. Loan and investment contracts (such as money market mutual funds) allow for the “bank” to make use of their clients’ funds while the intents of money owners are clearly classified without running into legal or ethical problems.
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von Mises (1953, 268) states: “A depositor of a sum of money who acquires in exchange for it a claim convertible into money at any time which will perform exactly the same service for him as the sum it refers to, has exchanged no present good for a future good. The claim that he has acquired by his deposit is also a present good for him.”
Elsewhere, we have dealt with this argument extensively (Bagus and Howden forthcoming).
Imagine that your wife and you leave for vacation and place her engagement ring in a safety deposit box at the bank. While you are gone, your banker “borrows” the deposit, his wife wears it during a night out, and they return it before you return. At your wife’s request, the ring is returned (i.e., made available to her), and she has no knowledge of its use while she was away. Despite being completely analogous to the conditions of modern deposit banking, most (if not all) people immediately see the rights violation involved in this simple example (Bitner et al. forthcoming).
Kim (2011, 955) classifies the contracts offered by goldsmiths as “self-contradictory” establishing “double-ownership.” He mentions “illiquidity” and “bank runs” on goldsmiths, as well as general goldsmith banking crises (946). Furthermore, the “coexistence of two disparate purposes” of the deposit and loan contract was already noted by contemporaries of the goldsmiths (947–948).
There was a period in the United States when fractional-reserve grain elevators operated. The result was similar to what we see in banking: overexpansion in the perceived supply of wheat, price discoordinations and an eventual crisis when this became apparent. The only reason that banking is different is that there is an exogenous institution capable of creating more money titles ex nihilo, something the grain elevators were unable to do. We strongly suspect that supporters of fractional-reserve banking do not support central banks in this role, and even if they did it would necessitate the practice resulting in the same circumstances that led to a ban in fractional-reserve grain elevators in 1860s (Williams 1984).
Bagus et al. (2014) discuss the legal legitimacy of the practice of securities lending, which is an analogous case to fractional-reserve banking in the world of investment accounts.
In Spanish law, Articles 306 and 307 of the Commercial Code point to a safekeeping obligation for depositaries including the case of monetary irregular deposit contracts. However, the law is not applied consistently as in practice fractional-reserve banks are not penalized for breaking the contract. It is, however, applied in this way in the case of bulk deposits of oil in olive mills. (Huerta de Soto 2009, 125, 129.) In Germany, the case seems to be even clearer. Legal scholar Köhler (2013, 916, 918) maintains that the privilege of money creation implied in fractional-reserve banking is not only unjust from a natural law perspective, but it stands also in contradiction to the existing private legal order. No German positive law allows for “money creation” by banks. “Money creation” is neither contractually agreed upon nor regulated in German civil law (919–920).
See Huerta de Soto (2009, p. 17, Fn. 18) for a small selection. See also legal scholar Köhler (2013, 891) who maintains that money creation by banks must be ended because it violates legal principles. He (908) considers today’s bank accounts as an example of deposits, as they fulfill the economic and legal definition of deposits, not loans. Köhler (912) regards the simultaneous existence of the purposes of deposit and loan contracts from a legal point of view as logically impossible.
Contrast this with the naivety of his later statement (p. 14): “For free bankers, by contrast, everything is legitimate within a free market in banking.” One cannot have a modern free market without a legal system. The legal system adheres to some a priori and evolved legal principles (e.g., though shalt not murder; children and others lacking sufficient mental capacity cannot legally contract, etc). The legal principles of such a system are what define the free market.
Of course, in today’s fractional-reserve system, banks are privileged by implicit bailout guarantees and credit lines from central banks. Moreover, traditional legal principles are not enforced. This answers Evans’ (p. 8 Fn. 20) point that people could, as a matter of principle, put their money in a 100 % reserve account (e.g., a safety deposit box). Banks abiding by traditional legal principles cannot compete with banks that are allowed to break these principles and receive support by governments and central banks—they receive a free lunch.
In contrast to his introduction where he assures the reader that “[t]his response will focus directly on the legitimacy of fractional reserve banking” (p. 2).
He writes, e.g., “If you consider a demand deposit (or indeed an overdraft facility) to be continuously ‘due’, then all banks and many businesses are insolvent” (p. 8).
For Evans, borrowing short and lending long, as well as fractional-reserve banking are legitimate as payment requests can be honored. The bank may be able to pay back the short-term loan and the deposit if it has sufficient reserves. Considering the different obligations of loan and deposit contracts, we have seen that this is not true. The obligation in a loan is to pay the money back at the end of the term. Maturity mismatching does not make the fulfillment impossible. The obligation in a deposit is to maintain full availability at all times. Using part or all of the deposited money does violate this obligation.
Evans (p. 4) maintains that “for the purpose of this article it is not important whether or not fractional reserve demand deposits would … cause the boom bust cycle.” We beg to differ again, since if the practice of credit expansion causes a bust then bank runs become likely. On the possibility of a fractional-reserve banking system causing business cycles see von Mises (1998, 439 Fn. 17, 570), Hoppe (1994), Hülsmann (1996), Huerta de Soto (2009), or Bagus and Howden (2010a, 2012). Excessive maturity mismatching induced by government interventions and central banking may cause similar intertemporal discoordination (Barnett and Block 2009; Bagus 2010; Bagus and Howden 2010b). We, however, do not regard the practice of maturity mismatching as unethical per se in contrast to fractional-reserve banking which is unethical as such.
The absence of central banking does not preclude coordinated credit expansion of fractional-reserve banks. Indeed, fractional-reserve banks can and did cooperate. Historically, interbank markets worked as cooperation devices (Bagus and Howden 2010a, Gertchev 2013, Howden forthcoming). Moreover, banks historically accepted their rivals’ notes at par value allowing for credit expansion. For the case of cooperating goldsmith bankers in England, see Kim (2011, 956 Fn. 15).
According to a recent survey (Evans 2010), most people today regard these instruments as perfect money substitutes or want them to be like them (they want convenient access). The same is true for the beginning of fractional-reserve banking. As Kim (2011, 944) points out, merchants regarded goldsmith account notes as “ready cash.” Kim hints to the fateful decision in common law by stating: “In contrast to merchants’ opinion, however, common law courts regarded the bankers’ notes as credit.” In fact, as Kim notes there was an “exception” made in common law for banks’ demand deposits (947). As Rothbard (1994, 93) notes, in the case of depositaries, like grain elevators, the obligation of safekeeping was (and is) uphold by common law courts.
Hoppe (1994, 71) comes to the same assessment. He adds that these lottery tickets do not fulfill the traditional functions of money. Hülsmann (2003) does not use the term “aleatory contract” or “lottery ticket” but regards the construct as an IOU with a redemption promise. See also Huerta de Soto (2009, 711–712).
That people actually do not want to make “aleatory contracts” when they deposit money is shown by their reaction when they stand last in line during a bank run. They are not just complaining about bad luck as they would do when they do not win in a lottery or the investment fund they bought loses value; they actually get angry, sometimes even violent. This is so, because they “subjectively” regarded their money in the bank, and the deposit to be theirs: they wanted, and thought they had, a demand deposit.
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“Lending is one thing, depositing another thing.” We thank the great third century Roman legal scholar Ulpian for this quote from Digesta (42, 5, 24§2).
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Bagus, P., Howden, D. & Gabriel, A. Oil and Water Do Not Mix, or: Aliud Est Credere, Aliud Deponere. J Bus Ethics 128, 197–206 (2015). https://doi.org/10.1007/s10551-014-2087-x
- Fractional-reserve banking
- Maturity mismatching
- Legal purpose