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Banking on Failure: History of Banking (Part 2)

WORLDWORKS by Joe PimbleyEditor’s Note: This is the next in a Continuing Series of Articles by Joe, as excerpted from his Book;“Banking on Failure” co-authored by Laurel McDevitt.

Preface: The previous excerpt for Chapter 6 discussed the “ Early Banks and Banking” and “Goldsmiths and Fractional Reserve Banking.”

Fractional Reserve Banking Today

[su_dropcap style=”flat”]F[/su_dropcap]INALLY, based on our earlier excerpt, we can define fractional reserve banking in today’s world as a bank’s deliberate retention of cash at a fraction (less than 100%) of its demand deposit obligations. As an example, let’s say the fraction for a particular bank is 20%. Then, if all demand deposit holders of this bank request their funds on any specified day, the bank can fulfill just 20% of the requests. The bank will fail on the remaining 80%.

In the analogy of seventeenth century goldsmiths to twenty-first century banks, banks replace goldsmiths and (paper currency) cash replaces gold. As we shall discuss in later chapters, the central banks of countries specify the minimum ratio of cash a bank must hold relative to its deposit liabilities (“reserve requirement”). In the U.S., the early-2016 reserve requirement is essentially 10%.[1] For China this requirement is closer to 16%[2] while for Eurozone banks it is 1% – yes, 1%.[3]

Banking on FailureWe defer a longer discussion of fractional reserve banking to the later treatment of central banking and money supply. Let’s note here, though, that there are alleged advantages and disadvantages. One textbook declares “this discovery [of fractional reserve banking] was the banking equivalent of the Newtonian Revolution.”[4] An evident disadvantage is simply that banks have an additional failure mechanism since depositors have the right of immediate access that a fractional reserve bank cannot honor.

Let’s revisit the excellent research and narrative that is Selgin (2011). Based on contemporary and preceding law and records of seventeenth century London, Selgin is persuasive on the point that gold coin depositors should have known and probably did know that their goldsmith “bankers” were lending the gold and/or the paper certificates. Let’s imagine that this is true: the depositors understood they were lending to the goldsmith and that the goldsmith would lend to other borrowers.

Why would depositor and goldsmith reach this agreement while apparently maintaining the depositor’s unambiguous right to demand return of his coins on short notice? Why not incorporate within the deposit agreement some latitude for the goldsmith to delay redemptions as the gold coin reserves dwindle? If the “dishonest” aspect of the goldsmith story is false, the likely reason the story persists is the assumption that depositor and goldsmith would codify such latitude if both parties agreed to this non-intuitive arrangement. It is surprising for this reason that the unstable practice of fractional reserve banking has survived.

This confusion has its own history. Hülsmann notes that lawsuits contesting the status of a deposit (“safekeeping” versus lendable funds under the fractional reserve concept) span many centuries:[5]

“Even though the legal records are clothed in the language of their times, the question of whether a certain sum of money was given to the banker for safe keeping or as an investment runs like a red thread through the history of banking.”

The earliest example Hülsmann finds is the 1342 case Isabetta Querini v. Bank of Mariano Vendelino.[6] Quoting Wicksell, Hülsmann writes that the confusion felled the Bank of Amsterdam:[7]

“It appears to have been the obscurity in this arrangement [of the bank lending its deposits instead of holding them] … rather than real insolvency which brought about [the Bank of Amsterdam’s] downfall in 1795, when in consequence of political events [the status of its deposits] became known for the first time.”

Basis of Bank Money

We summarize here a few obvious points that will serve us well in the next chapter “History of Money and Gold.” In the time of the London goldsmiths, gold coin functioned as money. Acting as modern banks, the goldsmiths received deposits of gold coin money and made loans. The goldsmiths’ paper certificates functioned as money since merchants believed they could redeem the paper and receive gold when they so desired. Thus, the paper that merchants paid and received in their market transactions represented gold and was gold in practical terms.

As a thought experiment, what if the goldsmith held no gold? Imagine that depositors simply deposited their paper certificates and withdrew them at various times. We imagine further that goldsmiths could make loans of paper certificates that borrowers would repay with interest in the same certificates. What collection of rules, laws, and practices, if any, would make this system of money work?

[1] See J. N. Feinman, “Reserve Requirements: History, Current Practice, and Potential Reform,” Federal Reserve Bulletin, 1993. The U.S. reserve requirement has not changed since this publication.

[2] See, for example, Appendix VII of S. Gray, “Central Bank Balances and Reserve Requirements,” IMF Working Paper WP/11/36, February 2011. The PBOC has adjusted this requirement several times in recent years.

[3] See, for example, https://www.ecb.europa.eu/mopo/implement/mr/html/calc.en.html .

[4] See S. I. Greenbaum and A. Thakor, Contemporary Financial Intermediation, Dryden Press, 2007.

[5] J. G. Hülsmann, “Has Fractional-Reserve Banking Really Passed the Market Test?,” The Independent Review VII(3), 399-422, Winter 2003.

[6] Id.

[7] Id. Hülsmann cites pages 75-6 of K. Wicksell, Lectures on Political Economy, 2, London, Routledge, 1935.

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Joe Pimbley
Joe Pimbleyhttp://www.maxwell-consulting.com/
Joe is Principal of Maxwell Consulting, a firm he founded in 2010. Joe is expert in complex financial instruments, financial risk management (certified as FRM by the Global Association of Risk Professionals), valuation, structured products, derivatives, and quantitative algorithms. His recent and current engagements include financial risk management advisory, valuation and credit underwriting for structured and other financial instruments, and litigation testimony and consultation. In a prominent engagement from 2009 to 2010, Joe served as a lead investigator for the Examiner appointed by the Lehman bankruptcy court to resolve numerous issues pertaining to history’s largest bankruptcy. Joe and his colleagues discovered Repo 105 and also reported the critical importance of pledged collateral mishaps and mischaracterizations to the Lehman failure. Joe holds a Ph.D. in Theoretical Physics and is a co-author of Banking on Failure (2014), Simple Money (2013), and Advanced CMOS Process Technology (1989). He serves on several corporate and academic Boards, has written more than thirty finance articles, presented more than sixty finance seminars, and holds numerous patents for engineering inventions.

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