George Selgin says fractional reserve banking is not fraudulent.

Summary.   The existing bank system, i.e. fractional reserve, is fraudulent because one of its main activities is, 1, accepting deposits, 2, telling depositors their money is safe, and 3, lending on or investing that money in a not totally safe fashion. Ergo it is fraud to claim deposits are safe. One of George Selgin’s answers to that (an answer which no one else supports far as I know) is that banks have never promised depositors their money is safe. I find the latter “never promised” claim bizarre. Anyway, the article below provides some evidence that ever since the Middle Ages, banks have actually promised depositors that their money is safe.

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The phrase “fractional reserve” is often used to describe the existing bank system. The phrase is not entirely satisfactory, but let’s stick with it.

The basic reason for saying fractional reserve is fraudulent is that one of the main activities of banks is to accept deposits, lend on the money concerned and then tell depositors their money is totally safe.

That “safety promise” made by banks is fraudulent because “loaned out” or invested money is never entirely safe, as the numerous bank failures throughout history demonstrate. Indeed, financial institutions other than banks (e.g. private pension schemes, unit trusts, mutual funds, etc) are specifically prohibited from making the above promise. The only exception (a justified exception) to that being mutual funds (in the US) which invest just in US government debt.

In short, the idea that a particular activity is not acceptable when carried out by most types of financial institution, but perfectly acceptable when carried out by an institution that has the word “bank” emblazoned above its front door makes as much sense as saying murder is wrong, but it’s OK when perpetrated by people with red hair.

Incidentally, some readers may object to the above claim that banks lend on depositors’ money, and wish to claim that banks create money out of thin air and lend it out, rather than lend on depositors’ money. Well it’s certainly true that commercial banks can and do create a certain amount of “thin air” money every year. At the same time, a bank cannot create limitless amounts of such money without having money coming in from depositors, shareholders and bondholders – else it will run out of reserves.

Thus in effect, banks do actually lend on depositors’ money (as well as creating a certain amount of “thin air” money each year).

So what is George Selgin’s answer to the above “fraud” claim? Well he claims (in the comments after one or two of his articles) that banks have never promised depositors their money is safe, which I find a totally bizarre claim. Plus he asked me to provide evidence that banks have actually made that promise in the past.

Actually I think the onus is on him to provide evidence to support his point rather than on me to prove mine because my view of deposits and safety is the normal or common sense one far as I’m aware. Anyway, I’ve set out some evidence in support of my claim below.


Deposit insurance.

Of course, since the arrival of government backed deposit insurance, any claim by a bank that depositors’ money is safe is justified in that if the bank fails, government will rescue depositors, though the amount so insured is of course limited in every jurisdiction (e.g. €100,000 in  Europe).

So to re-phrase the above fraud point as it applies in 2020 one could perhaps say that in a country where government backed deposit insurance operates, the existing bank system (fractional reserve) is fraudulent, but any harmful effects of that fraud, when they arise, are made good by deposit insurance.


Why does Selgin make his “no promise” claim?

The answer I’m pretty sure, is that he is a keen advocate of what might be called an “extreme version of fractional reserve”. That extreme version is known as “free banking”. Under that system there is no deposit insurance, thus depositors are more likely to lose their money than under a deposit insurance protected system. But clearly Selgin does not want the bank system he favours to be tarnished by the “fraud” accusation.


What banks did before deposit insurance.

Deposit insurance was introduced in 1933 in the US. In the UK, it was introduced in a limited form in the 1970s & 80s, and in a more thorough form in 2007.

Unfortunately it is difficult to get hold of material published by banks prior to 1933 in the US, and same goes for UK material prior to 2007. So it is not all that easy to prove the point that prior to deposit insurance banks were promising depositors their money was safe, nor would it be easy for Selgin to prove banks were not making that promise. Or rather it would probably be easy to settle this issue by visiting Bank of England archives in London or similar national archives in other capital cities. But I’m based in the North East of England and can’t be bothered travelling 300 miles to London for that purpose just for the moment, though I’d be happy to make the visit some time in the future if need be. So the evidence below is what I’ve dug up from online sources and local libraries in the North East of England.

However, all the evidence I’ve dug up so far does confirm my claim rather than Selgin’s.


Why do bank runs happen?

Before setting out the evidence there is a theoretical point to consider as follows. Why do bank runs occur? The reason (a very obvious reason) is that banks have promised depositors $X back for every $X deposited, and when the suspicion arises that the bank will not be able to make good on its promise, best thing to do is get your money out and get your $X while you can,  instead of waiting for the bank to be wound up and getting $0.9X, $0.5X or whatever.

In contrast, if banks promise to depositors (a la Selgin) was for example that the value of each person’s account at a bank varied with the value of underlying assets (i.e. loans made by the bank), then those so called deposits would be in the nature of shares, i.e. equity. And in that case there would be no run: people or institutions which have bought shares in a stock exchange quoted corporation do not sell their shares en masse when prospects for the corporation decline: they accept that buying shares involves gains and losses.

Thus the simple fact that runs occur, supports the contention that banks promise depositors their money is safe.


A trite interpretation of Selgin’s claim.

A possible, and I think trite interpretation of Selgin’s claim is that banks do not promise depositors their money back in the sense that if the bank goes bust, everyone knows depositors will not get their money back (absent deposit insurance). But that’s the equivalent of saying that a promise by me  to mow my neighbour’s lawn is a nonsense in the sense that if I fall seriously ill for several years or get sent to prison for an extended period I won’t be able to fulfil my promise.

I.e. the normal understanding of the word “promise” is that if X promises to do Y, X will make every effort to actually do Y and will only not do Y if it becomes plain impossible, due to unforeseen circumstances. Moreover, the normal understanding of the word “promise” is that if in fact X cannot possibly do Y, that does not prove that no promise was made.


A bank advert from the 1920s.

One bit of evidence that prior to deposit insurance banks were promising depositors their money was safe was dug up by my friend Vincent Richardson (a Positive Money supporter). It’s an advert from the 1920s in the US (at the latter link and reproduced below). Notice that the bank is trying to persuade customers that money placed with the bank is “safe”.

Books on the history of banking.

Next, a number of books on the history of banking (i.e. a history of what was going on with banks prior to deposit insurance) confirm my claim and cast doubt on Selgin’s claim. Relevant passages from these books are as follows.


Money & Banking in the UK by P.Cottrel, p.249:

“In the boom of the early 1870s, there was a further flurry of bank formations and altogether between 1860 and 1874, 24 new domestic joint stock banks were successfully established. The new banks took up limited liability from their inception but the banks formed prior to 1854 remained on the whole unlimited. Many bankers saw an advantage in being unlimited as it provided apparently an additional element of security for their depositors.”

That of course does not prove banks were promising to return 100% of depositors money, but it is evidence that they were keen to give the impression they would. 


Money and Banking in the England by M.Collins  p.94 chapter entitled "The Business of Commercial Banking 1826-1913”:

“Through their willingness to accept money on deposit, commercial banks offer places of safekeeping (customers no longer need to keep savings under their beds!) and a form of investment (as customers can earn interest on those deposits). Deposits formed the great bulk of commercial bank liabilities, even in the nineteenth century a large proportion of these deposits was on 'current account' and, therefor could be withdrawn immediately by customers.”

That suggests the object of the exercise is “safety”: i.e. that depsitors get 100% of their money back, not 90%, 50% or whatever.


"Money Banking and Credit in the Medieval Bruges" Raymond de Roover, Ch13, p247:

“As we have seen, it had become customary in Flanders, by the second quarter of the fourteenth century, for merchants and private individuals to deposit with money-changers any cash which was not immediately needed. The latter did not keep all this money safely locked up in their chests but used the greater part of it for their own purposes.

This was not a breach of confidence. The money-changers were indeed expected to meet every demand for repayment at the first request.”

Well if those proto-banks “were expected” to return deposited money, that strongly suggests they were making promises that such money would be returned.


Scottish Banking: a History. S.G.Checkland. p.189 (in chapter entitled "The system by 1810"):

“Treasurers' bonds faded out after 1792. This left the two elements, cash accounts in credit (repayable on demand), and promissory notes (repayable on a time basis).”

Well the most reasonable and common sense interpretation of money in an account which is “repayable on demand” is that 100% of the money is repaid, not 90% or any other percentage.


Commercial Banks and Industrial Finance by M Collins and M. Baker, Ch5, p.83:

“In the second half of the nineteenth century it was more obvious to contemporaries in Britain than it is perhaps today that the business of commercial banking depended fundamentally on retaining depositors' confidence in the banks' ability to safeguard their balances and to repay promptly at depositors' convenience."

Well there again, how do you interpret that? I take it to mean that banks undertake to return all of depositors’ money, not 90% or any other percent.


Bank charges.

The only exception to the above “nothing less than 100%” point is where it is agreed in advance by bank and depositor that the bank may pay so little interest that that interest is wiped out by bank charges in respect of administration costs involved in maintaining an account.

Indeed, the latter is common at the time of writing given the very low rates of interest that currently prevail: in fact bank charges on my own instant access account at my high street bank exceed the interest I earn. 


Conclusion.

I suggest it is now up to George Selgin to provide evidence from the days before deposit insurance that banks were not promising to return 100% of depositors’ money.