A recent QJAE paper by Bagus and Howden has reignited the controversy over Fractional Reserve Free Banking versus Full (100%) Reserve Banking. Per Toby Baxendale, “two very clear conceptions of money (have been) developed by Austrian School theorists past and present”. One is a Monetary Equilibrium Theory (MET) branch, favouring Fractional Reserve Free Banking, with “the rest of the Austrians favouring Full Reserve Banking.”
There are, however, some Austrians in neither camp; what I would call agnostic (Cochran 2010, p. 121-22) relative to free banking. As a long time contributor to developments of Austrian Business Cycle Theory (ABCT) with this view, I recognize the potential for a 100% banking system to eliminate the credit creation at the heart of the ABCT boom-bust process. However, I recognize the complexity of the saving-investment process in a capitalistic system with well-developed financial markets (including banks) which are heavily dependent on financial intermediation to funnel savings from ultimate savers to ultimate investors through what is often simplistically represented as a loanable funds market.
As hinted at by Baxendale, at the heart of many, if not most, of the controversies surrounding the role of money and banking in an advanced economy is the careful differentiation of dual services provided by banks: transaction services and intermediation. The issue is made more complicated by the possibility that the public may willingly and knowingly hold financial instruments that can be viewed by the holder as a transaction asset while, simultaneously, at least some of these funds may be a source of loanable funds; funds for which the bank intermediates between ultimate lender (depositor) and an ultimate borrower.
The ‘free bankers’ make an effective case that under proper conditions banking freedom is an institutional framework that would, given the great uncertainty and risk involved in any time-related planning, allow the voluntary interaction of agents to channel funds from savers to investors while minimizing trading at false prices, in this context deviations of interest rates from the natural rate(s).
In an earlier attempt to examine this issue rigorously, Cochran and Call (2000) concluded in favor of banking freedom:
A definition of commodity credit provided by Mises (On the Manipulation of Money and Credit 1978, p. 119), however, leaves the door open for a compromise. Commodity credit is “credit which a bank grants by lending its own funds or funds placed at its disposal by depositors.” Under what conditions are funds placed at the disposal of the bank by depositors? The problem is that the short run merges into the long run in gradations that are, as Marshall suggested, imperceptible. Money can be, and often is, both a present good and a future good, depending, in part, on the subjective evaluation of the depositor. As Friedman (“The Quantity of Money: A Restatement” 1956, p. 14) pointed out, economic agents hold cash balances because they derive utility from both sources and the same unit of money may provide both services. Where cash holdings are a form of saving, the holder may actually be willing to temporarily surrender the present for the future. Such funds (and the resources made available by the saving) can be made available for loans.
Here, the market, as it often does, provides a solution. Free banking is a process where the market makes the ultimate judgment on where to draw the line between money as a present good and money as a future good. Bankers must make a judgment on the proportion of their deposits that represent saving and the proportion that are currently serving as present money for the holders of the deposits. Only funds held as savings may be safely “invested” or loaned. Consumers of banking services make judgments about the safety and soundness of the banking institutions with which they deal. Successful banks will provide the mix of services that meet the needs of their clients. The market test makes it qualitatively difficult to distinguish the Mises from the Selgin outcome. While Mises expected the discipline of the market to move banks closer to the 100-percent-reserve position, Selgin anticipates lower levels of reserves and hence more intermediation and lending. Just as Marshall’s short run blends into the long run, the practical aspects of Mises’s theory of money, credit, and banking blend into the theory of free banking provided by Selgin.
A footnote provided the following caveat:
The above argument depends on the caveat that free banking means banks operate in an environment in which banks are subject to the general rules of commercial and civil law and are not the recipients of special privileges and protections granted by the state. As expressed by Mises (1998, p. 440 [Human Action: A Treatise on Economics. Scholar’s Edition]),
What is needed to prevent any further credit expansion is to place the banking business under the general rules of commercial and civil laws compelling every individual and firm to fulfill all obligations in full compliance with the terms of the contract.
In simpler words, those criticizing free banking, properly understood, on cycle grounds need to look elsewhere to justify a 100% reserve system.
Bagus and Howden represent the latest challenge and others (Selgin and Evans and Horwitz) have adequately responded. While applauding Bagus’s and Howden’s “abstaining from a discussion of legal and ethical issues”, both critiques expose the weakness of the arguments presented by Bagus and Howden. Evans and Horwitz then “attempt to specify how debate between the two sides might proceed more productively.”
Since my above-quoted article was penned, other touted challenges to the free banking argument have arisen particularly from De Soto (Money, Bank Credit, and Economic Cycles, 2009) and from Jörg Guido Hülsmann (“Has Fractional-Reserve Banking Really Passed the Market Test?”, The Independent Review, Winter 2003).
In correspondence with Larry Sechrest right before his untimely death, we agreed that we both had hoped these contributions would move forward the discussion and perhaps, especially for me, provide acceptable arguments in support of the 100% reserve position. We both were disappointed with the arguments presented, for reasons very similar to the criticisms by Selgin of the Bagus and Howden paper. Since Larry put his thoughts in writing, I’ll refer interested readers to the new preface in the Mises Institute reprint of his Free Banking.
The discussion generated both on the web and in academic writings by Bagus and Howden should be welcome in light of the recent crisis and its aftermath. It is more important than ever that “the question of banking freedom must … be discussed again and again, on basic principles” (Mises, On the Manipulation of Money and Credit 1978 p. 45).
“The market test makes it qualitatively difficult to distinguish the Mises from the Selgin outcome. While Mises expected the discipline of the market to move banks closer to the 100-percent-reserve position, Selgin anticipates lower levels of reserves and hence more intermediation and lending.”
I confess that I cannot see what the “difficulty” is in this case: with the exception of a small number of early “public” banks, all subsidized to some degree by the state, and all gone by about 1650, 100-percent reserve banking has been exceptional. In contrast, fractional reserves have been the norm, in all manner of regulatory regimes, including several very closely approximating free banking (and with nothing resembling guarantees and such that today give fractional reserves an artificial boost). Even in the earliest and most vulnerable cases, cash reserve ratios seldom exceeded one-third of banks’ current liabilities; and by the turn of the 19th century ratios below, and sometimes well below, 10% were the norm.
Now, if this mass of evidence doesn’t suffice to falsify the “prediction” that laissez-faire in banking will tend to result in cash reserve ratios approaching 100%, then what sort of evidence could possibly suffice?
I submit: Mises’ claim is testable, has been tested, and has failed.
Where do Hayek’s views on having private issues of fiat money fit in this debate?
It would seem to me that Hayek’s notion of competitive issues of fiat money would be preferable to rediscovering money ala Menger then moving to redeemable fiduciary currency. If the economy were a house, Hayek’s plan would require some renovations while the “White-Selgin” solution would require a complete demolition and rebuilding.
Good Afternoon George,
In Central Europe, Austria and Switzerland in particular, there are alot of full reserve banks and partner banks. Also in tax havens around the world.
There are also custody only banks specifically that hold all assets for regulated funds, mutual, life, pemsions etc as the funds of the world generally do not hold their own assets due to conflicts of interest. These amount to many trillions of dollars.
There is no mainstream “retail” offer that is 100% reserved. This model has not passed the test, but then it competes with one arm and leg tied behind its back with one of its eyes gouged out as a FR bank can use its current creditors money and a 100% RB cant for all the legally favoured reasosn you know of that we would both seek to abolish.
I am 60% to 40% that 100% reserves would win a fair test!
I think all can say “let the market decide!”
Even if 100% reserves did pass the “market” test it would soon (d)evolve into some sort of fractional reserve system as a large “shadow banking” sector would emerge for people wanting credit and instruments that 100% reserves would find it hard to provide (e.g. mortgages or revolving credit lines). One only need look at the interest rate difference between US banks, which operate with required reserves and offshore Eurodollar accounts that do not to realize that while 100% reserves has a niche market, the majority of capital out there wants to earn interest even with the additional risk.
All deposits at 100% reserve banks would become de jure time deposits, i.e. the bank would be under no legal obligation to provide funds on demand. However, competition would drive the banks to offer immediate withdrawal; deposits would become de facto demand deposits — not because of the legal rights of the depositor, but just because market competition. This system would have all the legal language of 100% reserve banking, but it would be operationally almost identical to fractional reserve banking.
In fact, this is pretty much what we have at the moment, since most banks reserve the right to suspend withdrawals for a specified period. Standard bank policy, I am told. Of course, they rarely actually invoke this contractual right, because it would be bad for business.
I am thinking about something a little different as I was taking for granted that 100% reserves would be in effect. Securitisation of mortgages and credit card debt as well as business credit lines would be especially common as banks using 100% reserves would find it difficult to offer these products. The end result would be (assuming none of the banks “cheated” (a dubious assumption in its own right)) stable banks with very little money in a very cyclical economy driven by offshore lending. Assuming the banks did “cheat”, you are correct, it would be just like it is now with respect to fractional reserves.
Good Evening Chris,
There is a very odd view that a 100% reserve bank means you bank in a shoe box and all credit dies, all investment dies , the whole world ends and we eat our babies for dinner.
If you have honesty in contract, the money you wish to keep as a present good, i.e. for expediture for you now, should be what an essential deposit is about.
If you want to hold money as a precaution , you should be allowed to and not have it lent out.
If you want to put some money away for future consumption and you wish to earn interest on it, then hey, you enter into the world of risk. This means the bank lends it for a duration you are happy with, 1,3,6,9,12,18,24,36 months etc.
This means savings match the lending in the economy.
Credit does not die, most companies still offer it.
Mortgages still happen as pension fund and life companies where you are saving for very long durations i.e. up to your whole life deal with the longer maturity spectrum of lending.
FR banks accounts for those who wish to pool their property rights could also exist contractually for those parties who want to engage in these activities. I would set that up as a legal “silo” so it could not not bring down any other parts of the bank.
All is possible with clarity in the legal contracts that people get involved with.
Chris, I would also like to add that bar the governments of the world, for whom no rules seem to apply and FRB’s, EVERY COMPANY that is solvent is 100% RESERVED .
All compnaies need to keep their creditors whole at all points in time. Offering you instant access and knowing that you cant perform if all your creditors demanded redemption as you have told them there and then is plain wrong. It is only the law of large numbers that protects banks and it is dishonest not to ackowledge that to your customers when you treat with them. No other company on the planet needs this special legal and accounting privilege . It shakes at the foundation of my Liberty loving bones.
If people want to trade on a fraction, great, let them do it, but why hide this fact and acount under different accounting rules to others?
You must ponder on this point for surely a system that works for every company in the world bar banks is good enough for the banking system?
Why do we need to set them apart and allow them to exist seperate to the rest of humanity?
I believe that insurance companies operate under the same system as banks. They promise they will indemnify you but only keep a fraction of their total outstanding liabilities on hand to pay claims. There are also ratings agencies that tell you about the relative strength of a particular insurance company. I fail to see how “on demand” is any different than “in case of x” or how this is a privilege. Banks as individual enterprises are inherently unstable, but it is not incumbent upon them to advertise it. Bereft of whatever government insurance scheme is being used people would demand it much as they do for insurance companies. It is a mistake to say that FRB depends on a privilege for its existence. FRB depends on the insurance scheme and a central bank to do grievous harm to the economy but does not depend on them to function.
“I believe that insurance companies operate under the same system as banks. They promise they will indemnify you but only keep a fraction of their total outstanding liabilities on hand to pay claims.”
Not so Chris.
An insurance company sells you a product called a policy. You give up money today in exchange for the policy and its benefits. They do not issue you a policy and take your money and say your money is always there when you want it back!
Some free banking theorist show staggering ignorance to this fact . Banking is called banking because it is doing something very different to insurance contractually and economically.
When someone talks to you about insurance companies doing the same as banks, glaze over, try and change the subject to football as the person does not know what they are talking about.
You consume the policy during the life time of the policy. It is predicated on the law of averages and will pay out , sometimes it will not. With most things arriving back at Lloyds the underwriters with unlimited liability, seldom has anything not be paid out. This is a risk you take when you buy a policy.
Selgin acknowledged in the above comment that fractional reserve banking is effectively subsidised today, thus giving it an “artificial boost” in the present marketplace. But the evidence he is referring to comes from a range of institutional arrangements across hundreds of years, both where fractional reserve banking has been supported and undermined by government policy.
Just use a 100% gold standard and let the market demand for money be measured by the money most sensitive to monetary demand, gold,(because of it’s unrivaled monetary characteristics and almost negligible change in new supply) be the yardstick. The market will soon demand gold be subdivided as each unit gains value(its claim on goods and services grows) in a growing economy, and vice versa. If you want some flexibility built-in to facilitate intermediary payments along the supply chain before the final payment for goods are due, eg for wages, then either include progress payments as part of the agreement between buyer and seller, or use expiring Real Bills cleared for gold, as outlined by Professor Fekete :
I might add that Sean Corrigan, among others, hates Real Bills, judging by the debate elsewhere on this topic. I can’t speak for him, but I think a crucial mistake the opponents make is that counterfeiting Real Bills is illegal, unlike the legal counterfeiting in our current system.
Chris Cresci writes that “Hayek’s plan would require some renovations while the “White-Selgin” solution would require a complete demolition and rebuilding.”
That’s the opposite of the truth: Hayek’s scheme for “private fiat monies” means whole new standards, and many of them; what’s more, it is almost certainly not feasible (See White’s critique of it and similar plans in his Theory of Monetary Institutions. The “Selgin” plan, as presented in Theory of Free Banking, calls for allowing banks to issue notes denominated in the established “outside” money, while recommending that the stock of that outside money be permanently frozen. It contemplates no disruptive change in the monetary standard. What’s more, it is a solution with historical precedents, whereas Hayek’s is entirely hypothetical.
I do not speak of the “White-Selgin” plan simply because there’s no such thing: Larry and I consider various alternative plans, all sharing in common the competitive issuance of banknotes redeemable in some common monetary base.
I agree that Hayek’s plan taken as a whole is not feasible. However, I don’t see a smooth transition to a redeemable currency occurring as our financial system is not set up for it. Whether people want it or not, I don’t believe that a transition from fiat money to redeemable money is possible as no bank will issue a redeemable currency.
Let’s say that you are correct and there is no disruption. The central bank is abolished and banking is deregulated full stop. People will use dollars and banks will not issue money. The opportunity cost is simply too great and the return on investment would be way to small. Redeemability increases this risk as banks cannot control the supply and demand of the underlying commodity. Thus, a bank acting alone would have to piggyback their issues onto the dollar and make immense capital investments with regard to marketing in order to insure acceptance. For their efforts the bank would be rewarded with more costs as its survival would be tied to its currency. The fact that the bank tied its future to the success of its currency would, at least nominally, make it scale back its risk and thus its short-term profit. The long term returns would be a counter-cyclical constraint on issue due to increasing marginal costs? Possible synergies? No, because all the other banks are issuing money that is fungible. Increased business? Again we have the problem of fungibility. In short, there is no value to banks in printing money.
The only scenario that would make business sense would be if all banks took the view that it would be better to make less money than fail. Unfortunately, it goes against precedent for one bank to scale back its risky activities in order to make less money and the precedent is even weaker for this model to be copied by other banks. Consequently, banks would have to reach some sort of entente and form a money syndicate, which would be eerily similar to what we have now.
Regardless of the historical record, I don’t see how, in the absence of coercion, if the central bank were to be abolished we would not be using dollars until someone came up with another fiat currency.
Chris, banks do create their own money today. A bank account is fiduciary media. They redeem too, whenever I go to a cash machine to withdraw that is redemption – redemption into fiat money because fiat money is the base money in the current system.
Some banks also create their own notes, Scottish banks and Northern Irish banks have this right and they still exercise it. Banks have a great incentive to do this because every note in circulation is an *interest free* loan to the bank. Fungibility doesn’t stop a note being a loan.
In the 18th and 19th centuries all sorts of organizations, some of them very small, issued their own money.
The notes you mention in Scotland and Northern Ireland are still denominated in the Pound so they are relying on the existing financial system. If they were not allowed to issue notes or bearer bonds in the existing currency, my guess is that they would not. The “interest free” loan denominated in the existing currency would not incur increasing marginal costs as the banks do not have to manage the currency themselves. Redeemability for gold makes the issue even riskier as swings in the price of gold could cause a run on the bank. All of these risks together should be considered “counter-cyclical”. However, this assumes that banks will be able to divine their long-term best interests in a way that they have so far been unable to do.
As for the historical argument, I am skeptical of the ability of banks to issue precisely because of the recent advances and interconnectedness of the financial system. With a regionalized banking system issuance is a great deal less risky. Contagion is much more difficult to spread and banks fail alone.
Gary, the Real-Bills doctrine, whether Fekete’s version or any other, has been demolished countless times–by Thornton, by Wicksell, by Mises, by Mints. Fekete’s arguments do not begin to salvage it from these devastating criticisms. What’s more, by trying to link the RBD to the gold standard, Fekete begs the question: if basing bank lons on real bills suffices (as the RBD claims) to prevent inflation, what need is there for gold convertibility? Why the fifth wheel?
Restricting bank lending to real bills is, in fact, neither necessary nor sufficient to keep the supply of credit and bank money within desirable bounds; and the RBD has no place in any sound understanding of the workings of a self-regulating banking system.
Sorry to be so emphatic but this is one dead horse that can’t be beaten often enough!
Amen to that.
This RB’s doctrine is the Zombie that you keep having to get the garlic and the post to stab into its heart out theory.
Keynesianism is nearly as bad as this, you keep each generation having to kill it.
“In Central Europe, Austria and Switzerland in particular, there are alot of full reserve banks and partner banks. Also in tax havens around the world.”
Where depositors place a premium on secrecy, they might trade off return for the purpose–as is certainly the case w.r.t. some of these accounts. Nevertheless, I doubt that relative to world bank deposits they amount to a hill of beans. What’s more, I wonder how many actually are backed fully by “cash” in the economists’ strict sense–that is, actual fiat currency or credits on the books of central banks. Swiss banks, for example, generally hold fractional reserves, though the ratio is high, in part because they cannot rely on overdrafts for settlement as banks in many other countries can.
“I wonder how many actually are backed fully by “cash” in the economists’ strict sense–that is, actual fiat currency or credits on the books of central banks. ”
Very good point. I was looking at one the other day with a exceptional maturity profile with over 1/2 billion in assets undermanagement and the money on one day call was lent over night to the likes of Credit Suisse and UBS, I thought, I would pass on that, too much counterparty risk.
Yes, you need to navigate these waters very carefully.
For what it may be worth, the Wikipedia article on “Full-Reserve Banking,” which seems generally both sympathetic and well-informed (I do not know who contributed to it), states: “There are currently no examples of full reserve banking with an established history of operation. However, a variety of organizations aspire to provide full-reserve banking or claim to do so.”
Good Evening George,
Do you count banks that provide custody and security services for the vast majority of world wide pension funds, mutual funds , closed end and open end as FRB , or 100% Banks (that is why they are used for custody) or not banks at all?
Do you consider all banks with no deposit taking mandates as banks or not banks?
I was on a small Island last month and there were 40 plus of them!
Is Goldman Sachs , now a bank as far as the USA govt and the UK govt a bank or not a bank? It does not have FR as far as I am aware.
When Bearings went bust, were cleint accounts all custody accounts or FR accounts or a mix? I think they were custody accounts i.e. no one bar the bank itself lost money and its trade creditors.
There is a very simple view out there that there are only FRB’s when in fact large sectors of the economy have full reserve banks who are custody only with regards to cash deposits . You do not hear about them as joe public does not use them.
Your reseach is very well in your academic work, I doff my cap to you sir, but don’t quote me rubbish from Wikipedia!
Custody accounts for base money? If it’s equity, gold, or other non-base money assets that are being kept in custody, then no, they aren’t banks. I certainly don’t believe that Goldman Sachs is a 100 percent reserve bank.
But if you will supply us with an actual balance sheet for any of the institutions you refer to, that will settle the matter I’m sure!
What institution could be considered a 100% reserve bank that makes most of its money doing proprietary trading? You have all of the risk with none of the compensation.
Is not prop trading with its own money, not its depositors?
I will send you one eg to your email, then some links to others.
Toby, I put in a request for links to a representative sample of these “full reserve” banks on the previous thread but things had obviously moved on.
So, a renewed request please. It would be helpful to get a better sense of the sort of institutions you’re talking about.
P.S. Did you read that Wikipedia article on “full reserve banking” that George mentioned by the way? I also thought it was surprisingly good.
I sent to George last night, the Bank of New York Mellon, (holding $25 Trillion of assets in custody) the largest custody bank I know of and the Kas Bank in Europe , a very top end custody bank. A good example of a full reserve a typical Swiss / Central European Bank is Wegelin, the oldest private bank in Switzerland still with unlimited liability partnership in place. There are 100’s if not 1,000’s of these.
Thanks Toby. Sorry to be so slow in responding.
I don’t know that any of these three examples are in any meaningful sense a bank. Wegelin appears to be solely in the business of wealth management and retirement planning; Kas Bank and BNY Mellon do do some lending in addition to their custodial and securities processing services but it seems relatively minor and principally involves margin and other lending against securities.
Safe keeping $25 trillion dollars is not a bank?
It is of course, strictly speaking.
A custodial bank, though, with a very small commercial banking operation included. Although it’s custodian for $25 trillion, its total balance sheet is (only) $247 billion and its actual loan book $38 billion, much of which is margin lending and lending to other financial institutions.
In terms of the discussion about banking on this thread, I don’t see how the example of BNY Mellon much helps us either as regards principles or practice. It is, to my mind, more of an intriguing aside.
Good Morning Ingolf,
This is one bank that is 10 times bigger than the Federal Reserve – and who the Fed choose to custody things with. It shows, despite the more wide eyed members of the FRFB School of Thought, that safe keeping is not actually a bad busines and is quite in demand!
Their lending is not a shabby amount as well as you can see.
Also, concerning Wegelin, the oldest private bank in Switzerland, they lend, they need to know you are god forbid, credit worthy! Oh, that last little bit has been forgotton about due to the large scale distortions that I think most readers of this site would like to see abolished. You will find most of these full reserve or near full reserve banks are conservative in approach, they know their customers personally, no computers making credit risk choices and your banker , who knows you, makes any lending choices. Good old fashioned , simple and highly booring banking!
Are you saying that NBY Mellon, for example, are holding large quantities of cash for their clients. That is, are they a “warehouse bank” as Rothbard suggests?
Or are you saying that they are holding *assets* for their customers? As I understand it NBY Mellon are mostly custodians for financial assets such as stocks and bonds, not money.
We FRFBers are not saying that little market exists for that service. Of course there is a market for that, most stockbrokers and “wealth managers” do that. We’re talking about money.
That “little service” is $25 trillion in this one bank (10 x bigger than the Fed). The entire TARP monies were deposited with it, it is a real bank. Most funds will custody their cash with it who use it to keep securities. It had loans of over $200bn last year.
Pension fund and life companies who STILL think they are fiduciaries with the un replacable savings of their clients is deposited in these institutions.
Current: It is a bank end of story.
100% reserved Swiss banks in a very healthy economy exist more as the norm.
Toby, are you saying that TARP was paid in fiat money (that is treasury notes) and someone is storing them?
What’s your evidence for this? Do you have any that is public domain that we all can read?
No evidence other than it is widely reported in the press at the time that the Bank in question was the one handling this all, I made a mental note of it at the time.
OK, but what the press reports say is that they are custodians for assets and money. How can we know how much of the $25 trillion is assets and how much is money?
Also, can you show any evidence that Swiss banks are fully reserved?
As a sidenote, some financial organizations use FRB indirectly. For example, my stockbroker is not allowed by regulators to be a bank. So, my stockbroker has a bank account with a commercial bank, and in that it keeps the funds of it’s clients as a custodian. (I don’t know if it open one account per client or uses one account for all). In this case the deposit is still fractionally reserved because the commercial bank uses fractional reserves.
Current, you can just go look at the Swiss and Austrian bank’s balance sheets , loads are fully reserved.
I do not know the cash / asset split in custodians like Mellon, it would be really interesting to find out.
Re your stock broker, if he has pledged to keep your client money as cusdotian and he was depositing in a regular commercial bank, he has failed in his duty to be a custodian.
I suspect he would either not be offering you custody on cash (but just saying it will sit as cash prior to being exchanged for shares) before shares are bought or he is not aware that that bank IOU he has is a claim on a fraction of what was actually deposited.
Let’s hope it is assets and not money. If it is money then we really could be in for some serious rises in prices.
Do you mean loans? In what sense is a loan reserved? Are you talking about collateral? Lots of bank have collateral agreements for nearly the whole value of their loan books.
Aren’t we talking about current accounts here?
Anyway, I’ll have a look on the internet for the balance sheets of some Swiss banks.
Perhaps I didn’t describe this well. The documents I got when I opened the account explain that the trading balance I have is kept in a bank account at a commercial bank that the stockbroker operates for me. The stockbroker doesn’t claim to be holding fiat money directly.
Loads = a lot of. Alot of banks in the Apls are full reserved as I see it. Cash is either over night in the central bank or lent with a matching maturity profile. Thus no FR in place , therefore the whole bank is 100% reserved.
See note to GS 2011/05/19 at 18:56 | In reply to George Selgin.
Do you think the losses will be limited to just its own money?
To be clear, when we say that “Banks have been FRB in the past”, we mean specific things. Firstly, it’s money that is under discussion, not anything other good. Secondly, were talking about the situation where a financial institution deals with the non-financial sector. In the past clearing-houses have offered 100% reserve banking to banks.
In reality , IOU notes or bills will arise spontaneously in lieu of cash payment in any case. Few purchasers would want to exchange cash before they receive the goods. eg goods that spend 10 days on the sea, but the purchase is agreed to before they are shipped. On what basis can the seller go to the bank to raise a loan to tide him over and pay for the shipping and wages until he actually receives the cash from the buyer ? He must have a note of some sort to present to the bank. He uses the IOU. These notes will always circulate as money(credit).
Since this is a fact of life , Real Bills is a legal framework to make those notes expire and mark-to-market timeously. It is not ideal, but then credit is never ideal, they are just facts of life.
BTW: I think the Austrians make a big mistake saying that money is only cash or MZM. There are practical limitations on this and credit is one of them, because something has to fill the lag between agreement and consummation of a transaction. Credit will always exist and will always circulate as money. Regardless IMO.
In all my years of importing goods and exporting goods, letters of credit, only issued by a bank as I had placed cash with them for the same amount and likewise with any counterparty have never been able to trade as money.
IN a 100% reserve or a FR (free or not) bank enviroment , there is never a need for Real Bills
There is certainly a liquid secondary market for your letters of credit, not least the factoring market and they are readily convertible to cash at any stage.Today most letters of credit take the form of that ubiquitous money/credit instrument, the plastic credit card.
So credit will arise spontaneously in a free market, the problem become s how do you tether the credit , the future claim on cash/gold, to the cash itself, in other words how do you enforce marking the outstanding credit to market ? You have to ensure that bills that are consummated are cleared. Clearing is the mechanism for marking the credit to the underlying. You also have to make sure that credits that are not cleared because the transaction did not complete are expired and removed from circulation. Real Bills fulfill these criteria. If either of these criteria are not met you run the risk of having more claims on cash/gold than you have economic activity and so you get credit inflation and boom and bust. Real Bills enforces discipline on credit.
With fiat currency the issuers can buy excess credit back themselves and then reissue it when needed. If the issue is private then securities or competing currencies can be liquidated in order to remove excess liquidity from the system. There is no need for expiration or redeemability if the issuer is not taking deposits from the public.
You are correct in that credit notes can be redeemed for debt bearing fiat or other notes, whether by banks or other parties, but they can never be liquidated by such means , the credit is just swapped for another form of credit. Fiat, as currently issued, is a credit note itself. And if the notes cannot be liquidated the debt would perpetuate and grow indefinitely, spawning inflation. Credit notes can only be liquidated, by non-debt bearing media and the best is gold. So, in any case , no matter who liquidates the notes it must be done for gold or some similar non-debt bearing media, the value of which is a function of the real economy AND in a timeous manner, if you want to mark the debt to market ie tether it to the real economy.
Your description is only relevant to fiat money issued by banks. When not issued by banks such notes are equity and not liabilities. How can fiat money be a credit note when it can only be redeemed for more fiat money? Additionally, if I issue money and then buy it back, there is no perpetuation of that money. I have taken it out of circulation much as companies routinely do with their undervalued shares. Thus, there is no problem of inflation (I am assuming from the context that you mean a general rise in prices) as I can control the value (if not necessarily the quantity) of money. If my previously issued currency is exchanged for other competing currencies then they can take their own notes out of circulation or not. However, this should not be confused with the extinguishment of debt as it is not liabilities that are being extinguished with assets but assets that are being exchanged for equity.
You are correct, debt can be extinguished by assets or non debt bearing fiduciary media. But, we don’t have anything as legal tender that can achieve this at the moment in this debt based fractional reserve system.
I think you need to separate in your mind banking from money production. They are different. Most currencies are only liabilities when and if they are deposited in the bank. Thus, only the issuer can remove currency from the system. To do this the issuer has to buy back the excess liquidity with assets. The existing central banks would be able to do exactly this (and they do). However, they do not know how much money is demanded because there is no competition to tell them when to print and when to contract the money supply. Instead, they rely on their own judgment, which is often wrong or political mandates, which are always wrong.
I have never met Toby and never seen his eyes. But, when I wrote about this subject a few months ago I got the impression they were glazing over. ;)
Now, Toby’s argument is that for other businesses “liabilities must be kept whole”. That is, if a greengrocer owes £50 at one time then he must have £50 to pay those bills. This isn’t true in all cases.
The first thing to understand about this argument is that a greengrocer isn’t a bank. In all likelihood the creditors of the greengrocer will claim on their loans quickly because those creditors will find money more useful than a greengrocer’s bill. That’s not true of fiduciary media though, which may be just as useful as base money and often more useful. As a result customers of banks are willing to hold bank account balances for long periods of time. This means that only a tiny fraction of a banks outstanding liabilities are redeemed over a short period such as a month, unlike most other businesses. This is why banks are treated differently, for a normal business the inability to pay debts as they come due can be predicted from whether their cash supplies can cover outstanding debts. For a bank though this doesn’t work because of the large balances that are kept in accounts over many months and years.
So, that’s why banks are treated as they are, but are other companies treated differently. What’s important to understand first is why we bring up insurance.
If I have a bank account then I pay for that bank account by lodging base money. Then under some conditions I can obtain base money from the bank. For example, I could put my card into an ATM enter my pin and specify an amount.
An insurance policy is quite similar in some ways. An policyholder pays a fee for the policy, then under some conditions that entitles them to obtain base money from the insurance company. For example, a car insurance policyholder can claim if his car is damaged. The difference here with the banking case is that the condition is different, the policyholder can’t just ask.
Now, the law could take the view that all policyholders could claim at the same time. In this case, to keep all policyholders whole the insurance company would have to keep enough cash to pay out all policies at any given time. This would make insurance effectively impossible. But, the law doesn’t take that view, even though there is a chance that a great many claims could occur at the same time the law takes the view that it’s acceptable for the insurance company to keep assets (such as shares) instead of cash. The law allows shareholders and customers to come to an agreement about the risk they can tolerate through competition between insurance companies.
So, the situation in insurance is quite similar to banking. In both cases there is a small chance that the business could be obliged to pay out a huge amount at once to creditors, and may not be able to pay. In both cases the law doesn’t consider this a serious enough possibility that this will happen to require the institution to be fully reserved. This is quite reasonable, episodes when banks have failed because of an unjustified rise in redemptions have been few. Normally when banks have gone bankrupt it has been because they’ve made bad loans.
The same sort of principle is implicitly applied to many normal businesses. Here’s an example of that I gave in an earlier post:
In this context 100% reserve proponents often bring up the idea of class probability and case probability. The argument here is that insurance risks can be measured by experiment, they are what Mises calls class probabilities. However, true uncertainties involve unique situations and the unpredictabilities of human behaviour, they can only be judged, not known and judgement of them is a case probability.
The issue here is the insurance doesn’t just involve class probabilities. Very often insurance companies agree to contract where they cannot precisely know the probability of having to pay out, and where whether they have to pay-out or not involves difficult-to-predict human actions. Ship insurers for example will insure new types of ship even if there is only one of that type of ship and it’s reliability isn’t yet known (they do this from estimating from facts about the ships design and previous experience). Car insurers offer insurance even though the wrecklessness or carefulness of their policy holders is a matter of human psychology.
The fact is that insurers never really know how much they are going to have to pay, all they can do is make a guess and charge accordingly.
Two ideas have not been put forward-
Competition from other FR banks will push initially higher profits back down to previous levels thus leaving the banks vulnerable to runs for no real gains.
And, there will be opportunities for profit by speculators who take a short position in the common shares of FR banks, and then deliberately trigger a run, by making large, abrubt withdrawals.
These two things should limit the curb appeal of fractional reserve banking in a truly free market economy.
With fiat money issued by an institution that does not take deposits both of these points are moot. The risk of a run is non-existant due to the fact that the issuer does not take deposits and large, abrupt withdrawals get absorbed by the issuer at a discount.
Free banks can provision against these threats by using option clauses.
In Scotland the banks occasionally tried these sorts of strategies to bankrupt each other. It generally didn’t work, but banks did a lot of damage to each other trying it. The option clause was a solution for some of that time, because the clause could be exercised on banks or speculators that tried what you describe. With current accounts there is often an option clause of some sort today. Banks can refuse to open current accounts for those they suspect of attempting this.
Even after option clauses were banned in Scotland the existing banks were not destroyed by note raids, and did not abandon fractional reserves. In fact they continued to improve procedures so they could use even smaller reserve fractions.
Morning Toby (hope you pick this up; for some reason, I couldn’t reply directly to your comment).
I wouldn’t for a moment deny the vital importance of safekeeping, or question the value of services provided by firms like BNY Mellon. Can’t imagine why you thought I might!
Still, its lending operations are miniscule in relation to their custodial activities. Indeed, on any absolute terms their principal activities are small and very restricted; certainly, they can’t be compared to either the Fed or any sizeable commercial bank.
Holding assets like equities and bonds on behalf of various institutions and high net worth individuals (and administering all the details related to settlements, dividends, other income etc etc etc) isn’t, to my mind, at all comparable to the business of commercial banking, of borrowing and lending. Isn’t it a role more akin to that of a trustee, albeit on a massive wholesale basis?
As for Wegelin and lending, it sounds as if you have personal knowledge and I’m certainly not going to argue with that. As it happens, I love the idea of unlimited liability private banks pursuing their craft. Would that there were any number of them.
I see from their website though that Wegelin call themselves one of the “leading independent providers of structured products” as well as being “one of Switzerland’s leading quantitative asset managers and . . . largest hedge fund managers”.
Nothing wrong with any of that, let me hasten to add, but it sure does suggest they’re anything but stodgy.
A bank holding 100% reserves is not comparable to an insurance company having enough money on hand to pay all potential claims.
The claim that depositors withdrawing money is a systematically unpredictable event in the same sense as the occurrence of insurable events completely misconstrues the nature of the contracts involved.
Banking involves EXISTING legal claims that can be exercised at the discretion of the depositors. Insurance involves POTENTIAL legal claims that do not exist and cannot be exercised until systematically unpredictable events occur.
It is banks holding less than 100% reserves that are the problem. Nevertheless, from the perspective of the bank or the insurance company what is the difference between someone taking out money when they want to or when some unforeseen event occurs? Both events can be estimated but not predicted because they are based upon “systematically unpredictable events” from the point of view of the institution. Both are based on legal claims that might not be honored in the event total claims exceed liquid funds. The main difference between banks and insurance companies is that the bank customer knows when they want to withdraw. However, this fact is of no import to the bank as they still estimate based on past events to accommodate an unknowable future.
You are not recognizing the critical distinction that I made in my post regarding EXISTING legal claims versus POTENTIAL legal claims.
The legal claim of a depositor does not spring into existence at the moment he requests withdrawal of his funds: his claim always exists and may be exercised at any time. The legal claim of an insuree, on the other hand, springs into existence at the moment that a systematically unpredictable event occurs.
I do recognise what you are saying. However, for the bank, the critical legal distinction makes no difference. If you wish to say that the bank is acting illegally in lending out money that is supposed to be kept “on demand” that is a completely different issue. Despite the contractual differences between banking and insurance the functional differences are slight. Both businesses revolve around having enough cash on hand to pay claims or satisfy demands while investing the cash not on hand to make a profit. This is to say that the bank and the insurance company invest money without knowing what claims the future will bring as from their perspectives both events are unpredictable. The legal distinction between the bank lending out money that I might come in and withdraw at any time and the insurance company lending out money for my life insurance policy that my heirs might claim at any time as neither I nor the insurance company know when this will happen is solely a matter of interpretation and not of function.
I agree with Chris Cresci here and I think he’s put the issue very well.
What I would add is this: Why do you think that the difference between “existing legal claims” and “potential legal claims” is important?
In practice both banks and insurance companies face uncertainty over the actions of their customers. Insurance companies are certainly in a better practical position because there is more delay between claims being made to the time when the insurance company must pay them. But, the fact remains that in both cases “case probability” is involved.
As I said above, all businesses face uncertainties and all decisions involve case probability. In some cases the law makes a heuristic decision such as considering a normal business insolvent if it doesn’t have enough cash to pay it’s upcoming bills. These laws we have inherited may contain wisdom, as Hayek emphasises in his later work. But, that doesn’t mean that they can’t be subject to change. It also doesn’t mean that “generalizing” them is necessarily wise.
Banks do not know WHEN their depositors will exercise their EXISTING legal claims, but depositors most certainly have EXISTING legal claims that they can exercise AT ANY TIME. Neither insurance companies nor their insurees know IF legal claims will COME INTO EXISTENCE, nor WHEN systematically unpredictable events will occur. Therefore, the comparison is completely inappropriate.
I forgot about this comment.
I understand what you mean, and you are right that there is a difference between asking to redeem and being eligible to make an insurance claim.
But, both deal with unknown risks. The argument against FRB is that businesses like insurers deal with risks that are known – class probability. I’ve shown that they don’t they deal with unknown risks too. So, if it’s permissible for one type of business to deal in unknown risks then why isn’t it permissible for another?
What Austrian FRB opponents are basically doing is allowing entrepreneurs in all areas to deal in uncertainty and use their own ideas and rules-of-thumb to set prices and contracts. But, they are dismissing this idea in banking and insisting that it should operate in the most risk free way they can think of. There is no good reason for this, “financial innovation” is as valuable as other types of innovation.
The aim of any monetary system should be that the total claims on goods and services(money) never exceed the total goods and services in the economy. Where the amount of goods and services in the economy increases, there must be a mechanism that feeds this information back and the money supply is increased accordingly, effectively fractioning the current money supply. But, that rate must be set by the economy and not by the money issuer. To set ANY reserve ratio is deluded, not least by the impossibility of Economic Calculation outside of the market/economy. We have the cart pushing the horse.
Since the price of gold is the most sensitive indicator of the demand for money, we should base our fractioning of the current money supply on the price/value of gold and have some way of enforcing the relationship. Real Bills does a better job than all the others.
The best indicator for the demand for money is the changes in money’s price relative to other money.
If you gauge demand for money by its price relative to other money you risk divorcing the amount of money from that demanded by the real economy. And if you do that you have no way to gauge if you are over supplying money and causing inflation. The value of gold tracks the REAL rate of interest better than any other commodity because of its many qualities as money(divisibility, durability,fungibility etc)
. Ie. Gold tracks the real growth in the economy.
Gold may or may not track the real (i.e. the natural) rate of interest better than any other commodity. However, in the sense you describe commodities are simply a proxy for money prices. In a competitive market we should expect that the competition between currencies should be enough to formulate the proper amount of money demanded by the market. Banks would then bid on securing loans of those funds to be issued in order to get a market interest rate.
I’m sorry to have left the discussion, as I had to do to travel to Istanbul and take part in a conference here. But I did look at those items, Toby, and I don’;t see anything resembling 100-percent reserve banking. As has been remarked, a custodial “bank” is only a 100-percent reserve bank to the extent that it keep actually high-powered cash in custody, and then only if it offers payments services along with custodial ones. (Otherwise any bank offering safety deposit box services is engaged in 100-percent “banking”.)
Looking at the current liabilities of the sample bank, I see that a large part of the assets backing them consists of deposits at other (presumably fractional-reserve) bank, and that even the fractional “cash” reserve is not a true base money reserve but consists rather of cash “equivalents,” including MMMF balances and (I’m willing to bet) short-term government securities.
So, no: this doesn’t supply evidence of the viability of 100-percent banks. Not even close. I therefore stick to my original assertion: that to find such, you have to go back to the early 17th century or before, and even then the examples were all government agencies, at least some of which owed their existence to the legal suppression of private fractional-reserve rivals.
George, with the Swiss bank I showed you, they are deposits over night in the Central Bank. I do not think they can do any better than that. I take this to be 100% reserved as if the Central Bank defaults, the deposit is worthless, the bank would be in a no worse off situation if they did indeed have a box with cash notes and coins in their own vault, as in this scenario these would be worthless as well as the State must have gone bust and thus its currency. I consider this to all intents and purpsoes 100% reserved.
Also, see your comment here “I don’;t see anything resembling 100-percent reserve banking. As has been remarked, a custodial “bank” is only a 100-percent reserve bank to the extent that it keep actually high-powered cash in custody, and then only if it offers payments services along with custodial ones. (Otherwise any bank offering safety deposit box services is engaged in 100-percent “banking”.) ”
This is exactly what I mean by 100% reserved . Custody of securities and cash held in custody. What about this is not 100% reserved? I think we are saying the same thing.
With regards the Swiss bank I showed you, every other bit of its lending is matched by an associated deposit for the same duration ie no maturity mis matching. So this aspect requires no reserving as the money has been lent and will come back to the original owner with interest when the bank is contractually bound to repay its debt obligation. There is a capital cushion there incase of default.
This is all safe, sound and honest banking. It also forms a large part of the econony of Switzerland for example.
The custody services of banks as bigger than Western nations in terms of what they are looking after and play a vital economic role currently that should not be over looked. With a un-rigged system, they would be even more important.
Happy days in Turkey. You must go and say hello to your best mate, that Germanic staunch defender of 100% reserve who I understand lives down there now !
What is missing is the “intermediation” or “loan broker” function of borrowing money at one rate and lending it out at a higher rate. This is to say: no loans, no bank.
There is borrowing by the Swiss Bank in question at x from it’s deposit base and lending with a maturity match at x + y % , they are true intermediaries .
Most of the “private banks” I know of have warehousing but they buy the money they use for loans and investments. This is not to say that 100% reserves are not as common as you say, but that this is a niche market which does not offer products that one would find in a “retail bank” or a “money centre”. The reason these banks exist is that all of their clientele have a great deal of money to deposit and thus the bank itself has very small fixed costs. Such institutions have minimum balances that amount to more money than most people in the western world make in a year, they have a vault attendant but very few other low wage workers (e.g. tellers) and their salesmen are paid on a commission basis. The banks for the other 99.99% of people need fractional reserves to make money from a larger base of deposits with a lot more depositors. The question, therefore, is not whether 100% banking is a viable business model. Rather it is whether or not it can become the banking model for all banks. I put it to you that if 100% banking became the norm, the limitations on profitability would be such that a great deal of people would find themselves underserved.
This is to say that until 100% banks can enter the business of being a financial McDonalds like the large retail banks their business model will not predominate.
God Morning Chris,
That may well be the case . I am not qualified to know . My entrepreneurial judgement does not look into that part of the future in any meaningful way.
When you say “underserved” I suspect this means a hard pressed person can’t get easy credit. This may well be a good thing.
I do not see why the savers for retirement , for Life policies, no matter how little, £100 here, £100 there , can’t add up on a regular basis to provide the long term loans and thus money needs of people. I cant see how the savings of people, not matter how meek can’t provide the basis of commercial loans . I cant see why equity and more of it, will not provide for the riskier activities some of us engage in.
I cant see why normal commercial credit as provided by business to other business can’t provide the ongoing credit needs of business.
I see no need why we need fractions.
That said, if freely consenting adults wish to knowingly get involved with this type of activity and I am in no way compelled to bail them out or suffer any negative consequences, then hey, I am up for letting people get on with it and let the market discovery process shape the outcome of this process.
When I say “underserved” I am not talking about credit per se but something as simple as a checking account. In a 100% banking scenario there is a very high threshhold where the increase in revenues from the deposit base falls short of the increased marginal costs of additional depositors due to the inability to use fractions. We do not need to exert much in the way of “entrepreneurial judgment” in this regard if we only look at the existing policies and products and services offered.
Clearly, the vast majority of humanity does not fit the customer profile of these institutions. Thus, it is not an issue of whether the savings of everyone can provide for the credit needs of everyone. Rather, the issue is one of whether it will be profitable under a 100% system to give the many a chance to make money from their money through saving.
Toby, George, everyone
To begin with, I think we should be clear about terms:
I think using the word “deposit” in this case is a bit confusing. I assume what you mean is that when one of these banks lends out, say, 5M swiss francs for 5 years to a business it issues a corresponding 5M swiss franc’s worth of bonds to savers which also have 5 years duration.
I think it’s sensible to consider central bank reserves to be fiat currency. So, a balance in a central bank account is base money.
If a bank:
1) Offers banking services on current accounts.
2) Keeps a franc of reserves for every franc of their customers on-demand current account balances.
Then I’d agree that they are practicing 100% reserve banking.
But, if the bank is keeping balances with another fractional reserve bank then that’s still FRB. Do they say anywhere that they are keeping balances only with the central bank? Or do they say that they are keeping most balances with the central bank?
Lastly a question to everyone reading here, not just Toby… Do we really know if Swiss banks are operating this way because of market discipline? Or, are there regulations that require them to maturity match or to hold large amounts of reserves. I haven’t seen any evidence that there are. But, does anyone here know anything about this?
Mr. Perkins, like so many critics of FRB, you reason as if there were no historical record to consult. To repeat (though it seems that one can shout it from the rooftops forever, only to have it fall on many deaf ears): FR banks have survived genuine market tests, and though bankers tried raids of the sort you describe, they did not have the results you predict. Larry White and I talk about why such raids tend to end with cooperative note exchanges in our paper “The Evolution of Free Banking System.” And we show point to historical episodes supporting our claims.
Again, there’s no need to try and deduce the likelihood that fractional reserve banks will survive while sitting in armchairs. There is a historical record, comprising many different episodes, that tells us the answer. By continuing to argue as if this weren’t the case, FRB opponents seem to be falling back on “logic” simply because the evidence doesn’t point their way.
What assurances are there in your particular system of FRB that the defaults of one bank or a few banks could not cause a “cascading default” that would cause the banking system to “blow up”? After all, the collapse of the Knickerbocker Bank was the impetus for the creation of the Fed.
As I see from Checkland, with regards to the Scots e.g. they had a little bit of help from England along the way and it was a bumpy ride. Granted , they survived multi generational , not quite ideal, better than what we have today, but I think we can improve of what did exist.
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