Banking on Failure: History of Banking

WORLDWORKS by Joe Pimbley

Editor’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.

[su_dropcap style=”flat”]T[/su_dropcap]HE COMPLETE history of banking is an immense topic. We seek here simply to tell this history in broad terms with the goal of making a few simple points: (i) bank deposits and lending have existed for centuries if not millennia; (ii) a fascinating story of goldsmiths explains the emergence of fractional reserve banking; and (iii) this deliberate fractional reserve banking is arguably unstable.

For rich and comprehensive histories of banking, we cite references of (i) C. P. Kindleberger, A Financial History of Western Europe, George Allen & Unwin (Publishers) Ltd, 1984, (ii) N. Ferguson, The Ascent of Money: A Financial History of the World, Penguin Press, 2008, and (iii) J. Grant, Money of the Mind: Borrowing and Lending in America from the Civil War to Michael Milken, Farrar Straus & Giroux, 1992.

Early Banks and Banking

Drawing on the historical research of the references we cite above, there exist records stretching back more than three thousand years of lending, currency exchange (“money changers”), and deposit safekeeping. These are the core banking functions. Typical lending would enable a farmer to plant, grow, and harvest his crop and apply proceeds from crop sales to repay his loan. Another historical example – which one could call “trade finance” – is that of a merchant who borrows funds to buy goods and pay expenses to travel with the goods to a distant market where such goods fetch a sufficiently high price to repay comfortably the initial loan.

Currency exchange was as much of a necessity and convenience in multi-currency ancient times as it is in the multi-currency present. An important difference is that the ancient version required assessment of weight and purity of metallic coins of different realms as well as the evaluation of non-metallic currency such as grain or livestock. The specialized nature and requisite skill of such currency assessment encouraged the role of an experienced “middle man” with high credibility and reputation for integrity.

The deposits of the long past were frequently “true deposits” in the sense that individuals would store crops or coins for safekeeping in a temple or other common, protected location. But Talmudic law did distinguish clearly between deposits intended for safekeeping and those deposits in which the receiver of such deposits was permitted to re-lend or otherwise use the deposits.[1] Hence, history has long seen both “true deposits” and deposits that are unambiguously “loans” to the person receiving the deposits.

Banking began to resemble the modern era in the twelfth century in western Europe. The varying restrictions on receiving interest on loans and other financial activities of Judaism, Christianity, and Islam drove the nature of early banking. One suggestion is that the word “bank” originated with banca (Italian for “bench”) since the financial traders sat on benches in town courtyards. When a merchant found that such a trader could not honor a commitment because he lost the merchant’s funds in a separate transaction, the bench had become “rotten” – as in banca rotta – to give today’s “bankrupt.”[2]

Of all surviving banks in the present day (2016), the oldest is the Italian Monte dei Paschi di Siena.[3] The Netherlands, Germany, France, and England all became important banking centers in the ensuing few centuries. The world’s second oldest surviving bank, created in 1590, is the German Berenberg Bank.[4]

Goldsmiths and Fractional Reserve Banking

We recount now the colorful story of goldsmiths in late seventeenth century London that purports to explain the origin and meaning of fractional reserve banking. We tell the story first before defining this term since the story itself is a great explanation. We draw copiously and relentlessly from the excellent article “Those Dishonest Goldsmiths” of George Selgin – which we call “Selgin (2011)”.[5]

In 1640, King Charles I temporarily seized gold bullion, plate, and coins that merchants had stored in the Royal Mint for safekeeping and possible minting of coins from the bullion and plate. Not surprisingly, the merchants’ trust in the government and the Mint fell precipitously as a consequence. The merchants began placing their gold deposits with goldsmiths.

Upon receiving a deposit of coins, the goldsmiths would issue a certificate to the depositor giving the bearer the right to redeem the paper certificate for the stated amount of gold coin upon demand. The goldsmiths found that depositors generally left their coins in the custody of the goldsmiths for extended periods of time without withdrawals. The paper certificates acted as currency in the sense that a merchant with gold coins on deposit could pay his certificate for the coins to a seller of provisions rather than go to the goldsmith, retrieve his coins by surrendering the certificate, and then pay the coins to the seller. Thus, these paper certificates served as paper money and were credible claims on gold coins placed with a designated goldsmith.


Figure 6‑1 Paper certificates “as good as gold”

Having observed the infrequency of movement of gold coins out of their safes, the goldsmiths found they could lend the coins they held and receive interest. Since all original depositors of gold coins had the right every day to retrieve their coins, it would seem that the goldsmiths’ responsibility would be to retain all coins at all times. That’s the general concept of “safekeeping.” With the actual behavior of depositors differing so greatly from their right to retrieve coins daily, however, the goldsmiths seized the opportunity to earn interest on lending the “excess coins” that they felt with reasonable certainty would not be demanded on any given day.

This goldsmith lending created two risks. The first was that the borrowers might not repay the goldsmith. With the total stock of gold coin reduced by the amount of the failed loan, either the goldsmith or the original depositors would suffer the loss. The second risk was the “liquidity risk” of the goldsmith not having sufficient coins in the safe to satisfy gold coin redemption requests on some particular day. The goldsmiths had become banks in the sense of accepting deposits and making loans.

With the paper certificates for deposited coins functioning as money, the goldsmiths could make their loans with the certificates rather than with the gold coins themselves. Hence, the proper measure for goldsmith lending activity was not simply (i) gold coin in the safe divided by (ii) original deposited gold coin. Even if all coin in the safe equaled the original gold amount, the goldsmith could conceivably fail to honor his obligations if the total of paper certificates exceeded the gold supply (due to his “creation” of certificates in making loans). Rather, the ratio that properly measured the extent of lending was (i) gold coin in the safe divided by (ii) outstanding certificate claims.


Figure 6‑2

Thus, a ratio of £1,000 in gold coin to £1,000 in certificate claims is 100% and there is no “liquidity risk.” All certificate holders could claim gold coin on the same day and the goldsmith could pay each claim. But if the goldsmith holds only £500 in gold coin for the £1,000 in certificate claims, the ratio is 50%. With any ratio less than 100%, the goldsmith will default on his redemption obligation if all certificate holders demand gold coin simultaneously.

Selgin (2011) raises and debates the question of whether the goldsmiths in seventeenth century London acted fraudulently in this lending of gold coin deposits. The alleged fraud over the following centuries is that the depositors did not know the goldsmiths were lending the coins (thereby posing risks to the former and gains to the latter). One may find a standard version of the “dishonest goldsmith story” in W. J. Baumol and A. S. Blinder, Economics: Principles and Policies, 11th Edition, South-Western, 2009. This standard version, as we call it, is simply the story we relate here with the added assertion that the depositors had not knowingly permitted the lending of the gold.

By careful review of earlier authors from the 1600’s to the present and of original sources, Selgin (2011) argues there is no direct evidence of goldsmith fraud in this lending activity. The preponderance of indirect evidence tilts, in fact, to the likely innocence of the goldsmiths. In summary, the jury is out – there is no proof to the case in either direction. What is clear is that the goldsmiths did lend the “excess gold” in both coins and paper certificates. Banking history credits these London goldsmiths with the invention of fractional reserve banking. As Selgin (2011) notes, even this “invention” claim appears dubious, but let’s call it the beginning of fractional reserve banking for the modern era.

The next excerpt for Chapter 6 will discuss “Fractional Reserve Banking Today” and the “Basis of Bank Money”

[1] See H. E. Goldin, Mishnah: A Digest of the Basic Principles of the Early Jewish Jurisprudence, G. P. Putnam’s Sons, New York, 1913.

[2] See, for example, .

[3] See, for example, .

[4] See, for example, .

[5] G. Selgin, “Those Dishonest Goldsmiths,” University of Georgia, 2011, originally prepared for the colloquium Money, Power & Print: Interdisciplinary Studies of the Financial Revolution in the British Isles, 1688-1776.

Joe Pimbley
Joe Pimbley
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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    • George, I’m glad for your comment! I loved your article – “Those Dishonest Goldsmiths” – and a Cato lecture of yours I attended in NY last year. Please help me here. I had understood that the “myth” consisted simply of the belief that the depositors were not aware that the goldsmiths would lend their gold. Your article advocated the view that the goldsmiths did not act fraudulently and that the depositors did understand the lending activity. Please tell me what I’ve missed, misconstrued or otherwise messed up.

    • George, I’m glad for your comment! I loved your article – “Those Dishonest Goldsmiths” – and a Cato lecture of yours I attended in NY last year. Please help me here. I had understood that the “myth” consisted simply of the belief that the depositors were not aware that the goldsmiths would lend their gold. Your article advocated the view that the goldsmiths did not act fraudulently and that the depositors did understand the lending activity. Please tell me what I’ve missed, misconstrued or otherwise messed up.