Fractional reserve banking and its effect on maturity mismatching

 

The following is an excerpt from my presentation at the 3rd International Student’s Conference: Time to Rethink Economics, Beyond Frontiers that took place in Zagreb, Croatia in June, 2011. The title of the working paper is: Dangers of maturity and currency mismatching in a fractional reserve banking system with the example of Iceland and a look at alternative banking models.

Fractional reserve banking and its effect on maturity mismatching

For one to understand modern banking, history is an essential backbone unto which the pillars of modern financial intermediation are to be analyzed. The first and foremost example is Ancient Rome and the introduction of Roman Classical Law. In the time of great advances in philosophy, the beginnings of primal government structures and other forms of key institutions, a form of so-called jurisprudence evolved. Jurisprudence came about from the nature of societal and human understandings championed by Roman scholars, as” […] they embarked on an interpretation of legal customs, exegesis, logical analysis, the tightening of loopholes and the correction of flaws; all of which they carried out with the necessary standards of prudence and equanimity.“ (de Soto, p. 24)

The work of the jurisprudence was subsequently archived thanks to Emperor Justinian during the middle of the six century, as to be later on compiled into one monumental book, the Corpus Juris Civilis. Roman legal scholars, as part of this jurisprudence came to a conclusion that haunts modern banking to this very day. The pivotal conclusion regarding not only banking, but the core social edifice of society, but in the realm of banking, was the distinctive and fundamental difference of demand deposits which represent a sum of money deposited at a depositary institution, receiving the name of a monetary irregular deposit (to be shortly explained) also known as a tantundem, and a loan contract, under which an individual relinquishes his/her monetary sum for a distinctive period of time, at interest, also known as a mutuum contract.

A monetary irregular deposit stems from the notion of fungible goods deposited at a depository. This means, that if someone wishes to place a certain good at a bank for safekeeping, for example, oil, grain and so forth, it is in the depositories obligation to immediately relinquish this good at the demand for the depositor. Since grain and oil are by nature fungible, it is economically inappropriate to keep these goods separated or compartmentalized for the marginal cost would be too great. Therefore, grain and oil are kept together, since no qualitative or quantitative standards are violated.

Moreover, this fungible asset is, in its essence, a demand deposit. Any failure of delivery results in a law suit against the depository not being able to bring about this demand to its rightful owner. “In other words, the owner of the grain warehouse or oil tank can use the specific oil or grain he receives, either for his own use or to return to another depositor, as long as he maintains available to the original depositor oil or grain of the same quantity and quality as those deposited“. (de Soto, p. 59)

A demand deposit is not relinquished for any time. It does not represent a transfer of present consumption for future consumption, unlike a loan (mutuum). A loan transfers present for future consumption, in line with consumer preferences. One of the key roles here is the charging to interest.

Why banks grant interest payments to depositors? There is clearly no transfer of consumption patterns when a deposit is kept for safekeeping. A monetary loan on the other hand signifies a transfer of ownership where a demand deposit does not. In that case, banks are obligated to maintain a 100% reserve requirement for demand deposits.

However, fractional reserve banking manipulates this legal and economic understanding of not only ownership transference, but time transference of funds. Notable examples of this misconception derive all the way from ancient times to modern day banking with the clear deviation from logic, adopted in Anglo-Saxon Law. The practice of loaning out demand deposits and concealing them as loans is a concept known in the Middle Ages as depositum confessatum.

Under this veil, banks had the ability to pay out interest to depositors, even though it should be reversed, the depositors for various reasons, decide to safe keep their funds, and must pay a service fee, not the other way around!

Economic activity is therefore altered, for confusion enters the market, and one doesn’t know if funds are genuine savings, as in loaned out, or funds are safe-kept, to be instantly used. Primary examples include the government sponsorship of these actions in the past, so-called ius privilegium. Under such circumstances, banks were allowed to create credit out of nothing, loaning out deposits that should have been backed by a 100% cash reserve.

Fractional loaning of demand deposits, therefore, when visualizing from an accounting perspective, transfers leverage and unjustified profits from society to banks practicing this form of intermediation, creating a profound and unjustified act of usury.