Are “normal” businesses 100% reserved?

When discussing the “fraudulent” nature of fractional-reserve banking, the crux of the issue seems to be how the law distinguishes between banks and other businesses. I think all sides accept that accounting requirements are different for banks than for other businesses, however accounting principles are different for different types of business. I simply don’t have enough knowledge of auditing law to pass judgement on whether banks are treated differently because of legal privilege, or simply because they have unique attributes that auditors attempt to interpret accounting law in light of. (Note: and neither do the auditors I have asked about this!)

The argument against fractional reserves relies on the assertion that “normal” businesses are unable to operate in the same way as banks, and are forced to maintain “100% reserves” at all times. Here is an example that I’d be interested in feedback on. Consider the following bet:

“The FTSE 100 will rise by 5% or more within the next week”

I am willing to bet £1,000 that it *will*, and you are willing to bet £1,000 that it will *not*

  1. From a legal point of view, based on current UK law – have I committed fraud?
  2. From a free market perspective – have I done anything wrong?

Is it possible to answer those questions from the information given? If so, how do your answers to those questions change based on the following information:

Scenario A: When we make the bet I do not have £1,000 in cash available and have no hope of having £1,000 in cash at any point in the near future. I win the bet though, so this isn’t revealed

Scenario B: When we make the bet I do not have £1,000 in cash available and have no hope of having £1,000 in cash at any point in the near future. I lose the bet. I can’t pay you

Scenario C: When we make the bet I do not have £1,000 in cash available, however my salary is due to enter my account before the end of the week, which would mean that I do have the cash available. I also have lots of highly liquid assets that I could liquidate should I need to. I am able to convince a reasonable person that should I lose the bet, I would be able to pay out.

Scenario D: When we make the bet I have £100,000 in cash available, and have £1,000 set aside in an envelope with your name on it, just in case I lose

Which of the above scenarios would make you answer “yes” to either question 1 or 2? It strikes me that A and B do, and D does not. So the real issue is scenario C. If you told me that scenario C is illegal I’d be very surprised – how often do you make an agreement to make a future payment and have the finances available throughout? If C is illegal this suggests that if I bet £1m at odds of 150-1 that Everton will win the Premier League, the bookies is required by law to increase their cash reserves by £151,000,000 today and to maintain this for the duration of the season. Do they?

Here’s how I think the analogy ties into the fractional reserve debate:

  1. You and I have a £1 bet on whether the FTSE 100 will rise by more than 1% by 1pm
  2. I lose the bet, and don’t have £1 on me. So I write you an IOU that says “I promise to pay the bearer of this note £1” and you are willing to accept it
  3. You go to a cafeteria, and ask to use the IOU to pay for your cup of coffee. The barista agrees to accept it as payment
  4. The following day the barista comes to me and wants to redeem the IOU. I now have £1 and give it to him
  5. Seeing how the barista is happy to accept this, I issue 100 similar notes. People voluntarily accept them
  6. Since I don’t want to have to keep £100 cash on me, I put a small caveat on the note saying that I reserve the right to not pay out, but will pay an interest rate for any day that I don’t

Which of those events (1-5) are illegal? Which should be illegal?

Cross posted at The Filter^

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2 replies on “Are “normal” businesses 100% reserved?”
  1. says: Current

    I think one of the critical points here is risk.

    We have to ask the question: what is the probability that event A will happen and require the business to liquidate assets? If we answer that by saying “and probability above zero” then that effectively makes all businesses fraudlent.

    Take a small shop for example. One day a careless shelf stacker could kill a customer by overturning an aisle of tins onto them. The chances aren’t very high certainly, but if it happened then the shop would have to pay large damages. But, as soon as a customer walks in the store then that probability arises. Does that mean that the business must keep enough liquid assets to be able to pay for any number of such claims? I don’t think so. Business would be practically impossible if it did.

    Any adjudication must take into account the probability of occurrence. It doesn’t matter if the situation in question is one that can’t be avoided or one that the business has deliberately put into place. That’s where the reasonable man standard and the Hand rule come from in Common Law.

  2. says: Jeremy

    In normal usage fraud means to intentionally deceive, with the object of profiteering. As all contracts refer to future obligations, all contracts are necessarily speculative. It is the duty of each party to assess the riskiness of the other by asking questions and providing answers.

    I do not regard savings held at a bank as fundamentally different from any other type of contract. The pubic should understand that deposits held at any bank are not 100% safe. Even a 100% reserve bank, with all the durations of savings accounts and loans matched, does not offer certainty, because there will always be a proportion of the loans which will go bad. It is true that a bank with a low proportion of reserves will be riskier than a bank with a high proportion of reserves. However riskiness is not only determined by the reserve ratio, but also by the type of assets held by the bank: a bank with 10% reserves and 90% risky investments is riskier than another bank with 10% reserves and 90% safe investments. It is the bank’s duty to make all of these risks clear to the saver, so that the saver can demand an appropriate interest rate. As long as the bank does this there is no deception and therefore no fraud.

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