Fractional reserve banking

In a loan contract, the availability of money is transferred to the borrower, who must return in at the end of the term and pay the interest. The borrower is free to use in in any way. In a deposit contract, the money is in custody and the depositor can withdraw it on demand, it is available to him at all times. The borrower - the bank - must keep a 100% cash reserve, if the reserve is smaller it is known as fractional reserve banking. (This is sometimes shortened to FRB for convenience.)

Legalization

Roman law recognized that bankers were often tempted to use the deposits for themselves. To penalize these actions, they should be not only charged with theft, but to pay interest "so that, in fear of these penalties, men will cease to make evil, foolish and perverse use of deposits".

In early medieval Europe, the bankers preserved their deposits fully at first, but later began to use them for their own purposes, creating deposits and granting credits out of nowhere. Since the canonical law banned the charging of interest on loans, bankers would instead pay "penalties" for "delays" in payment and in effect pay interest on a disguised loan, and justified any misappropriations on this basis. This practice was defended by some scholars, while others wanted to expose all hidden loans and equated all deposit contracts for loans. As a result, the distinction between them was obscured. Experts failed to clear up the resulting legal chaos until the end of the nineteenth century.

The authorities failed to enforce sound banking practices, and often granted banks a government license to operate with a fractional reserve, while taking advantage of easy loans to finance governments and public officials. Some rulers created government banks to reap the profits. But banks were still required to guarantee deposits.

As late as twentieth century, court decisions in Europe have upheld the demand for a 100-percent reserve requirement. In 1927, the Court of Paris convicted a banker for the crime of misappropriation for having used the funds deposited with him by a client, confirmed in 1934. After the failure of the Bank of Barcelona the Spanish Supreme Court also pronounced, that "the depositary does not acquire the right to use the deposit for his own purposes".

See also: History of Money and Banking

Securitization

Known since 18th century, securitization as it is known today was created in 1970, when the Government National Mortgage Association (Ginnie Mae) issued a mortgage-backed security (MBS) in the form of a pass through. Securitization has had an exponential growth since.

Economic actors can obtain rights to future payments of money - for instance, a car dealer that sells his cars on credit for five years in exchange of his cars. Such credits are relatively illiquid because their characteristics tend to be sector and client specific. Their owners may prefer to exchange them for an amount of money that is available now. Each of these claims can be passed to an economic actor that has the opposite preferences. Or, relatively similar claims, possibly coming from different owners, could be grouped together within a single holding entity that could then create standardized claims to be sold to investors on the financial markets. This process of putting together relatively illiquid assets and using them is called securitization - "... the process of pooling and repacking loans into securities that are then sold to investors."

Securitization allows FRBs to withdraw from the market the credit they have created and lent out. It reduces the money supply by the amount of liquid assets used to purchase the asset-backed securities. Therefore, it hides the increase in the money supply, i.e., inflation. It makes the economic environment appear less inflationary than it should be, given individuals' growing indebtedness to banks. Securitization portrays a bank-credit driven boom as noninflationary, savings driven growth. Also, securitization insulates lending activity of banks from the central bank's monetary policy. It contributes to the widespread illusion that more factors of production are available than in reality, and so becomes a factor in the generation of the boom-bust cycle.

External links

• Fractional-reserve banking on Wikipedia
• "Legal Tender Laws and Fractiona-Reserve Banking"(pdf) by Jörg Guido Hülsmann
• Fractional Reserve banking and boom-bust cycles by Frank Shostak