What is wrong with banking, part 1: the legal nature of banking contracts

This article gives a summary of the legal nature of banking contracts as presented by Jesús Huerta de Soto in Money, Bank Credit and Economic Cycles (PDF). A second article will discuss artificial credit expansion and its effects.

In his speech in the 2009 Banking Bill debate, the Earl of Caithness, one of the most experienced Conservative peers, said:

My Lords, the Banking Bill which we are currently discussing in the House is very complex and detailed, but it does nothing to resolve the current banking crisis, which lies at the heart of our economic problems. […]

The Banking Bill fails to address the fault which has led to every major banking and currency crisis during the past 200 years, including this one. It merely, lazily and weakly, papers over the cracks. Like Lilliputians, we are trying to tie down Gulliver with ever more strands of rope. It did not work then; it has not worked since 1811; and it will not work now.

He went on to explain that no Act of Parliament established the present banking system but that it emanates from a base of judicial decisions:

Prior to 1811, title to the money in depositors’ accounts belonged to the depositor. However, in that year, decisions in Carr v Carr and, in 1848, Foley v Hill gave legal status to the banking practice of removing depositors’ money from their accounts and lending it to others. Since then, title to depositors’ money has transferred from the depositor to the bank at the moment when the deposit is made.

Bankers have always seen it as their job to invest as much of their depositors’ money as they prudently can, in order to earn income for themselves while, at the same time, maintaining sufficient cash flow to be able to honour depositors’ cheques when presented and to meet withdrawals when demanded. If new deposits fail to materialise in sufficient strength or if borrowers fail to repay on time or at all, banks need to be rescued or they will fail. Historically, bank failures then led to a demand for central banks to act as lenders of last resort to save imprudent bankers who got caught short.

These judicial decisions meant that, from then until now, money deposited belonged to the bank and not the depositor, thereby allowing bankers to use customers’ deposits as they saw fit, always provided that they could manage cash flow so as to meet depositors’ requirements. In good times, that enabled them to take greater risks. Then, with the advent of central banks as lenders of last resort, the bankers soon learned they could take even greater risks with virtual impunity. When their lending became too aggressive and their reserves and deposit receipts were less than required to meet cash flow, they began to lend to each other. Banks with excess reserves would lend on the overnight market to those with a shortfall. With all these supposed safety mechanisms to protect them, bankers came to believe they could become even more aggressive in their lending, enabling them to make increased profits for themselves.

The provision of these safety mechanisms had, in some cases, merely encouraged them to take excessive risks. Further, these two judicial decisions overlooked or failed to consider the fact that when banks lend depositors’ funds, more than one receipt for the same deposit is issued. This was not done intentionally by individual banks or it would immediately have been seen as fraudulent. Rather, it was done by the system as a whole. This process continued to the present. It is as a result that our UK money supply has grown from £31 billion in 1971, when President Nixon closed the gold window, to in excess of £1,700 billion today. Let us consider the implications of those last two figures. They mean that every year since 1971 the banking system has created, on average, for its own use, in excess of £44 billion. That is more per year than the entire money supply which had, until 1971, sustained our economy since recorded history and through two world wars. Is it any wonder that we have suffered such serious inflation over that period? It is clear that the normal, everyday onward lending of depositors’ funds by retail banks has been the principal producer of inflation.

Now, the 1844 Bank Charter Act ended the overissue of notes over specie but it did not deal with the overissue of demand deposits drawn by cheque. This omission, combined with the judicial decisions described by Caithness, left open the possibility of the same mechanism which was known to cause economic crises in the nineteenth century and which has caused the crisis we are in today: artificial expansion of credit.

This article deals with the legal principles under which banking should operate; a second article will explain artificial credit expansion and its consequences.

Loan contracts and deposit contracts

There are two sound categories of loan contract and two sound categories of deposit contract1:

  • The commodatum loan contract: a loan for use of a thing to be returned, for example the loan of a car.
  • The mutuum loan contract: the loan of fungible goods for consumption, for example the loan of oil, wheat and, especially, money.
  • The deposit contract: safekeeping of particular goods, for example jewellery.
  • The irregular deposit contract: safekeeping of fungible goods, for example oil, wheat or money.

Under a commodatum contract, ownership is not transferred and the thing loaned must be returned.

Fungible goods are those for which others of the same sort may be substituted: they are treated not individually but by quantity, weight or measure. Money is the quintessential fungible good, by definition. Goods loaned under a mutuum contract are consumed and, at the end of the contract, the borrower is obliged to return an equal quantity of goods of the same type and quality. The ownership and availability of the goods loaned are transferred to the borrower, who may use the goods as if they were his own. The mutuum contract is an exchange of present goods for future goods and therefore an interest agreement is normal. At the end of the agreement, the borrower is obliged to return the same quantity and quality of goods borrowed, plus interest. During the period of the loan, the borrower enjoys ownership of the quantity borrowed: a fixed term is therefore vital to a mutuum loan contract.

While loan contracts involve the transfer of the availability of some good for a term, deposit contracts require that the availability of the good is not transferred. The fundamental purpose of deposit is custody or safekeeping and it is therefore carried out at the cost of the depositor, who can request return at any moment (setting aside pedantic arguments about the opening hours of depositaries). The depositor is obliged to pay the cost of the deposit; the obligation on the depositary is to guard the deposit diligently and to return it on request. One might imagine the deposit of a painting, a diamond necklace or important documents.

However, fungible goods may also be deposited for safekeeping and this is the purpose of the irregular deposit contract. Complete availability of the quantity and quality of goods deposited and their safekeeping is vital. The difference between a deposit of a particular good and the deposit of fungible goods is that fungible goods become mixed with others of the same type and quality. One might imagine a warehouse holding grain, an oil tank or a banker’s safe. When the depositor asks for goods to be returned, they will have to accept receiving the same quantity and quality of goods, but not the specific goods deposited. As in the case of the deposit of a specific item, ownership is not transferred because the element of control is not transferred: the depositary must keep the deposit in safe custody to meet the obligation for immediate return.

The function and features of irregular deposits

The function of irregular deposits is to avoid the absurd overheads which would arise if fungible goods were kept safe for return of the specific goods deposited. For example, it would obviously be impossible to operate a meaningful network of bank branches on such a basis.

The essential feature of the irregular deposit is the obligation upon the depositary to keep available at all times the full quantity and quality of goods deposited — known as the tantundem — for immediate demand and use by the depositor. That is, if I give you a £20 note for safekeeping, you can use it, but you had better have two £10 notes, or some other mix, available the moment I want £20 back. That is, irregular deposits of money based on sound legal principle require a 100% cash reserve against all demand deposits.

If a depositary sold a painting held for safekeeping, they would be guilty of misappropriation. We must consider whether the same can be said of depositaries holding money who fail to keep full reserves by, for example, lending money held on demand. This is the feature of contemporary banking cited by the Earl of Caithness above.

The important differences between monetary deposits and loans

Huerta de Soto provides a table of differences between sound monetary irregular deposits and sound loans as follows:

Economic differences:

Monetary irregular deposit Monetary loan
1. Present goods are not exchanged for future goods. 1. Present goods are exchanged for future goods.
2. There is complete, continuous availability in favour of the depositor. 2. Full availability is transferred from lender to borrower.
3. There is no interest, since present goods are not exchanged for future goods. 3. There is interest, since present goods are exchanged for future goods.

Legal differences:

Monetary irregular deposit Monetary loan
1. The essential element (and the depositor’s main motivation) is the custody or safekeeping of the tantundem. 1. The essential element is the transfer of availability of the present goods to the borrower.
2. There is no term for returning the money, but rather the contract is “on demand.” 2. The contract requires the establishment of a term for the return of the loan and calculation and payment of interest.
3. The depositary’s obligation is to keep the tantundem available to the depositor at all times (100% cash reserve). 3. The borrower’s obligation is to return the tantundem at the end of the term and to pay the agreed-upon interest.

Contrast this with your present experience of banking and I expect you will find some key differences:

  1. Your money is loaned to others, irrespective of whether it is held on demand.
  2. You earn interest on your current account — ie, your demand deposits.
  3. Your savings — ie, loans to the bank — may be on demand.


At this point, we can see the first problem with our banking system: it does not operate on the same legal principles as every other business.  Our current accounts and our instant access savings accounts do not accord with any one category of sound legal contract but instead mix the principles of deposits and loans. Banks have the privilege of lending money held on demand.

That breach of legal principle makes banks vulnerable to runs and ensures that our  money supply is determined by bank lending. The dangers of the former should be obvious. The problems of the latter are more subtle but not not least of them is the redistribution of wealth and the boom-bust cycle. I will explain the mechanisms of these phenomena in a later article.

Further Reading

  1. Eagle-eyed lawyers may spot that this aerospace and software engineer is using Huerta de Soto’s terms, which are crafted for the European civil law system. Submissions are welcome which recast the arguments in common-law terms! []
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