Selgin on the History of 100 Percent Reserve Banking

Steven Horwitz

Over at the new Free Banking blog, George Selgin weighs in with a look at the history of 100% reserve banks and argues that:  "every significant 100-percent bank known to history was a government-sponsored enterprise, which depended for its existence on some combination of direct government subsidies, compulsory patronage, or laws suppressing rival (fractional reserve) institutions."

This is a must read for those interested in this topic.

Comments

[Jerry O'Driscoll]

George has provided us a useful bit of history. I hope some 100% reserve advocates reply.

[Current]

George and I had an interesting discussion about this on the CobdenCentre blog with Toby Baxendale.

http://www.cobdencentre.org/2011/05/the-importance-of-debate-on-banking-freedom/comment-page-1/#comment-28863

The argument centred around whether NYB Mellon and various Swiss banks are really 100% reserved. (My thread is close to the top of the page, George's is near the bottom since he started a new thread). I think it became clear that NYB Mellon really aren't a 100% reserve bank, or anything close. The situation for Swiss banks isn't so clear though, I challenged Toby to show that these banks really are fully reserved but he didn't present that much evidence.

[Nicolas Cachanosky]

Very interesting post! Given the listed contributors I'm sure it'll become another interesting blog to follow.

[Josh S]

One argument for a 100% reserve bank is that fractional reserve banking is a form of fraud/counterfeiting (in other words, is technically insolvent but pretends not to be), and so ought to be illegal.

Another way of putting it is that yes, a company that cooks it books to make itself look solvent will always attract more investment than an honest one...but the market will eventually find it out via a catastrophic failure. So the question is whether repeated catastrophic failures due to the eventuality of reality catching up to the cooked books are preferable to the "tyranny" of laws against fraud.

[Jerry O'Driscoll]

100% reserve banking is not fraud for reasons that George explains. (Deposit banking is not bailment.)

The economic argument stems from the volatility in short-term credit under fractional reserve banking. It is an argument made by Henry Simons and later Milton Friedman. (And, more recently, people like Ronnie Phillips.)

George counts the elasticity of credit as a plus, while critics view it as a minus. I was hoping for some engagement on the economic argument.

[Mario Rizzo]

We don't need another good blog.

[Doc Merlin]

As a side note, excess reserves are now larger than M2.

[Leonardo Baggiani]

FRB is not fraud, though it involves a degree of (entrepreneurial) risk. A 100% reserve law would be a way to just avoid risks, thus concealing bank entrepreneurship.

Being able to time-lend sight-deposits maintaining just a part of the latter as reserves (i.e. FRB) allows banks to "discover real time-preferences"; as this (entrepreneurial) activity has got a value, the market pays the bank with revenues. Hence, no FRB, no revenues: such a 100%-reserve bank would have only costs with no revenues. It helps explain why a full reserve bank could need vast support by the State (a boomerang for the supporters of free market indeed)

[Bill woolsey]

Josh S:

Insolvent = assets less than liabilities.

Fractional Reserve banks generally have assets greater than liabilities.

The difference is called "capital."

While it is normal for fractional reserve banks to be in a situation where if no one will continue lending to them they will be insolvent, the issue of demand deposits doesn't make this inevitable.

The market value of a bank's assets could be greater than the value of its liabilities. Even if it must sell those assets at "fire sale" prices, if the bank has sufficient capital, it would remain solvent.

If your vision of banking is that banks issue checkable deposits (or perhaps hand-to-hand currency,) and then make term loans, and that there is no secondary market in loans, and that a bank cannot borrow from anyone else on short noitce, and you completely igore bank capital (net worth,) then something like withdraws leading to insolvency seems inevitable.

Start adding in some complications, and are back to the standard distinction between insolvency and illiquidity. If a bank is having difficulty in borrowing, they will generally have difficulties. If those financial difficulties are bad enough, it will become insolvent and fail.

[Don Lloyd]

Is there any reason to believe that supporters of free, fractional reserve banking would not, for the same arguments, also support free, zero reserve banking as a limit case?

Thanks, Don

[Niko]

"If your vision of banking is that banks issue checkable deposits (or perhaps hand-to-hand currency,) and then make term loans, and that there is no secondary market in loans, and that a bank cannot borrow from anyone else on short noitce, and you completely igore bank capital (net worth,) then something like withdraws leading to insolvency seems inevitable.

Start adding in some complications, and are back to the standard distinction between insolvency and illiquidity. If a bank is having difficulty in borrowing, they will generally have difficulties. If those financial difficulties are bad enough, it will become insolvent and fail."

So Madoff had a solvent business model, it was those pesky clients who panicked and bankrupted him.

Another way of putting it is that banks don't fail because they cannot honor their contracts, but because they are unlucky.

And about bank entrepreneurship with other people money, I guess the thief who stills and spends my money, which I plan to spend two months from now, is a true hero (and eventually returns them to me without me noticing).

Are you guys serious?

[Gary Chartier]

Niko, presumably the thief didn't contract with you for the option to do what you describe.

[Current]

I certainly support the freedom of banks to have zero reserves. Though I wouldn't bank with a zero reserve bank myself :)

Niko misunderstand's Bill Woolsey's post. Madoff's liabilities were larger than his assets, so he was insolvent in the way Bill describes.

[Bill woolsey]

I oppose legal reserve requirements, which I guess is the same as a zero percent legally required reserve.

I don't believe banks should be prohibited from promising to "back" some or all liabilities with some fraction of reserves, but I don't believe it is sensible from either the bank's or the customer's perspective.

Choosing a bank with lots of capital is the key, but even there, I think making committments to specific percentages is unwise. This is our capital ratio, we are safe. Not we promise to keep our capital ratio at least x percent.

[Bill woolsey]

Selgin's paper on the goldsmith's is very interesting.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1589709

[David Johnson]

Analogy time. Suppose you hire some roofers to redo your roof. They tell you they will be at your home at 9:00am to start work. But on the way there they have a flat tire and so do not show up until 2:00pm.

Is that fraud? Of course not.

Demanding that banks have 100% reserves just because a bank run might happen, is like demanding roofers walk to work because their truck might get a flat.

[Steve Horwitz]

There's also a difference between "fraud" and "breach of contract."

[ivanfoofoo]

This is the never-ending dilemma. Free marketeers should acknowledge that FRB is a natural production of the market and that it's also the source of business cycles. I think Selgin has the history right, but he and the other free-bankers have too much faith in the stability of their system. And we should also consider that if a deposit is not a bailment, but it is debt, so fiduciary media is not a present good, but a future good.

[Leonardo Baggiani]

@ivanfoofoo

ok, so what? Who's the right to say I cannot buy a future good from someone who is willing to sell it? Who can say it's a bargain or garbage?
I suppose I am the one who has the right to decide.

[ivanfoofoo]

I neved said the opposite!

[Josh S]

For clarification, I'm not a proponent of 100% reserve banking--I'm undecided.

Rothbard defines insolvent as accounts payable due before accounts receivable. All of a banks assets are future payments, while its demand deposits are due immediately--those they owe the money to simply choose not to collect, which is how the bank manages to stay operational.

The argument, as I've generally understood it (along with reworking it a bit myself), is that the average client doesn't understand that 90% of his money (or whatever) isn't actually there. This is evidenced by the fact that bank notes trade at 100% of their face value. Since the probability of being able to get all your money back at any time is less than 100%, bank notes *ought* to be discounted by the market. But they aren't, which shows the average depositor is operating under misinformation at best and deception at worst. Bank runs happen (at least in this argument) when the depositors realize that there is some non-zero probability that they *won't* get all their money back.

I tend to lean one of two ways:

1) 100% reserve banking.

2) Banks should be required to explain to depositors--as in a bank rep sits down and tells you when you open an account, as opposed to burying it in fine print in a contract he knows you won't read--that less than 100% of their deposits will be held in reserve, and that at any time, the bank may choose to not make good on a 100% withdrawal in order to maintain liquidity.

The reason for (2) is that I think historically, you see the average person not really understanding that the bank doesn't actually have his money, and the banks taking advantage of that until a panic ruins them (and enough panics lead to the public accepting central banking). But I admit I do not have a very broad knowledge of banking history.

[Bill Woolsey]

As long as a fractional reserve bank is meeting its obligation to redeem, its notes or deposits won't trade at a discount relative to base money (coin?) or deposits and notes from 100% reserve banks.

The argument that there must be a discount fails because it violates the law of one price. There would be riskless arbitrage if the bank buys bank its liabilities (banknotes, checks, and deposits) at par, while everyone else supposedly trades them at a lower price.

The quantity of fractional reserve bank liabilities--notes or deposits shrink until it equals the quantity demanded at par. A dollar banknote, check, or deposit has an equilibrium price of a dollar.

This doesn't apply to the liabilities of banks currently in default. They aren't redeeming and so the law of one price doesn't apply. Also, with unit banks, it is not at all unusual that a the notes or checks of a bank redeeming at its home office will trade at a discount elsewhere.

Since monetary instruments issued by banks (whether storage receipts or debt instruments) are usually in deposit form, the storage fees and interest paid is what explains how they could both exist at the same time and trade at par. People really worried about run scenarios would hold deposits in 100% reserve banks and pay fees. People less worried could hold deposits in fractional reserve banks and earn interest. The difference between the fee and the interest compensates for the risk.

The payment of interest is difficult on hand-to-hand currency. And so, the puzzle would be how noninterest bearing hand-to-hand currency that has some risk of loss, can trade at par with base money. As long as the bank is redeeming, the quantity will be zero if there would have to be a discount to get people to hold it.

If the currency is gold coin, then there are any number of benefits to holding paper currency even though the is a risk. It has to do with problems associated with the wear of coins, their weight, and their bulk.

As for 100% reserve paper money, it is necesary to pay for it. If the storage charge is assessed with it is turned in, then the issue is the risk of loss from banknotes issued by fractional reserve banks versus the certain loss from warehouse receipts. Of course, if they are prepaid, then they should trade at a premium until they must be cashed in.

And, of course, 100% reserve banks do have a risk of loss--robbery.

As Selgin explained, there isn't a lot of experience with 100% reserve bank currency trading side-by-side with fractional reserve bank currency. That's because the 100% reserve currency has only existed when it is sponsored by the government and usually fractionaly reserve currency was surpressed.

By the way, I believe that banks could easily get hand-to-hand banknotes into circulation. With a person holding a deposit account withdraws banknotes, keep on paying interest on the balance until the banknotes clear. People will take them just like they take checks--they want the sales. And then deposit or cash them if they want.

I don't think it is particularly sensible to bury banknotes in the yard as a store of wealth. I think the notion that there must be a discount on banknotes is based on an implicit assumption that they aren't being used as money, but rather being left in a safe or buried in the yard as a long term investment.

You know, like the gold coins that some investors keep these days. A group that involves substantial crossover to those favoring 100% reserves.