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Fractional Reserves

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John McVey

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It was that case that formally cemented the legal status of the depositor-bank relationship as credit rather bailment, making futile any attempt thereafter to try to have full-reserve accounts. I'll continue looking for it, and I'll post the citation when I find it.

Found it accidentally while looking for another matter. I can be a twit at times, it's a classic in all the textbooks and I was looking in the wrong places.

Foley v Hill 1 Ph. 399; 2 H. L. C. 28

The interesting thing about the case was that this particular account was not one of bailment because he knew explicitly that he was getting interest and that he was trying to cite law of bailment so he could skirt the English Statute of Limitations as applied to overdue debts. All modern depositing originated in bailment, that people kept their holdings of gold and silver in the care of goldsmiths because they had the best vaults and security. Over time, the goldsmiths started helping themselves to loans from their clients' holdings and on-lending it to merchants and others. Thus fractional accounts were born, thanks to a lack of clear law: the goldsmiths who did that should have been prosecuted, but they weren't. The law wouldn't lift a finger (the English Crown was itself among the 'others', and demanded loans on pain of outright legalised theft if they weren't forthcoming), so the meaning of a banking deposit started slipping again to the biblical references. By time of Foley there were both fractional and non-fractional accounts, and everyone knew it. Generally, the former were credit (and had to be) while the latter may or may not have been bailment. As to these latter, there was no clear-cut law that said either way, only custom. What this case did was rule in favour of all depositor relationships as creditor rather than bailment. This killed the remaining non-fractional accounts because it opened the door to the institutions up and borrowing from the deposited funds whenever they felt like it, since the court had just said the money was theirs to do with as they judged fit and that the institutions were entitled to keep the profits from that action.

Interestingly, later on the English law community realised there was still something skewiff because even ordinary creditors can't withdraw their principle at a moment's notice whereas depositors can as though the law of bailment were still in operation. They ended up saying that the banker-customer relationship is not a plain credit one, but nor is it a bailment one. The relationship is instead sui generis to banking as something in between. IOW, they wanted their cake and eat it too. I haven't tracked the state of English law on the matter from after that.

I have no idea what the state of US law on what constitutes a deposit and what the legal relationship is between banker and customer.

As to Australia, the authority of Foley v Hill was affirmed by N. Joachimson v Swiss Bank Corporation [1921] 3 K.B. 110. For today, if anyone's interested here's an article from one Rhys Bollen, in 2006, on what legally constitutes a deposit for banking purposes under Australian law (for some reason there's a secure-connection attached to that web-page, so I don't know if that means its available to Australians only or what the deal is.) He says the law is in need of a thorough-going definition of just what on earth "deposit" means, and I agree, though not for the purposes he has in mind.

For my purposes, it is clear to me that rational epistemology is sorely needed to sort things out. I stick with my definition of deposit as I laid out elsewhere: the thing so deposited just sits there, unused. But, more than that, this entire mess also needs full understanding of the consequences of FRB and what this implies about what the proper definitions are of a host of related economic and financial concepts, such as inflation and deflation. I stand by mine: inflation is an increase in the money supply beyond the increase in the number units of the actual commodity serving as the objective media of exchange. That definition can only be justified after demonstrating why fractional banking has nothing to contribute.


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That is an interesting discussion on how the law regarding money changed. However, my read is that you reversed cause and effect. Fractional reserve banking did not so much arise because the law was changed. Rather, the market demanded fractional reserve banking, and the law changed to acknowledge the new practice.

The market demanded that change from both the demand and supply sides. Parties, such as the king, wanted loans from the goldsmiths. The goldsmiths, in turn, wanted to get greater value from their idle gold hoardings.

As a broad observation regarding laws and economics, typically an economic change happens first, and then the law gets around to acknowledging what has already become true in commercial practice. For example, the discovery of oil gives rise to a whole body of law on mineral rights, or the rise of banking gives rise to a whole body of law defining creditor-debtor relationships, etc. This appears to be another example of that phenomenon.


Edited by Galileo Blogs
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Therefore, FRB causes total real capital maintained to be less than it would be had there been no FRB.

This can only be true if there is another means by which lending can be accommodated, and if that means can be shown to require less monitoring costs than FRB, and if that means can be shown to provide an overall higher ROI than FRB. Overall ROI combines interest paid with risk incurred, risks including both loan failure risks and personal risks incurred due to non-liquidity of invested monies.

My argument is that when an individual is given the interest rates, empirical and/or theoretical loan risk rates, probability of liquidity (i.e., money availability), including probability of cash depleting runs, he can make a rational decision on whether to deposit his money in the bank v. invest it other options.

For most people, the liquidity probability afforded by banks will make them likely to deposit an amount in the bank equal to their greatest expected requirement for short term liquidity, while they invest the rest in other investment options. A rational person will also maintain an absolute minimum amount of cash in pocket representing his maximum expected instant liquidity requirements (balanced against risks such as inflation, robbery and loss), and may well establish a safe deposit of cash and other valuables, weighing lowered liquidity (i.e., waiting for the bank to open) and higher security for a certain amount of his money.

FRB provides a useful "color" in the spectrum of low-to-high liquidity, low-to-high risk, low-to-high paying investment options, without which our options would jump from safe deposits immediately up to marginally illiquid investments.

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