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On the Necessary and Sufficient Conditions for Legitimate Banking Contracts


What role do demand deposits serve in the financial system? The answer to this simple question has great implications in keeping the legal terms of the contract consistent with the demands of the financial system. Demand deposits are a perfect monetary substitute. Since money is only held to hedge against perceived uncertainty in both the timing and magnitude of future expenditures, demand deposits are demanded for the same reason. From this we derive three main conclusions. First, a financial contract similar to a demand deposit (e.g., very short-term bonds, money market mutual funds, etc.) cannot substitute for money. Second, full agreement to a financial contract does not create a perfect substitute for money unless it provides money’s two key characteristics: on demand and par value redemption. Finally, the demand for fractional-reserve demand deposits is fostered by an exogenous source (deposit insurance) and that demand for a good or service is not a sufficient condition to justify its legality or ethicality.

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  1. We can appreciate that Nair’s analysis focuses on the ethical nature of the fractional-reserve demand deposit, which is a more fruitful starting point than the secondary issue of the economic effects that such a product creates (Barnett and Block 2009; Davidson and Block 2011).

  2. Offering a supply of perfect money substitutes is the one unique characteristic of banks. All other financial products they offer (e.g., time deposits, loans, equity investments, etc.) are also available at alternate financial institutions. Furthermore, the role of the deposit is a commonly cited condition for the creation of a perfect money substitute (see e.g., Nair 2011).

  3. See also Mises (1949, p. 429) for an analysis of money substitutes.

  4. By “money qua money” we refer here to money’s use only as a medium of exchange. Under older monetary regimes, e.g., the gold standard, commodity money could have qualities beyond those endowed in it as the monetary unit viz. the direct utility the monetary good provided. Fiat money, as is exclusively used throughout the modern economy, lacks a direct utility and only functions with exchange value or, in other words, has value only to the extent that it functions as money.

  5. Note that both bonds and futures can function as equities to the extent that only their market value is realizable if sold in the present.

  6. For the classic differentiation between risk and uncertainty see Knight (1921) or Mises (1949, Chap. 6).

  7. Although Nair (forthcoming) does not discuss the option, Bagus et al. (2015) discuss the use of money market mutual funds for those depositors who are looking for a financial product that is highly liquid, and which functions as an imperfect money substitute owing to the fact that such products need not trade at par value either de jure or de facto (an outcome better known as “breaking the buck”).

  8. We exclude the numismatic demand for money, partly because the demand by collectors is trivial relative to the total exchange demand for money, and partly because of the fact that numismatically valued money is almost always a defunct non-circulating currency, and as such is not really money by any definition. At any rate, as the accepted definition of money is that it is the “commonly accepted medium of exchange,” money demanded for numismatic purposes is not demanded as money but rather as some collectable good.

  9. If demand deposits were aleatory contracts they would not trade at par value. Only a perfect money substitute can trade at par value in the present. On the discount of imperfect money substitutes relative to money, see Mises (1949, p. 442).

  10. Applying Nair’s definition and standard of fraud, fractional-reserve banking may actually be regarded as fraudulent. Nair claims that misrepresentation implies fraud and states (forthcoming: fn. 4), that Bernard Madoff’s scheme was fraudulent “because of misrepresentation of the fact” that led clients “to believe that they can earn unusually high returns.” Similarly, it may be argued that there is a misrepresentation of facts when fractional-reserve bank clients are made to believe that they can obtain full availability while the bank uses their money.

  11. Another way to consider this problem is that there is no fraud taken from each individual party’s point of view as they each honor their contractual obligations and, provided the bank remains liquid, enjoy their contractual rights. Taking a bird’s eye view of the problem there is an obviously contradictory nature to this contract which would nullify it under standard contract law either through one party misrepresenting the other, i.e., a case of fraud, or through a lack of a meeting of the minds (Bagus et al. 2015). Interestingly, some supporters of fractional-reserve banking agree that these two conditions make voluntarily agreed upon contracts unenforceable (and void) in the general sense, but fail to apply to the logic to banking contracts in particular (see, e.g., Evans forthcoming).

  12. It could be said that supporters of fractional-reserve banking who focus on average instead of marginal redemption demands commit the same error as the classical economists did in focusing on the total or average utility of a good in lieu of its marginal utility.

  13. When two students share the work of an assignment, the one with the goal to pass the class, the other one with the goal to fail the class, we would not speak of collaboration either.

  14. The reader could consider whether he or she counts their deposit account as part of their cash balance or as a potentially illiquid loan or as an equity investment.

  15. The welfare effects of fractional-reserve banking are a separate, though no less contentious, topic than the ethical nature of the transaction. We direct the interested reader to Rothbard (1990), Huerta de Soto (1995, 1998, 2006), Hülsmann (2000), Hoppe et al. (1998), Bagus and Howden (2010, 2012b), and the collection of essays in Salerno (2010) for a reappraisal of the alleged benefits of the practice.

  16. Note this reasoning rests on an important assumption that prices are sticky throughout the economy, and that changes to the general price level are a suitable substitute for adjustments to specific goods’ prices (Bagus and Howden 2011, 2012a).

  17. Money substitutes are demanded for convenience among other reasons. The convenience, however, can be achieved without fractional-reserve banking. Nair (forthcoming p. 9) seems to equate the demand for convenience with the demand for fractional-reserve banking: “If people or banks’ clients find it more convenient to use and hold bank notes or checking balances instead of the actual money, then banks will be able to engage in fractional-reserve banking and hence ‘‘create’’ more money…” Note that the same convenience may be provided by issuing money certificates, and does not necessarily create the need to issue fiduciary media.

  18. Bank notes did serve as money substitutes under the commodity standards of the past.


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We would like to thank an anonymous referee for helpful suggestions. All errors are our own.

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Correspondence to David Howden.

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Bagus, P., Gabriel, A. & Howden, D. On the Necessary and Sufficient Conditions for Legitimate Banking Contracts. J Bus Ethics 147, 669–678 (2018).

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  • Banking ethics
  • Demand deposit
  • Fractional-reserve banking
  • Full-reserve banking
  • Money substitutes