Is Fractional-Reserve Banking Fraudulent?

Nelson Hultberg

September 19, 2005

“Where you and Professor Fekete are making your mistake is that you are condoning fraud with your toleration of fractional-reserve banking in the discounting of real bills. It is incumbent on government to prohibit such a practice. The law must make sure that in the case of time deposits, bankers be required to loan no more than the amount of the deposit. And the law must stipulate that demand deposits can never be loaned at all since they are payable to the owner on demand.”

So wrote a reader in response to my recent article, The Money Fallacies of Rothbard. This reader is defending the advocacy of 100% gold reserve banking. And he is prepared to enforce by law its requirements. Under such a system, no banker would be able to issue credit in excess of the gold coins that have been given to him under a time contract, and no banker would be able to loan or invest demand deposits of gold coins at all. Any violation of these requisites is to be termed fraud, and any banker partaking in such is to be prosecuted. This is basically what the Rothbardian camp will have to endorse if they are to implement their goal of a 100% gold monetary system.

How Do We Define Banking Fraud?

The important questions that we must ask here are: Would such a legal approach be logical and practical? Would it be true to freedom and justice? And most crucial of all, is it fraud for bankers to loan in excess of their gold reserves? Let’s investigate further and see if we can come up with some definitive answers.

The determination of what is “fraud” in the policies of banking revolve around how we are to define the money that a depositor gives to a bank. For several centuries now, it has been defined by the courts in Europe and America as a loan to the bank. The banker is thus entitled to invest those funds in various profit-making ventures. In this sense, all banking can be considered to be “investment banking.” We as depositors operate fully aware of this. We realize that the banker is going to invest our money in any number of possible vehicles — real estate loans, auto loans, venture capital loans, treasury bonds, muni-bonds, real bills, etc. We know that banks are in business to make money, and that they are going to put our deposits to work in pursuit of profits. In other words, we know ahead of time that this is going to take place. We also know that we don’t have to deposit our money in such a bank under these conditions. But we do so because it is more preferable than keeping our money under the mattress, or in a safe deposit box.

Murray Rothbard challenges this practice and says that it should be declared by the courts as fraudulent. He maintains that the depositor’s money should be declared to be what is termed in legal jargon, a “bailment.” This means that the deposit should be declared to be equivalent to a warehoused item. The banker cannot loan it out; he must keep it on hand for whenever the depositor wishes to demand it back. In other words, the depositor is not loaning his money to the banker; he is putting it there for safekeeping to be retrieved whenever he wishes. [See The Case Against the Fed, Mises Institute, 1994, pp. 40-45.]

The banker, under the Rothbardian “bailment” system, would be able to only loan out or invest clearly stipulated time deposits of gold and gold notes, i.e., CDs. All demand deposits of such, i.e., checking accounts, would have to be warehoused. No percentage of them could be loaned out or invested by the banker, whether in real estate, bonds, or real bills. Period. Thus the term 100% banking. All deposited money (whether in gold or gold notes) must be warehoused unless it is stipulated as a time deposit. And any credit issued by a banker on time deposits of gold cannot exceed the amount of the time deposits.

This certainly is one way to structure the banking system. It would be super safe that is for sure. But would it be practical, and would it be free and just under the principles of a free-market society? Unfortunately the real issue is being overlooked by almost everyone: Are we to mandate by law that all banking be of this nature? Or should we simply leave the market FREE to decide on its own what kind of banking structure people would prefer to utilize?

For example, in a genuinely free-market there would be nothing to stop entrepreneurs from forming Rothbardian “warehouse banks” by opening up for business to try and attract customers. And no doubt, they would gain a certain portion of the depositing public. They would have to charge their customers for this service, but I’m sure there are a certain amount of people who would be willing to pay for such a warehouse form of banking. However, I doubt their number would be sizeable. Far and away, most depositors would prefer to deposit their money in the more conventional “fractional-reserve banks” because these types of banks would offer higher interest for their time deposits, and they would not charge for their demand deposits. In fact in a true free-market, many such banks would probably pay interest on demand deposits also. Some do right now under our present form of banking.

Government or Market — Which Is Best?

Here is the paramount issue involved — to which Rothbardians remain steadfastly impervious. What they are advocating will require that government mandate what type of banking the people should be allowed to partake in, rather than letting the marketplace decide. Government will have to legally stipulate that no one be allowed to operate a “fractional-reserve” bank, that all banks must in fact be “warehouse” banks. This is why I have stated in past articles that Rothbardians will have to become government interventionists in order to implement their 100% gold monetary system. They must interject government into the free interaction of entrepreneurs and customers to dictate what form of trade they may partake in.

If men and women are simply left alone to make up their own mind (i.e., if we allow the marketplace to decide), then both fractional-reserve and warehouse forms of banking would spring up. My guess is that the overwhelming majority of people would choose to bank with the former rather than the latter. But which one they choose is not the issue. The issue is who is to make the choice between these two forms of banking — the government or the people? Are we to have the choice dictated to us by politicians and their armed police, or are we going to be allowed to freely decide for ourselves in the marketplace?

Because they declare fractional-reserve banking to be fraud, Rothbardians must opt for state dictates and armed police to decide. If they truly believe such banking practices to be fraudulent, they must bring in the law. This is the law’s job, to prohibit “fraud.” The question of allowing fractional-reserve banking thus cannot be left up to the free choice of the marketplace. It must be mandated by government. But this is a very sticky issue, this thing the Rothbardians are calling fraud. Are they defining it correctly? I don’t think so. Fraud’s first requisite is what we call “intent.” The defrauder has to be “intending” to deceive and rob the other party of his property. He has to be engaged surreptitiously in acts of thievery. He has to be purposely trying to steal values from someone by not fully disclosing relevant details.

Is this what would take place in a free-market banking system? In other words, would it be fraud for bankers to partake in fractional-reserve lending under the requirement to redeem all notes in gold upon demand and openly disclose their policies and their portfolios? I think not. It is fraud for banks to be able to suspend specie payment and still operate, and it is fraud for banks to hide their portfolios from the public. But if these privileges and policies are disallowed, then what bankers and their depositors do between themselves in free trade is their business. If the bankers wish to hold only 50% gold coin reserves behind their purchase of merchants’ real bills because they know from hundreds of years of experience that such a reserve is more than sufficient to handle redemption requests, it is not fraud. They are openly divulging this aspect of their portfolio to the public, and they are not intending to steal anything from anybody. To some this might be risky and irresponsible, but to suppress this by use of government law is to violate the rights to free trade of the bankers and depositors.

The Rothbardian detractors of fractional-reserve banking have constructed a theory of malfeasance to serve their ideological agenda! In so doing, they are leaving out the concept of “intent.” And they are ignoring the fact that under a free-market system of banking the policies and portfolios of all bankers would be fully disclosed.

Therefore the practice of fractional-reserve banking in a free-market system would not be fraudulent. The reason why is because all banks would be required to redeem all gold notes in specie (and if they didn’t, they could be held liable under law for their failure). In addition, they would have to fully disclose the content of their portfolios, which would be brought about through the “competition for reputation” that would naturally develop in a monetary system devoid of government control. See my article, Real Bills vs. Rothbard’s 100% Gold System for a detailed discussion of why and how this would work. So the key is to divorce banking totally from the government control and intervention that is corrupting it, and it would police itself as far as quality and liquidity are concerned through natural market forces. Perhaps it could even be mandated legally that banks fully disclose every quarter, but that is a question that legal scholars such as Edwin Vieira would have to answer.

Further Disclosure — Boon or Bane?

Rothbardians, no doubt, would insist on further, more explicit forms of “disclosure” on the part of banks, such as mandating a written warning to be issued to all potential depositors stating that they are engaging in business with a fractional-reserve bank, and that they as depositors are not to assume their funds are held 100% in the vault. If such a warning were to be legally required, I doubt that such a disclosure would deter many would-be depositors.

In a free-market system, the primary determinant as to where one deposits his or her funds will always be that bank’s reputation built up over the years. Fractional-reserve banking is perfectly capable of being operated safely if done in a system with gold convertibility backing it that is devoid of central government control. The reason why such a system became abused in the past is because banks were granted special privileges by government regarding their portfolios and the necessity for specie redemption. Eliminate the privileges and protections from government, and fractional-reserve banking ceases to be dangerous.

Under such a benign form of fractional-reserve banking, the responsible practitioners would gain the lion’s share of customers via the reputation they have built up over the years. Requiring them to announce in writing to all potential depositors that their funds will be loaned out and invested for profit rather than stored in the vault would be rather gratuitous; it would be to announce what everyone already knows.

To be consistent, the Rothbardians would then have to also require that all airlines announce, ahead of time in writing, to all their passengers that they are embarking upon a journey in an aircraft that could crash and kill them? Rather gratuitous, I would say. It’s something that everyone knows and basically lives with. No one has to get on the plane; they could choose to drive, or take a train to their destination. They could choose safer forms of travel if they desired.

Here is where we meet the slippery slope of state interventionism! Our politicians and bureaucrats, operating under a Rothbardian mandate to warn bank depositors and airline travelers of the dangers of their endeavor, would certainly not stop there. They would, of course, extend their “protective bureaucratism” to every nook and cranny of our lives. Is this not what they are doing presently in modern society? Thus if Rothbardians wish to legally mandate that depositors be warned about engaging in fractional-reserve banking, they are going to have to abandon their free-market philosophy and don the hat of Nanny State bureaucratism. There is no logical cut-off point where they can successfully contain their “banking mandates” from spilling over into all other human endeavors.

What are we to conclude from all this? Fractional-reserve banking, properly conceived and implemented, is not fraudulent. To try and prohibit it will require an unjust violation of the rights of free men. To try and discourage it with government propaganda warnings will merely unleash the monster state to permeate the rest of our economy. Depositors basically live with the fact that bankers are investing their deposits, rather than storing them in their vaults. If Rothbardians will just allow the marketplace (that they so rightly champion) to freely and fully operate, then all depositors would be able to choose a warehouse form of banking if they desired its higher level of safety over the fractional-reserve form. And they would also be able to choose the opposite if they so desired. Would this not be far more in keeping with the ideals of freedom? Would this not be the more just way to organize our banking system?

The answer should be obvious. Those who have bought into the Rothbardian agenda of a 100% gold system are grievously wrong about what proper banking is and is not. Their prescriptions will never build a sane and prosperous economy, much less a free one. Our answer to this monumental monetary question is to restore a true free-market society in America that gives all men and women the right to make their own choices as to which form of banking they prefer.