Economics

Remember: Real Bankers are Fiduciaries

The Interim Report on our banking system by Sir John Vickers was released on Monday. There is no mention in all of the report that a banker is a fiduciary to his client first and foremost. Call me old fashioned, but the casino banking of “lets place our bets” (of course with other people’s money) is now the vogue.

I submit that on the strong foundations of the fiduciary relationship sits a solid and sound banking system. Until we understand this, we are just tinkering around the edges.

Professors Kevin Dowd and his co-author Martin Hutchinson remind us of the partnership roots of banking and how this kept bankers from being too risky, and focused them on the long term needs of their clients, to whom they had open ended liability. Fiduciary or not, this forced honesty in the system.

A fiduciary duty is a legal relationship between one party, the principal, who is dependent on the better knowledge and judgement of the person he trusts, the fiduciary. This relationship exists between the doctor and the patient, the teacher and the student, the lawyer and his client, the accountant and his client and yes, the banker and the client. A fiduciary duty is the highest form of duty for you to dispense advice, offer services and do business. Your clients’ interests are above your own.  You must avoid conflicts of interest, and you must only profit from your transactions so long as your client is aware of this. This is contrasted with the ordinary tort duty of care required when individual parties act only to avoid harm to others.

When you deposit your life savings with another party such as a bank, you are not requiring just reasonable tort standards of care, but absolute standards of car, i.e. fiduciary standards. Nothing can replace lost savings set aside for retirement. The banker has an enduring obligation of fiduciary care.

Now, in a modern bank from the very outset we have confusion. Its raison d’être, after providing safety for your money, is to offer to intermediate deposits to pass them through to where they are demanded, to willing borrowers of the bank. We are told by the majority of our bankers that the money in those deposits is ours. In reality, as recognised by law, a deposit is a debt from the bank to the depositor. This comes as a surprise to most, as evidenced by our Cobden Centre survey on banking. Some would say that this is fraud. I would say this is negligent misrepresentation. The latter requires only a false statement of fact being made to induce a party into a contract, which I submit is what actually happens when you go to open a bank account. Most offers of opening a bank account make no reference to the fact that you are becoming an unsecured creditor to the bank. This is a critical point, as most people are very shocked at this revelation. I am amazed that even after the total collapse of the banking system, the majority of people still think that their money is in their bank (and safe!). We have discussed on this web site before how there never is any mention of what you are actually legally getting involved with when you enter into an act of depositing or savings with a bank.

A group of us have tried to make matters very simple and clear up this confusion by supporting this Bill in Parliament. By requiring a distinction between deposits for safe custody and deposits for lending, we have cleared up some confusion in the banking system and laid the foundations for a solid system to grow and flourish.

The banker as fiduciary can then act in your best interest with your money kept aside for safe keeping and instant access, and investing the money you have allocated for lending, thus earning you interest. An honest fiduciary would then advise you according to the time-frame you choose for the investment, and your appetite for risk. You could invest in different parts of the bank to reflect this time and risk profile. At all points in time the bank could pay its safe-keeping deposits out, as they sit in the vaults as cash. Should some of the assets of the banks (the loans) turn bad, it is the liability of the partners, not the current account depositors, still less the taxpayers.

A fractional reserve bank, be it state-supported as they are today, or even a free one as some readers of this site advocate, could never guarantee this all the time. Thus they are immoral and thoroughly dishonest if tested under the fiduciary standard. A fractional reserve free bank could well exist with full disclosure as to the nature of the arrangement, but I would suggest this is not a fiduciary relationship. It implies reasonable standards of care, not absolute standards. This must be the case as the fractional reserve free banker can never say to you with certainty, “you can have all your money back when you demand it”. Only the fiduciary 100% reserve banker can. A fractional reserve free banker can say “with the law of large numbers, I am pretty sure I can guarantee you your money back, but never all of my deposits at the same time”.

That may well be fine for large numbers of people. Not for me.  A humorous look at the mislabelled “Fidelity Fiduciary Bank” in Mary Poppins reveals the inherent contradictions. A boy does not want to deposit his tuppence, preferring to spend it on feeding the birds. The bankers attempt to persuade him to part with the money, eventually grabbing it from the boy. Other customers are concerned, and demand their own money back, with a chain reaction leading to a run on the bank.

To found a system of money and banking on such fragile foundations does seem insane to me. As I have said, the first step is to clarify the law with regards to the legal status of the banker and the client.

The establishment of the banker as a fiduciary is the next step in the reform process. This does not mean a banker can never earn anything other than a wage, like a law firm or an accountancy firm. They can always run their business in the most efficient manner, and thus profitably. They would only be forbidden from profiting at the expense of their clients.

Address these issues and we may well move towards an unregulated and honest money-orientated banking system that is wonderfully boring and fit for purpose.  I see nothing in this Report that addresses those issues.

24 comments to Remember: Real Bankers are Fiduciaries

  • Gary

    I believe that until the underlying mechanism of fractionally creating new money for a loan to finance a new enterprise BEFORE that enterprise is functioning profitably and also extracting interest from day one of the loan, precludes any fiduciary niceties. Under such a system the money supply absolutely has to grow faster than the economy ie inflation is guaranteed, because not all new enterprises survive to grow the gdp. Money loaned for completed houses certainly does not grow the gdp. The money supply can only be non infating when either new money is created after a 100% reserve loan creates a profitably performing new enterprise or no new money is created but the existing stock of money becomes more valuable and so the market demands smaller denominations of the existing stock. Under such conditions can the banks have a fiduciary relationship with the client. Under the present fractional reserve system I don’t believe it is possible.

    • Current

      That all depends on the situation. Where are the funds coming from to allow the fractional reserve banks to make new loans? If we have a central banking system that’s creating base then certainly you’re right.

      In other situations however banks overall can only increase lending and money supply if they can find a way to use less reserves. If they can’t find a way to reduces the use of reserves then they can only lend in ways that don’t alter the money supply; by using timed savings or issuing bonds.

  • Tim Lucas

    Mary Poppins had it about right. The future looks bleak andt the system is stacked firmly against us. It realy seems much better, therefore, to really enjoy the things that the authorities find hardest to take from us. I intend to spend as much time as is possible – therefore – flying a kite with my young son.

  • waramess

    The fragility of our banking system is quite unbelievable. Not only the problems you identify but also the act of mortgage lending against short term deposits.

    This has always been justified on the grounds that a certain part of the banks’ deposit base is very stable. Now of course the situation has changed and with savers being given short shrift, the stability of the liabilities must be questioned.

    The entire business of banking supervision has been totally neglected over many years and another crash would not be at all suprising

    • Current

      This has always been justified on the grounds that a certain part of the banks’ deposit base is very stable. Now of course the situation has changed and with savers being given short shrift

      Not really, the amount lent to banks is quite stable, take a look at the BoE statistics. The recession hasn’t really changed that.

      • waramess

        Well, I suppose that would be the case as all money in the economy, other than that under the matress and circulating as notes and coin are the property of the banks.

        I was however talking about the maturity profile of bank deposits and whilst very short deposits can move quickly in the event of turbulence the asset base cannot be shrunk quite so easily.

        Paying savers a negative rate of interest over a long period of time might look clever but be sure there will be unforseen negative consequences, and the longer it goes on for the more severe the punishment.

        • Current

          Well, I suppose that would be the case as all money in the economy, other than that under the matress and circulating as notes and coin are the property of the banks.

          Well, it’s issued by banks. It’s a debt they own to their customers. That’s why I sometimes call it “debt money”.

          I was however talking about the maturity profile of bank deposits and whilst very short deposits can move quickly in the event of turbulence the asset base cannot be shrunk quite so easily.

          Yes, that’s quite true. For that reason banks have to be conservative. They can do that in a number of ways. By holding more reserves and less in less liquid assets. They can also persuade their customers to use timed bonds by offering good interest (I notice lots of UK banks and building societies have been doing this in the past couple of years).

          Lastly, they can do it by keeping a much larger buffer of shareholder capital. Every bank must keep more net assets than net liabilities. Whatever that amount is is what the bank’s shareholders own outright. If that amount is kept high then in times of crisis the share price can fall rather than the bank going bust.

          I agree that many banks don’t do these things, but that’s because they have Central Bank protection and don’t have to.

          Paying savers a negative rate of interest over a long period of time might look clever but be sure there will be unforseen negative consequences, and the longer it goes on for the more severe the punishment.

          I see this from a different perspective. The question we should be asking is after the bubble burst the Central Banks started creating money. Why didn’t that satisfy the demand? Some say that’s simply because the demand was so huge and they didn’t create enough. I’m not satisfied with that explanation. I think it has more to do with future expectations. The Central banks were seen to be failing from when the crisis emerged in 2007 until now. Often they gave mixed messages about what they were going to do next, recently the Fed have got better about that though. In my view this uncertainty caused a further increase in demand for money holdings.

          Now things have started to become clearer money demand is falling and as a result inflation is rising quickly. The BoE especially haven’t realised the need to shrink the quantity of money.

  • Strikes me the main weakness in fractional reserve is that it promotes instability, or to use the jargon, it is “pro cyclical”. That is, commercial banks create and lend money just when they shouldn’t, i.e. in a boom. And they (and their customers) destroy money or “deleverage” in a recession: exactly what they’ve been doing in the current recession.

  • Still on the subject of pro-cyclical (see my comment above), there are some amazing charts on page 2 of a Credit Suisse paper which show the destruction of private sector money and the way central bank money came to the rescue in the current recession. See:

    http://faculty.unlv.edu/msullivan/Sweeney%20-%20Money%20supply%20and%20inflation.pdf

  • It occurs to me that a bank issues fiduciary media in our state supported fractional reserve banks. . Despite this, they have no fiduciary duty to those who get the new issue of fiduciary money . Thus, as we have come to expect, they really do have their cake and eat it.

  • FRFBers say that a banker is not a fiduciary to a bank depositor, because the depositor is a debtor to the banker. The “depositor” surrenders ownership of money in return for a demandable debt claim against the bank. He is not a bailee whose “property” the bank is merely managing.

    I agree with this. Thus, the disagreement between 100%ers and FRFBers, it seems to me, is an ecoomic one: it is a disagreement over whether these promissory notes or IOUs “can be” money substitutes; whether the banks “can” “always” redeem them on demand. Of course they cannot; hence the suspension clause, which is inherently part of the relationship even if it is not made explicit (because future things are always uncertain, so the bank’s ability to repay a loan *at all*, much less “on demand” (even with a suspension-clause grace period) is never guaranteed.

    But it is important, in my view, to realize that it is more than that: not only can the FRFB not guarantee that it “can” repay the note “on demand-plus-an-optional-suspension-period”–they cannot guarantee it *at all*. After all, the other, non-money assets the bank has might fall in value compared to gold/money; and some of these assets are loans, which may go bad. If the bank has a spate of bad loans then it will not have enough assets to cover the outstanding IOUs, even with suspension clauses being invoked. That is, it is entirely possible for the bank to become insolvent because too many of its non-money assets (in particular loans) might become worthless or worth less. In this case the grace period of a suspension clause cannot save them and stop insolvency, or at least a partial run. At best, if the bank is insolvent in this sense and acts early enough to stop a run, then the “depositors” get 80cents on the dollar, or something. But the longer the bank waits to invoke a general suspension and go into insolvency liquidation, the more early people it pays off 100% and the worse off latecomers are–which is the reason there are runs.

    I.e., such loans are risky–which is why they cannot be money substitutes (in the view of the Rothbardians). Further, you cannot insure them since this kind of entrepreneurial risk is inherently uninsurable (unlike the custodial accounts which can be insured against natural risk like fire etc.).

    • Current

      But it is important, in my view, to realize that it is more than that: not only can the FRFB not guarantee that it “can” repay the note “on demand-plus-an-optional-suspension-period”–they cannot guarantee it *at all*. After all, the other, non-money assets the bank has might fall in value compared to gold/money; and some of these assets are loans, which may go bad. If the bank has a spate of bad loans then it will not have enough assets to cover the outstanding IOUs, even with suspension clauses being invoked. That is, it is entirely possible for the bank to become insolvent because too many of its non-money assets (in particular loans) might become worthless or worth less. In this case the grace period of a suspension clause cannot save them and stop insolvency, or at least a partial run. At best, if the bank is insolvent in this sense and acts early enough to stop a run, then the “depositors” get 80cents on the dollar, or something. But the longer the bank waits to invoke a general suspension and go into insolvency liquidation, the more early people it pays off 100% and the worse off latecomers are–which is the reason there are runs.

      You’re quite right that there is that risk. Life is full of risk and nothing is without it. The question is whether it is worth the bank customer’s while to do something about this small risk. Historically bank customers haven’t thought that it is. I don’t see why that would change if free-banking were reintroduced.

  • Current–people would of course take risk when they lend money. But the question is would such IOUs serve as money substitutes. Sure, on occasion I get a check, and if I owe my brother in law $100 I might persuade him to let me endorse over a $100 refund check someone gave me, to extinguish the debt to him. But as a general matter? I doubt it, but would love to see enough freedom to be imposed to let is try.

    • Current

      In the case that we know of that are closest to free-banking the choice customers made was to use fiduciary media. I think it’s very unlikely that they would choose anything different today.

      The chances of being caught in a bank-failure are not really large. Bank customers can deal with them in many ways, but using several banks and by careful choice of bank for example. The extra costs of 100% reserve banking are too high to warrant the extra security is provides.

      I admit I may be wrong and free banking may lead to full reserve banking, but I very much doubt it.

  • Current

    Going back to Toby’s original post…

    As I see it in a free society people should be free to associate and make arrangements as they please. A person who needs legal advice may ask a lawyer who takes fiduciary responsibility or they may ask a lawyer who does not. It should be up to the customer.

    The reason professions are sometimes tied to particular ideas about duty is because those ideas have proven useful in those professions, though not in others. It has been a matter of Hayekian evolution of market structures and norms of behaviour. It’s not something that can be second guessed by pure logic.

    This must be the case as the fractional reserve free banker can never say to you with certainty, “you can have all your money back when you demand it”. Only the fiduciary 100% reserve banker can. A fractional reserve free banker can say “with the law of large numbers, I am pretty sure I can guarantee you your money back, but never all of my deposits at the same time”.

    The difference is really much more a matter of degree. A full reserve banker can’t guarantee that he won’t be robbed, he can’t guarantee that his employee’s won’t embezzle the customer’s funds, or that the government will shut him down. A fractional reserve banker can’t either, and in addition he can’t guarantee that he can predict reserve demand perfectly. But, for most of these risks precautions can be taken.

    The example of the bank run in Mary Poppin’s is fiction. In reality few bank runs have happened that way. The structure of what happens reflects real runs though. Current account holders are concerned about a bank that refuses to hand over reserves, that can lead them to demand reserves. But in practice it would take a much more significant event than an argument with a child. Bank customers are not necessarily stupid. Even if there were a run in a particular branch a bank could pay it.

    What generally happens isn’t that solvent banks suffer from runs caused by panic. Generally insolvent banks suffer from runs caused by real facts about their finances. In many case in a run, a solvent bank could obtain reserves to service redemption requests by selling assets and buying reserves from other banks. It could exercise option-clauses and delayed-payment-clauses on accounts and then pay later once funds were obtained from elsewhere. The reason this doesn’t happen is that generally runs happen in the situation where a bank can’t show others that it’s assets really are valuable.

    • mrg

      “A person who needs legal advice may ask a lawyer who takes fiduciary responsibility or they may ask a lawyer who does not. It should be up to the customer

      A full reserve banker can’t guarantee that he won’t be robbed, he can’t guarantee that his employee’s won’t embezzle the customer’s funds”

      Well said, Current.

      I still have my doubts about fractional reserve banking, but I don’t think it’s helpful to phrase the debate in terms of “absolute guarantees” or “absolute duty”, which don’t exist in the real world.

      • A banker gives you his absolute duty of care. This is what he / she should be doing. Never entertaining gaming / betting / quantitative risk assestments / computer driven lending ,as they essentially do now.

        Robbery (theft with violence) can be insured against so can burglary in the vault . Fraud, this is not insurable as far as I am aware. Doing his / her absolute duty of care is mitigating all these eventualities. This is the highest standard, not to prevent in absolute terms these types of events happening.

        Current is taking you down a blind alley way on this.

        • Current

          This is where we get into the problem of what legal terms mean. I’m no expert on that.

          I’ll assume your right and “highest standard of care” means that banker mitigates against all of the eventualities you mention.

          Even in this case the probability that any depositor will get back their money doesn’t become a certainty. My point is, it’s still a matter of comparing different degrees of risk.

          Like any other financial decision it’s up to the individual to decide on their level of risk. Many people go further than trust their life savings to bank accounts, they trust them to investments in shares and property.

  • George A Selgin

    It’s crucial that the strict legal meaning of “fiduciary” be understood for the purpose of any such discussion:

    http://legal-dictionary.thefreedictionary.com/fiduciary

    By this meaning, a banker is not a fiduciary to a bank depositor, because the depositor is a debtor to the banker, that is, someone who surrenders ownership of money in return for a demandable debt claim against the ban, not a bailee whose “property” the bank is merely managing. This is quite crucial.

    Of course a banker can also be a trustee, but not w.r.t. ordinary depositors. Bankers are trustees to persons who put money in safety deposit boxes, for example. The legal obligations of a banker to a depositor are however not those of a “fiduciary”: they are those of a debtor only.

    The assumption that, insofar as it issues ‘fiduciary’ media, a bank must have a ‘fiduciary’ duty to the media’s holders, is a perfect example of the importance of distinguishing the distinct legal and monetary-econ meanings of the term ‘fiduciary’.

  • George Selgin

    I originally made my comment above to Toby after a private alert concerning his planned post, though it was only just entered, with my permission. Consequently it appears to repeat or to ignore parts of what Stephan’s and others say. In any event I am glad to see that there’s some agreement on the point I wished to emphasize.

    I remain puzzled, however, by Stephan’s suggestion that fractionally-backed bank IOUs aren’t likely to serve as money substitutes under free market conditions. This is one of those Rothbardian “predictions” that has already been amply falsified by centuries of baning experience. Yes, the Rothbardian’s can claim that the Scottish and Canadian arrangements were not ones of pristine-pure freedom in banking (though neither were they as impure as some have claimed (see White’s reply to Rothbard and other critics of the Scottish case in the 2nd ed. of his _Free banking in Britain_). But the departures from perfect freedom were in neither case such as could have served to convince holders of Scottish and canadian banknotes–which certainly were “money substitutes” by any reasonable definition–that those notes were as safe as 100-percent money would have been. (By the way, White has also demonstrated that circulating paper notes were ipso-facto fractional reserve money.) Stephan, if you wish to claim that FRFB notes and deposits can’t be money substitutes, you must explain away somehow the long record of the use of such as money in past banking systems that did supply their holders with any sort of guarantees.

    Current’s discussion of bank runs, on the other hand, is consistent with my own understanding of the historical record. What he nicely presents as the “Mary Poppins” myth is, unfortunately, what both some proponents of 100-percent reserve banking and most apologists for central banking subscribe to.

    • The tuppence pushes the bank over in Mary Poppins. It is a fictional tale , but nevertheless a valuable tale. It most have been that one penny that the bank did not have, that marginal one penny, that pushed over Northern Rock.

      FRB’s nearly went bust here in the secondary banking crisis of the 70’s. The BoE Govenor “raised his eyebrows” and notified other banks that they needed to club together and make sure the weaker banks (one was Nat West! I believe) did not fall over.

      With 100% state support in place for over a century with a LoLR central bank, you would expect total stability in the banks.

      In the FB systems in place such as in Scotland, you did have failure of banks and this is / was a good thing.

      FRFB can go bust form being badly run as well as a currency or redemption run, 100% reserve banks can only go bust via being badly run. We would be better off in this respect to be in a 100% reserved environment.

      If faced with the chooice between a bit a paper with a claim to a 100% lump of gold / silver / some thing solid or a bit of paper or number on a screen with only a partial promise to a lump of gold / silver etc, I know which one I would choose.

      Anyway, I think all could agree that we should let the discovery process of the market decide ie let the people choose what is or is not their money and be done with it.

      • Current

        I’m not an expert on the Northern Rock nationalisation.

        But, from what I understand NR could borrow from the wholesale markets and from the BoE. The reason they borrowed from the BoE was because the wholesale credit markets wouldn’t supply them. Why would the wholesale credit markets not supply them? Perhaps because those other banks believed that they were insolvent.

        It’s not clear that NR’s failure was caused by liquidity issues, without there being other underlying problems with their assets.

  • George Selgin

    Toby writes: “With 100% state support in place for over a century with a LoLR central bank, you would expect total stability in the banks.”

    Let’s not forget that the same central banks that stand ready to bail-out troubled commercial banks are also responsible for the unstable macroeconomic environment that has been a major cause of commercial bank (and savings institution) failures during the last century. It would be a mistake to suppose that, on balance, government intervention serves to make FRB more stable than it tends to be in the absence of such.

    Also, the “dichotomy” Toby erects of “badly run” versus “redemption run” is a false one. Historically, redemption runs have almost always targeted badly run banks, that is, banks that were pre-run insolvent or close to it. The belief that purely panic-based or random runs have been common in the history of banking is a myth propagated by central bank/LOLR apologists, which their critics should resist swallowing. (I will happily supply references on the empirical evidence if asked.)

    • Yes please re last point, might as well get things accurate.

      A bank could go bust on loan defaults on its own in what ever bank environment (FRFB, 100% Reserve etc) ie once the capital is burned, that is it, unless you are one of the choosen ones of today being to big to fail.

      I would hope redemption runs historically, a bit like short selling today, only attacks the poor performing banks ie it becomes self fulfilling .