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Fractional Reserve Banking, Client Collaboration, and Fraud
Malavika Nair
Received: 6 November 2013 / Accepted: 10 April 2014
� Springer Science+Business Media Dordrecht 2014
Abstract This paper traces the recent debate over the
legitimacy of maturity mismatching and fractional reserve
banking. It shows that there is common ground between
Bagus and Howden (Journal of Business Ethics,
90(3):399–406, 2009, 106:295–300, 2012) on the one hand
and Evans (Journal of Business Ethics, 2013) on the other
regarding contractual arrangements that lead to fractional
reserve banking, while both agree that fractional reserve
banking that arises out of a bailment or storage contract
constitutes fraud. Block and Barnett (Journal of Business
Ethics, 88(4):711–716, 2009, 100:229–238, 2011) stress
the illegitimacy of fractional reserve banking for creating
more money substitutes than there is actual money. While
it is true that fractional reserve banks are capable of cre-
ating money, this activity still cannot be regarded as
fraudulent using a common law definition of fraud for it
can only take place with requisite client collaboration that
makes it impossible to identify a victim.
Keywords Fractional reserve banking � Fraud � Client
collaboration
Introduction
The recent debate about whether maturity mismatching and
fractional reserve banking are fraudulent has brought up
several interesting issues relevant to the monetary system
(Barnett and Block 2009, 2011, henceforth BB), (Bagus
and Howden 2009, 2012 henceforth BH), Evans (2013) and
Cachanosky (2011). BB and BH are in agreement over
whether fractional reserve banking is fraudulent but dis-
agree as to the question of whether maturity mismatching is
fraudulent or not. Both agree that fractional reserve bank-
ing is fraudulent under any scenario, however BB argue
that maturity mismatching also ought to be regarded as
fraud because it is a more general case of fractional reserve
banking. On the other hand, BH argue that maturity mis-
matching is not fraudulent because it arises out of loans and
hence is fundamentally different from fractional reserve
banking that arises out of deposits.
Cachanosky (2011) and Evans (2013) critique both BB
and BH by arguing that neither fractional reserve banking
nor maturity mismatching are fraudulent while also pointing
out practical ways in which businesses can overcome diffi-
culties in both. This paper takes its cue from Block and
Davidson (2011) that ‘‘the moral argument must always
come first’’ and focuses only on the question of ethics. In the
first section of the paper, it is argued that the views of Evans
(2013) and BH regarding fractional reserve banking are not
mutually exclusive. On the other hand, there is one limiting
case where fractional reserve banking would indeed be
fraudulent, the case of a bailment or storage contract.
However, BH’s description of an ‘‘aleatory contract’’ (2009,
2012, 2013) that is permissible in a free market is the same
‘‘callable loan’’ or demandable debt contract defended by
Evans (2013) and others (White 2003). Hence, the first sec-
tion shows that there is more agreement in this debate than
meets the eye. Both sides (BH on the one hand and Evans on
the other) agree that under certain contractual arrangements,
fractional reserve banking is permissible. Hence the point of
contention is no longer one about ethics, rather one of
whether fractional reserve banking would survive and
flourish in a free society.
The next section of the paper turns to the issue of maturity
mismatching. BB argue that maturity mismatching is but a
M. Nair (&)
Troy University, Troy, AL, USA
e-mail: [email protected]
123
J Bus Ethics
DOI 10.1007/s10551-014-2176-x
more general case of fractional reserve banking and hence
must be regarded as illegitimate for it involves the over-issue
of more property titles than there is actual property. First, it is
problematic to theorize that more property titles, than there is
property, are being issued because maturity mismatching
arises out of loan contracts. Property titles or warehouse
receipts would be issued only in the case of bailments or
storage contracts, debt claims or bonds would be issued in the
case of loans.
On the other hand, it is true that maturity mismatching
can be seen as a more general case of legitimate fractional
reserve banking that arises out of redeemable demand
deposits. Hence fractional reserve banks can indeed ‘‘create
money’’ or put into circulation more banknotes or money
substitutes than there is actual money. However, this
practice cannot be categorized as fraud using a common
law definition, which requires an intention to misrepresent
(scienter) as well as a clear victim and aggressor. This is
because in a free market, no bank can force customers to
use its money substitutes as money and the extent of money
creation by fractional reserve banks directly depends on
how much its clients use substitutes in place of money.
Hence, it is impossible to identify a victim (as long as
clients are aware the bank lends their money) due to the
inbuilt problem of requisite client collaboration (both
depositors and borrowers) that is required for fractional
reserve banking to exist in the first place.
The remainder of the section then tries to provide a
theoretical answer as to why fractional reserve banking
may come to play a legitimate non-trivial role in a free
society using Mises’ (1953) typology of money. This is
because money substitutes or redeemable claims to money
are technologically capable of performing all the functions
of money itself. This is unlike any consumption good
where a claim to the good can never satisfy the demand for
the good itself. The final section then concludes.
All Demand Deposits are Not Storage Contracts
BH claim that while loan maturity mismatching is not
problematic, fractional reserve banking is indeed fraudu-
lent. As pointed out by Evans (2013), this distinction relies
heavily on the meaning of the terms ‘‘deposit’’ and ‘‘loan’’.
A deposit is defined as a contract where ‘‘the depositors
deposit goods with the depositary because they wish for the
depositary to safe-guard the goods, while retaining at all
time the availability of their use’’, while a ‘‘loan’’ involves
‘‘the borrower relinquishing the availability of the car,
olive oil, or money for a specified time period.’’ (Bagus and
Howden 2009, p. 400, Emphasis mine) Hence, fractional
reserve banking that involves the loaning out of money
placed in a redeemable checking account violates the initial
terms of the contract (safe-keeping and availability). On
the other hand, the fungibility of money makes possible
borrowing short-term loans and lending them for longer
periods. Since a loan contract does not promise the con-
stant availability of money, but only that the money be
repaid when the loan is due, such maturity transformation
is not illegitimate, argue BH.
As alluded to in Evans (2013), BH’s strongest case
arises if the deposit was one of only pure safe-keeping or a
storage contract.1 It is only this limiting case that would
require a 100 % reserve. This coincides with BH’s
description of a ‘‘deposit’’ as shown above. Fractional
reserve banking that arises out of lending money placed
with the banker for the explicit purpose of safe-keeping and
nothing else (a storage contract) amounts to fraud. There
seems to be implicit agreement on this point. However, the
implicit agreement does not end there. As shown below,
the type of fractional reserve banking contract defended by
Evans and others of the Free Banking School has the same
essential features of the ‘‘aleatory contract’’ so named by
BH to be permissible in a free society. Hence, both sides of
this debate actually agree that under certain contractual
arrangements, fractional reserve banking is not fraudulent.
The disagreement is thus no longer one of ethics, rather one
of whether fractional reserve banking would flourish in a
free society.
To be clear, it is only when the original intention was
one of safe-keeping in the form of a storage contract, that
there is a necessity for the banker to hold 100 % reserves.
This amounts to saying that the bank or warehouse keeper
must not appropriate the funds for personal use, he must
safe-guard them. For this, the depositor must pay a fee to
the banker. However, if it is not a pure safe-keeping con-
tract, and if the banker promised availability but never to
keep the depositor’s money in a safe deposit box, then all
he must do is return the money whenever it is asked for.
This may come from a reserve fund at first, if that runs out
in a contingency; the banker must supply the money by
liquidating assets or borrowing. In the latter case, the
waiting time may increase to a few hours or days, bankers
may include such a stipulation in the original contract via
an option clause. Demand deposits that pay interest would
be an example of such a contract. For how could a bank
pay interest on a redeemable deposit if it were not lending
it out?2
For it is perfectly possible to have contracts that provide
redeemable or checkable deposits (available at all times)
1 Evans (forthcoming) writes ‘‘Obviously, it would be considered
either fraud or outright theft for the warehouse to use or lend out your
property to another person without your permission.’’2 Selgin (2012a) provides such an example about Goldsmith banks in
seventeenth century England.
M. Nair
123
that do not involve any safe-keeping, rather the bank
openly discloses the fact that the money will be lent out
further or invested. Evans (2013) calls this type of contract
a ‘‘callable loan’’. Fractional reserve banking that results
from these types of contracts does not involve any fraud-
ulent activity. In other words, it is the violation of the safe-
keeping or storage function alone that can lead to fraudu-
lent fractional reserve banking. On the other hand, deposits
that promise redeemability of money while openly lending
it out further do not involve a violation of any contract or
fraud. Evans (2013) describes this type of redeemable
deposit contract as ‘‘a loan may be callable, and be repaid
upon the lender’s demand.’’ For a more substantial expla-
nation from the point of view of the Free Banking School,
White (2003, p 427) writes of legitimate fractional reserve
banking contracts: ‘‘As the term to maturity goes to zero,
such a contract becomes a demandable debt that gives the
customer the legal right to reclaim (and transfer, if it is a
checking account) any part of the deposited sum on any
date, but that also allows the bank to continue using the
sum until the date the depositor actually reclaims it…The
customer who holds a banknote or a demand deposit has a
debt claim payable on demand.’’
Evidence that BH actually agree that this type of con-
tract is not fraudulent comes from their description of what
they name an ‘‘aleatory contract’’ (Bagus and Howden
2009, 2012, 2013). They write that ‘‘we classify a frac-
tional reserve demand deposit contract showing that it may
be considered, at best, an aleatory contract—0 a contract
contingent on an uncertain event. Such a contract contra-
dicts the reason individuals deposit money—the mitigation
of uncertainty’’ (Bagus and Howden 2013, p. 627). While
BH are skeptical about why someone might patronize a
bank that offers them such a contract, this question is not
relevant to whether an ‘‘aleatory contract’’ is fraudulent.
They further describe this contract as:
Both parties are aware of the fact that the bank uses the
money for its own purposes. The ‘‘depositor’’ would
not have the availability of the money but the right to
ask for the money and the bank would try its best to give
it to the ‘‘depositor’’ (citation suppressed). The
‘‘depositors’’ motivation for entering the contract
would not be to maintain full availability of the money,
but rather to invest it. Hence, the purposes of the two
parties to the aleatory contract are compatible and
possible to carry out. It then becomes a question of
probabilistic forecasting if the bank will have the
money and be willing to return the money when the
‘‘depositor’’ asks for it. Many members of the Rothbard
School (Huerta de Soto; Hulsmann) have acknowl-
edged the possibility of aleatory contracts.
They go on to state ‘‘Hulsmann (2003) does not use the
term ‘‘aleatory contract’’ but calls the contract an IOU with
a redemption promise. Hulsmann (2003) sees these types of
redeemable debt contracts as not fraudulent and legally
permissible in a free society. He too, however, remains
skeptical about the extent to how much these types of
contracts would exist in a free society. He describes these
contracts as ‘‘It can so happen that a person who
‘‘deposits’’ a sum of money with his banker really means
to buy an IOU plus redemption promise. Indeed, it is not
difficult to see that a free market might exist in IOUs plus
redemption promise (IOUs ?RP). Although these IOUs
yield lower returns than other investments, they are more
liquid; and although they are not always as liquid as money
titles, they are costless or even promise some return.’’
(2003, p. 402).
The evidence presented above allows us to acknowledge
that there is some agreement as to whether certain con-
tractual arrangements that allow for fractional reserve
banking are legitimate or not. Both sides of the debate
acknowledge that a certain type of deposit that allows for
redemption and pays interest is legitimate. While different
sides of the debate may have different names for the same
contract, the agreement over whether they are legitimate
remains. The relevant point of contention then becomes
whether these contracts would survive and proliferate in a
free society. For example, insurance contracts too are
widely accepted to be ‘‘aleatory’’ in nature, and insurance
companies play an important and prominent role in society
(with or without government support). Could not it be that
fractional reserve banking, even if we were to accept the
‘‘aleatory’’ label, could have a prominent role to play in a
free society? While BH and Hulsmann (2003) argue that it
would not and Evans (2013), White (2003), and other
members of the Free Banking School argue that it would,
this is no longer a question of ethics. It is rather a question
of practice and institution-specific analysis.
Client Collaboration and the Question of Fraud
The paper now turns to an analysis of BB’s arguments.
BB’s argument for fraudulent fractional reserve banking
differs from BH’s argument. BH stress legal arguments for
fraudulent fractional reserve banking that they see as
applying only to demand deposits, not time deposits. Hence
BH see fractional reserve banking as fraudulent but not
maturity mismatching. BB stress the over issuance of titles
or claims, unbacked by actual money to be the main cause
of fraud. They see the ‘‘over determination of property
titles’’ (Barnett and Block 2009, p. 713) as representing an
inherent conflict of rights. BB argue that this applies in the
Fractional Reserve Banking, Client Collaboration and Fraud
123
case of both fractional reserve banking and borrowing short
and lending long and hence see both these practices as
fraudulent, contra BH.
Barnett and Block (2009) argument goes as follows. If
a bank borrows money from A for 1 year and lends
money to B for 2 years, it is committing fraud for cre-
ating credit or more claims to money than money exists.
For on the day that A’s loan comes due, there are two
people with an equally valid claim to only one amount of
money. First off, this argument is problematic on its own
terms. If the bank has promised to pay back A when his
payment comes due, then this logically and necessarily
requires the bank to borrow before the payment is due in
order to honor its contract. This is not an ‘‘extra-con-
tractual’’ maneuver as (Barnett and Block 2011, p. 236)
term it, it is very much a contractual requirement on the
part of the bank. There is no conflict of rights, neither are
there more claims to money than there is money. The
bank must borrow money from let us say C and hence
increase its liabilities by a corresponding amount to pay
back A, while at the same time removing from circulation
the amount of money he owes A. When B’s loan comes
due, the bank uses it to pay off C and makes money off
the interest differential. If the bank fails to borrow in the
short term, then debt holder A has a preferential claim to
the bank’s assets. Even now, there is no case of more
claims than money, as long as the bank is able to increase
liabilities by borrowing or liquidate assets; every liability
is ‘‘backed up’’ by money. In the extreme event that the
bank fails to do so, it must declare bankruptcy, which is
not the same thing as fraud.
Further, using the distinction laid out above between
pure safe-keeping deposits and demandable debt, it is
possible to distinguish two distinct types of claims that
come into existence. When a depositor puts money into a
safety deposit box, he receives a ‘‘warehouse receipt’’ that
may be redeemed at any time. That receipt represents a
property title. The depositor owns the bailment and may
transfer ownership of his property by transferring the title.
If a depositor puts his money into a demandable deposit
that pays interest (demandable debt), then he receives a
redeemable debt claim.3 This claim represents a debt that
the bank owes the depositor and that may be redeemed at
any time (unspecified maturity). In this sense, it resembles
a bond.
As an illustration of how a debt claim or IOU is distinct
from a property title or warehouse receipt, consider the
following example. Because the two are conceptually dis-
tinct, it is perfectly possible to have a property title and a
debt claim or bond on one asset at the same time. If Mr.
Jones buys a house, then he receives and holds the property
title to that house, and it represents his ownership of the
house. Now Mr. Jones can lend or rent out the house to Mr.
Smith for one year. Mr. Smith signs a rental contract saying
that he must return the house to Mr. Jones at the end of one
year. That rental contract is a debt claim or IOU that Mr.
Jones holds onto. At the end of one year, Mr. Smith owes
Mr. Jones the exact same house. If it were true that there is
no difference between property titles and debt claims, BB
would have to claim that all rental contracts are fraudulent
as well for there has been an ‘‘over determination of
property titles’’ (Barnett and Block 2009, p173). This
would be an absurd conclusion. Just the same way, in the
case of a monetary loan or a redeemable deposit contract,
debt claims or IOUs are issued, not property titles. The
fungibility of money is only an added feature that allows
for the banker to return an equivalent amount of money as
well as lets him engage in borrowing short and lending
long. It would indeed be fraudulent to borrow a house for
1 year and lend it for two, but not because of the over
determination of property titles (for property titles are not
involved in rental contracts), rather because houses are not
fungible.
Applying this analysis to BB’s description of what
causes fraud in the case of borrowing short and lending
long reveals the same problem. For borrowing short and
lending long and legitimate fractional reserve banking of
the type described above is always a debt transaction.
Money substitutes that are issued as a result of a debt
transaction are not property titles. Property title or ware-
house receipts would only be issued if the initial deposit
was a safe-keeping or storage contract. In every other case,
the bank note or checking account represents a debt claim.
Hence money creation by banks in this sense does not
amount to more titles to property than there is property in
the same way if there were more titles to houses than actual
houses. What does exist however is more debt claims than
there is money to redeem all of them simultaneously.
Mises (1953) himself never uses the term ‘‘property
title’’, rather he uses the more general ‘‘claim’’ when
writing about money substitutes, a term that could
encompass both a debt claim and a property title. The
practice of using ‘‘property title’’ only starts with Rothbard
(1993), however this is understandable given the fact that
he only envisions warehouse deposits and warehouse
receipts when talking about demand deposits. The concept
of ‘‘over-issue of property titles’’ does not exist in the case
of fractional reserve banking that arises from redeemable
debt.
Now, I turn to an analysis of what can be seen as the
strongest case for the fraudulent fractional reserve banking
being made by BB. BB are right in pointing out the affinity
between fractional reserve banking and maturity
3 Selgin (2012b) uses historical samples to show the differences
between warehouse receipts and bank notes (debt claims).
M. Nair
123
mismatching. As BB (2011, p. 236) point out: ‘‘FRB, in
addition to being a special, limiting, case of BSLL, is
unique in another way. BSLL always, i.e., whether or not
of the FRB type, involves an increase in credit. But only
FRB also and always involves an increase in money,
something that BSLL of the non-FRB type never does.’’
Fractional reserve banking can indeed be seen as a special
case of borrowing short and lending long; however, there is
one crucial difference. Credit is not being created; it is
merely being allocated in the case of borrowing short and
lending long. However, it is possible that money be created
in fractional reserve banking by the creation of more
money substitutes in circulation than there is money.
The analysis in the earlier part of the paper argued that
fractional reserve banking cannot be regarded as fraudulent
on account of the underlying contract for it is possible to
construct contracts that allow for it legitimately. If there is
full disclosure between the bank and the depositors that the
bank will lend the money while depositors have use of the
money through money substitutes, then the bank cannot be
charged with fraud. Only if the bank misappropriates funds
placed with it for safe-keeping or storage will fraud have
taken place. However, can we deem the practice of frac-
tional reserve banking fraudulent solely on account of this
money creation?
Before answering that question, a brief detour to set up a
clear understanding of what is meant by fraud at least under
current law is helpful. Using a common law definition of
fraud as understood in the American law system, fraud is
defined to be ‘‘a knowing misrepresentation of the truth or
concealment of a material fact to induce another to act to
his or her detriment’’ (Garner 2001). It is ‘‘defined to
include intentional wrongdoing and usually also includes
scienter, an intention to deceive and induce reliance by the
other party’’ (Rohwer and Skrocki 2006, p 290). Another
legal source defines fraud as consisting of five elements:
‘‘(1) a material misrepresentation; (2) the defendant acted
with the requisite scienter: she knew the statement was
false or made it with reckless disregard as to its truth or
falsity; (3) the defendant intended to induce reliance; (4)
the misrepresentation caused plaintiff’s justifiable reliance;
(5) pecuniary damages resulted to the plaintiff.’’ (Diamond
et al. 2010, p. 332).
Using the above definitions of fraud as a guide, we must
conclude that it is not possible to classify fractional reserve
banking as fraud on account of money creation for two
reasons. The first reason is that one cannot blame the bank
for deception if it discloses all the facts to its clients at the
outset, and they still choose to engage in placing their
money with the bank. The second more important reason is
that there is no clear victim. One cannot tell who is
defrauding whom for voluntary actions of the bank’s cli-
ents (depositors and borrowers) are required for the bank to
engage in fractional reserve banking in the first place. The
extent to which a bank can engage in fractional reserve
banking is also determined by its clients’ collaboration.4
The following two examples help to illustrate this point of
how the clients’ actions directly determine the extent to
which a bank can engage in fractional reserve banking. The
first example illustrates the simple case where a bank
engages in fractional reserve banking by lending out
money proper (not money substitutes). The second exam-
ple then moves to the more complex yet realistic case,
where like today, banks engage in fractional reserve
banking by issuing money substitutes, not lending money
proper. While the extent of money creation can be much
greater in the second case, the limits faced by the bank are
the same.
Consider the following simple example of fractional
reserve banking. Depositor A deposits $1000 cash in
checkable deposit account at Bank B. Bank B issues a
checking deposit with a balance of $1,000 and gives A a
check book, debit card, and ATM card. A is free to with-
draw cash at any time; he may write checks or even pay for
goods using his debit card. In this scenario, the checking
deposit with a book balance (equivalent to contemporary
online balances) is the money substitute. The actual cash or
money is with the bank. Now the bank has disclosed the
fact that it will lend the money out further. So far, there is
$1,000 worth of claims or money substitutes that A can
redeem for actual cash at any time, and there is $1,000 of
actual cash in this system. Let us say that over a few weeks
Bank B learns of A’s spending and redemption habits.
Every week A only withdraws $50 in cash while making
payments worth $100 using her debit card. Bank B makes
the call that if it were to keep and maintain $100 in reserves
and lend out the rest, it will be able to satisfy redemption
demand as well as meet contingency redemption for A with
ease. So it proceeds to lend out $900 in cash (for simplicity
sake let us assume it lends out the actual cash rather than
4 It is important to point out how this differs from fraud in a Ponzi
scheme. For one could argue that voluntary client collaboration is
required even in that case. Bernard Madoff could not have done what
he did without clients voluntarily giving him money. The Ponzi
scheme case is different for two reasons. It is regarded as fraud
because of misrepresentation of the facts, clients are made to believe
that they can earn unusually high returns from a real investment
opportunity accessible to the manager, while in reality their returns
are coming from new entrants’ contributions into the scheme, and
there is no actual investment opportunity. The second reason is that it
is very easy to identify a victim; those people who unknowingly
invested money into the scheme and stood to lose from it. Neither of
these is the case with fractional reserve banking that arises from
legitimate contracts. On the other hand, similar schemes where clients
are fully aware of the business model and there is a legitimate product
or investment involved are considered legal and thrive, for example:
multi-level marketing schemes.
Fractional Reserve Banking, Client Collaboration and Fraud
123
by issuing more money substitutes). So far, the Bank B’s
balance sheet is illustrated by Fig. 1.
At this point, BB would claim that the Bank has com-
mitted fraud, for the bank has managed to nearly double the
money supply in this economy. So while the borrowers
have a valid claim to the use of the $900 loan they have just
got from Bank B, so does Depositor A have a valid claim to
the entire $1,000 at the same time, only one tenth of which
lies in the bank’s vault. Hence, there has been an over-issue
of claims, and fraud has been committed.
However, let us closely examine what allows this bank
to ‘‘create money’’ in the first place. If Depositor A with-
drew the whole $1,000 cash out of her account over the
course of every week, while re-depositing every Monday,
then Bank B would be unable to lend out anything for it
would not have any cash in its possession. On the other end
of the spectrum, if A only withdrew $5 worth of cash and
was content to make use of her account the rest of the time
by simply drawing down the book balance by using her
debit card or check book, then Bank B would now be in a
position to loan out the cash. Of course, another crucial
step here is whether or not others in the economy to whom
A makes payments demand cash redemption from Bank B
or whether they too are happy with an increase in their
checking account book balance.
Let us assume A buys a television worth $800 from
Store C and pays with a check. Store C does not have a
bank account, so he goes to Bank B and cashes out the
check for a whole $800. Again Bank B is legally bound to
make the cash payment on demand. It is now however
unable to loan out the initial deposit of A since it is once
again cash poor. On the other hand, if Store C was a client
of Bank B and was content holding a higher checking
account balance rather than the actual cash, all Bank B
would have to do is draw down A’s balance in favor of C’s.
No cash would change hands at all and Bank B would once
again be in a position to loan it out.
It appears that Bank B has a strict limitation in its ability
to ‘‘create money’’ by loaning out the money in checking
accounts. It is entirely dependent on its clients and others in
the economy making use of the money substitutes instead
of the money proper. For if its clients and non-clients ask
for cash redemption constantly, as made clear in the
example above, the bank is unable to make loans and hence
‘‘create money’’. The key, it appears then, is that the bank’s
money substitutes must first circulate as though they were
money. Now, it is important to stress that a bank in a free
market and in the absence of a central bank or legal tender
laws, cannot force its clients to use money substitutes. It is
entirely up to the people in the economy whether or not
they hold a particular bank’s money substitutes as though
they were money or whether they ask for redemption for
real money.
This brings us back to the question of fraud as described
by BB. If the clients of the bank choose to use money
substitutes rather than money, then the bank is able to
‘‘create money’’ and not if they do not. Who is defrauding
whom here? Can we accuse the bank of defrauding the
clients? If we do, then we would have to accept that the
clients are also equally culpable in this act. For their own
free actions are crucial for the bank to engage in fractional
reserve banking in the first place. If they freely choose to
make use of money substitutes and not ask for frequent
redemption, are they defrauding themselves? The questions
itself is absurd. As long as the bank discloses the fact that it
will lend out money deposited in checking accounts and
promises to pay back depositors whenever they ask for
redemption (it may have to liquidate assets if its reserves
run out as described previously), no fraud has been
committed.
What if the bank understands this process and engages
in coaxing its customers to use money substitutes by
making it easier and more convenient to do so than car-
rying cash? The bank may invest in many ATM machines
or tie up with other banks so that they mutually accept each
other’s money substitutes. Such efforts would indeed make
it easier to use money substitutes for clients could be
assured of being able to purchase goods at more places
without having to carry cash. Does this activity on the
bank’s part imply fraud? Again, in a free market for
money, there would be no compulsion for any client to use
money substitutes instead of money. Furthermore, every
bank has to honor its contract to redeem substitutes for
money at any time. How much ever the bank tries to cajole
its clients, the ultimate choice and responsibility for
understanding this process lies with the client. You can
take a horse to water, but you cannot make it drink. Again,
no fraud is being committed.
Now, let us turn to another case of fractional reserve
banking, one where the bank does not loan out cash, rather
it makes loans by issuing money substitutes or by opening
a checking account for the borrower. Let us keep the ori-
ginal scenario where Depositor A deposits $1,000 in Bank
B. This time Bank B keeps $1,000 as cash reserves and
makes loans worth an additional $1,000 to Borrower C, this
time by creating a checking deposit for that amount and
thereby increasing its liabilities along with its assets.
Assets Liabilities
Cash Reserves: $100 Checking Deposits: $1000Loans in cash: $900
Fig. 1 Bank B’s balance sheet
M. Nair
123
Hence, the bank has made loans this time by issuing more
money substitutes. Now the Bank’s balance sheet is illus-
trated by Fig. 2.
Again, it is clear to see that the bank has effectively
‘‘created money’’, since now there is $2,000 worth of
checking deposits backed by only $1,000 cash. However,
the same caveat as before applies. If A constantly redeems
cash or others in the economy do not value Bank B’s
money substitutes highly, then this practice would be
impossible. The extent of money creation again is com-
pletely contingent on clients’ actions, even more so than in
the previous case. Again, it is impossible to identify a
victim. It is also important to note that C’s relationship to
the bank is very different from A’s relationship. C is the
bank’s debtor; it owes the bank money and not the other
way around. The bank only promises to redeem cash to C if
he may want it to make payments. C is the one who owes
the bank money when the loan comes due. When C pays
back his loan, the bank reduces its liabilities and assets for
$1,000 simultaneously, and the money creation is reversed.
On the other hand, the bank is A’s debtor, it owes A
money. Only if others value the bank’s money substitutes
highly enough that neither C nor the people C pays with the
loan money regularly redeem for cash, can the bank engage
in this type of fractional reserve banking.
An often overlooked feature of Mises’ (1953) monetary
thought helps provide us with an understanding as to why
such a practice may well lead a prominent role in a free
society. Mises (1953) is to be attributed for creating and
elaborating upon the distinction between money proper on
the one hand and money substitutes as valid redeemable
claims to money on the other.5 Mises writes about the
ability of money substitutes to replace money proper in
people’s cash balances: ‘‘A claim to money may be
transferred over and over again in an indefinite number of
indirect exchanges without the person by whom it is pay-
able ever being called upon to settle it. This is obviously
not true as far as other economic goods are concerned, for
these are always destined for ultimate consumption’’ (1953,
p. 50).
This is because money is a medium of exchange, it is
held or demanded only to be given away in exchange
again. Hence, a perfectly secure claim to money (like a
checkable deposit balance or a bank note) is technically
capable of performing this function just as well. This is
not the case with consumption goods or capital goods. A
claim (whether a property title or an IOU) to a car, house
or carton of apples can never perform the function of the
underlying good for the underlying goods only provide
utility in consumption. This means that consuming or
using a title to a house as though it could render the
services of a house itself would necessarily prove to be
fruitless. On the other hand, money provides utility pri-
marily as a medium of exchange, which is when it can be
used to exchange and acquire those goods that people do
wish to actually consume. Hence in a technological sense,
a liquid redeemable claim to money can take the place of
actual money while performing all the functions of
money. Mises stressed that this feature is distinct from the
fungibility of money.6
Of course, it is an empirical question as to the extent that
such claims may circulate in place of money proper.
However, it provides an answer to the question of how
fractional reserve banking may exist and even proliferate in
an ethical way. If people or banks’ clients find it more
convenient to use and hold bank notes or checking balances
instead of the actual money, then banks will be able to
engage in fractional reserve banking and hence ‘‘create’’
more money. If clients choose to redeem money often, then
that will place a natural limit on the extent of money cre-
ation. BB might argue that no person would knowingly
Assets Liabilities
Cash Reserves: $1000 A’s Checking Deposit: $1000 Loans: $1000 C’s Checking Deposit: $1000
Fig. 2 Bank B’s balance sheet
5 Mises (1953) takes this distinction between claims to and goods
themselves from Bohm-Bawerk (1962). Bohm-Bawerk (1962) theo-
rizes that issuing claims to goods does not double the amount of
actual goods in existence because claims do not give one power of
disposal over the good in question. Mises (1953) takes this idea and
applies it to money and money substitutes. Yet, Mises (1953)
recognizes and stresses the fact that money is unique and that claims
to money can technically give one all the benefits (power of disposal)
of holding money itself. Yet, he remains steadfast to Bohm-Bawerk’s
(1962) distinction between claims and goods and thus sticks to his
terminology of money and money substitutes, rather than just money.
For more on this, see Nair (2012).
6 Here we find Mises (1953) distinguishing between fungibility and
the ability of claims to be used in place of money proper.
In the first place, money is especially well adapted to constitute
the substance of a generic obligation. Whereas the fungibility
of nearly all other economic goods is more or less circum-
scribed and is often only a fiction based on an artificial com-
mercial terminology, that of money is almost unlimited… A
still more important circumstance is involved in the nature of
the function that money performs. A claim to money may be
transferred over and over again in an indefinite number of
indirect exchanges without the person by whom it is payable
ever being called upon to settle it. This is obviously not true as
far as other economic goods are concerned, for these are
always destined for ultimate consumption. (Mises 1953, p. 50
Emphasis mine).
Fractional Reserve Banking, Client Collaboration and Fraud
123
patronize such a bank and hence in a free society, banks’
ability to create money will be seriously circumscribed.
This might be true, but what if certain people still know-
ingly choose to patronize such banks? At that point still, no
fraud would have been committed. For as long as people
choose not to redeem for cash, the ability of banks to create
money is enlarged. Why would people willingly and
knowingly choose not to redeem for cash even if they knew
their bank was effectively creating money if they did not?
Mises’ (1953) insight about how money substitutes can
play the same function of money helps shed light on how
fractional reserve banking can play a legitimate role in a
free society. Hence Mises (1953) stresses the utilitarian
argument as well as the ability of free banking to keep
excessive monetary creation in check.
Conclusion
The debate over the legitimacy of fractional reserve
banking has been through several iterations and the latest
installment brings up important issues about the linkages
between fractional reserves and maturity mismatching.
This paper showed that there is more common ground
between the views of BH and Evans than meets the eye
regarding the possibility of contractual arrangements that
lead to legitimate fractional reserve banking. It was shown
that both BH and Evans would agree that there is one type
of contract under which fractional reserve banking may be
rightfully seen as fraudulent, the storage or bailment con-
tract. On the other hand, demand deposits of the type
defended by the free bankers have the same essential fea-
tures as the ‘‘aleatory contract’’ described by BH. The
disagreement between can thus be seen no longer to be on
the question of ethics, rather one of practice as to how
much such contractual arrangements may proliferate in a
free society.
On the other hand, BB’s argument regarding fraud as
arising from an ‘‘over determination of property titles’’ was
shown to be inapplicable to the case of debt contracts
(whether borrowing short and lending long or fractional
reserve banking arising from demandable debt). This is
because property titles are only issued in the case of bail-
ments or storage contracts, whereas IOUs or debt claims
are issued in the case of debt contracts. Nevertheless, even
contractual fractional reserve banks are capable of creating
money de novo and the question of whether they should be
regarded as fraudulent on account of this still remains and
represents BB’s the strongest case argument for fraud. It
was shown that even in this case, one cannot classify
fractional reserve banking as fraudulent on account of
money creation alone for it is impossible for the bank to
pull it off without requisite client collaboration. This along
with a lack of misrepresentation (which would be the case
if the bank discloses the money is being lent) makes it
impossible to identify a clear victim. Hence, at least using
current common law definition of fraud, one cannot clas-
sify contractual fractional reserve banking as fraudulent on
the charge of its ability to create money. The paper then
points to an underappreciated theoretical point in Mises
(1953) that helps explain why fractional reserve banking
may well flourish in a free society.
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