Thought on Fractional Reserve Banking

Economics Political Theory
1

I was pondering on the question of whether FRB could be lawful per a libertarian law code, when I had an epiphany: what is currently called a “demand deposit” is actually a demand loan with an indefinite duration.

That is, when I “deposit” money in a bank, I am actually making a loan to the bank. The bank receives title to the money, and I receive title to interest payments on some regular schedule until/unless I exercise my contracted-for right to call back the loan, which I can do any time during regular business hours. This is essentially the same thing as a margin/call loan, nothing exotic.

A “demand deposit” is mislabeled, it is not a bailment. However, defined as a demand loan, it is perfectly legitimate. I have no more reasonable expectation for the bank to keep the money I lent them via the demand loan on hand in their reserves than I do for the bank to keep money I lent them via a CD or any other standard time deposit on hand in their reserves. As such, it is perfectly legitimate for the bank to keep fractional reserves against my demand loan - in fact it’s vital, as the whole point is for the bank to loan out the money I loaned them, otherwise they couldn’t pay me interest.

If we understand that a “demand deposit” is actually a demand loan, this eliminates the objection to FRB based on the notion that it involves duplicate ownership titles to a single piece of property: i.e. such that the bank and the depositor simultaneously have title to the same money. On the contrary, the bank has sole title to the money I lent them, which they can loan out at their pleasure, and I have sole title to the bank’s obligation to pay me interest and to repay the principal at my request.

Am I missing something here or is this a very simple solution to the FRB problem? Strictly speaking, FRB is not compatible with libertarian law: i.e. insofar as it involves the pretense that a demand loan is a “demand deposit” (i.e. bailment) it’s fraudulent. But I think it’s questionable whether FRB now does in fact involve that pretense, or ever has. And in any case, if we eliminate that pretense, and suppose that libertarian law would simply require that FRB call demand loans what they are, then FRB as it operates currently (sans State intervention of course) can continue to exist under a regime of libertarian law.

No?

2

Correct.

3

A note on banknotes (pun intended):

We have three types of “banks” in question here:

  1. time-deposit banks (they take in time-deposits and make loans, profiting from the spread)

  2. money warehouse banks (they act as custodians for money and profit only on fees)

  3. fractional reserve banks as described above (they take in demand loans [“demand deposits”] and make loans, profiting from the spread)

Where do banknotes fit in?

Time deposit banks don’t issue banknotes in any meaningful sense, they issue various kinds of debt securities such as certificates of deposit and bonds. These might trade in a secondary market but they aren’t going to circulate as money most likely. Also there is no possibility of inflation, because from the day I loan my money to bank to the day the bank repays me with interest, I have no access to that money: i.e. I’m not writing checks against it or spending banknotes backed by it.

Money warehouse banks issue banknotes (or checks) which are in fact warehouse receipts, which are redeemable on demand for the money which the bank has in custody. Again there is no possibility of inflation: if the money warehouse bank creates extra banknotes or checks and spends them, or if it loans out the money it has in custody, it is engaging in fraud.

But then we have fractional reserve banks, which issue banknotes that are explicitly not warehouse receipts. These banknotes (or checks) are debt securities. However, unlike the debt securities issued by the time-deposit bank, these involve the right to recall the loan on demand, and so they will more likely circulate as money. Obviously this does involve inflation. Banknotes from fractional reserve banks will be discounted relative banknotes from money warehouse banks, because the former are known to be backed with fractional reserves, whereas the latter should always be backed with 100% reserves. Likewise, the banknotes from a FRB with low reserve ratio will tend to be discounted relative the banknotes from a FRB with a higher reserve ratio.