The Phaserl


Safety in Banking

by Alasdair Macleod, GoldMoney:

There was a time when banks acted as custodians of their customers’ money. Indeed, keeping a person’s money and using it as if it belonged to you without their agreement is fraud in common law. A banking license legally exempts banks from charges of criminality in pursuing the normal course of fractional reserve banking business, by making it clear that you, the customer, agree to being a creditor of the bank instead of the bank acting as custodian for your money.

Modern banking has its roots in England’s Bank Charter Act of 1844, which led to the practice of fractional reserve banking. Fractional reserve banking is defined as making loans and taking in customer deposits in quantities that are multiples of the bank’s own capital. Case law in the wake of the 1844 Act, having more regard to the status quo as established precedent than the fundaments of property law, ruled that irregular deposits (deposits for safekeeping) were no different from a loan. Judge Lord Cottenham’s judgment in Foley v. Hill (1848) 2 HLC 28 is a judicial decision relating to the fundamental nature of a bank which held in effect that:

The money placed in the custody of the banker is to all intents and purposes, the money of the banker, to do with it as he pleases. He is guilty of no breach of trust in employing it. He is not answerable to the principal if he puts it into jeopardy, if he engages in haphazardous speculation…”i

This was probably the most important legal ruling of the last two centuries. Today, we know of nothing else other than legally confirmed fractional reserve banking. However, sound or honest banking had existed in the centuries before the 1844 Act.

It was probably with sound money and sound banking in mind that Goldmoney recently announced a tie-up with a British-based and regulated peer-to-peer lender, which enables owners of gold and silver bullion to use it as collateral to raise funds.ii The purpose of this article is to explain how honest banking worked before fractional reserve banking was devised. This is the logic behind the recently announced collaboration between Goldmoney and Lend & Borrow Trust Company Ltd. We will start by looking very briefly at the bones of the Goldmoney deal, before going on to explain how banking worked when money was sound, and the serious flaws behind fractional reserve banking.

The Goldmoney – LBT collaboration.

On 23rd May, Goldmoney announced an investment and collaboration in and with the UK-based peer-to-peer lending platform, Lend & Borrow Trust Company Ltd. LBT is unique, being the only peer-to-peer facility in Western financial markets that allows businesses and individuals to use their investment-grade physical bullion as collateral against loans, without the loan obligations and collateral being comingled with other customer business. For example, an individual might have gold stored for him by Goldmoney in an LBMA-recognised vault, and wishes to borrow money against it, utilising it as collateral. LBT’s platform permits lenders and borrowers to agree between themselves – without disclosing their names to each other – the duration and interest rate on loans under an agreement template provided by LBT, which administers the loans. Both the lender and borrower must comply with the terms laid down between them in a standardised LBT agreement.

At no time is LBT a principal in the transaction, so lenders and borrowers can agree an interest rate without having to take LBT’s creditworthiness into account, based solely on physical gold or silver as collateral. Furthermore, LBT is regulated by the Financial Conduct Authority to operate an online electronic system that facilitates peer-to-peer lending.

The logic of a collaboration between Goldmoney and LBT is obvious, in that it enables customers to raise finance using bullion. But there is an underlying sound-money logic as well. Between them, Goldmoney and LBT are the template for sound-money banking as it existed before fractional reserve banking became the standard banking model, after Britain’s Bank Charter Act of 1844.

It should be noted that neither Goldmoney nor LBT operate as banks. Banking licences are granted to banks specifically so they can take customers’ assets onto their balance sheets, exposing them to counterparty risk. In other words, you, the bank customer, become a creditor of the bank. Neither Goldmoney nor LBT have this relationship with their customers, both companies being non-banking regulated financial service providers in their relevant categories and jurisdictions.

The roots of banking

Throughout history, there have been two types of distinctly different financial activity, which today we call banking. The first was the safe storage of monetary deposits on behalf of merchants, safeguarding their money from the day-to-day risks and inconvenience of holding large sums in their possession. The development of coinage, in the form of fungible units of gold and silver, allowed banks to make payments on their customers’ instructions using coins that were not necessarily the original ones deposited. And because the basic business of merchants was transporting goods from one place to another, the ability to make payments drawn against a merchant’s funds became a natural extension of depository banking.

Deposits at the London goldsmiths enabled them to issue notes to their depository customers, representing their specific deposits in whole or part, and these notes began to circulate between merchants in lieu of physical payments. Possession of a depository note was evidence of ownership, and the circulation of these notes became the forerunner of today’s paper money.

The second activity was for a bank, using its own capital or capital it had collected from others specifically for this function, to make loans to farmers and merchants to facilitate the production and delivery of goods. There is an important distinction between holding deposits and lending money, the former was a custodial function, while the latter was loan finance.

Loan finance need not be a banking function. It was more normal for people to borrow money from their masters in Grecian and Roman times, their feudal superiors during the middle ages, or their family and friends. The primary banking function was therefore the custody of money and to expedite its use. But as is always the case with money and trust, the temptation to use deposited money for other purposes without the consent of the owner has recurred throughout the history of banking.

There was the simple fraud, where a banker took customer deposits and lent them out for his own personal gain. The profits made could be substantial, but the risk was a customer might request a large withdrawal that could not be met, and the banker would be found out. Banking fraud became more complex when governments latched on to the potential that banks offered for satisfying their own repeated need for money. Therefore, governments pushed bankers into lending money to the state. They gave bankers privileges, insulating them from the legal consequences of fraudulent conduct. From time to time repeated government bankruptcies caused bankers to reform their behaviour, returning to sound money practices. But this was never to last, the relationship between law-creating governments and the banks they permitted to operate fluctuating between honesty and deceit.

The 1844 Bank Charter Act was the foundation of today’s government-sponsored banking system. The note-issuing facility was gradually transferred from private banks to the Bank of England, which ceased its commercial activities. The Act placed strict controls on the Bank of England’s note issue, requiring every extra pound sterling to be backed by gold.

At that time, the expansion of bank credit was not regarded as an increase in the quantity of money, this only being widely understood by the consensus of monetary economists much later. Consequently, there was no credible challenge to banks issuing credit unbacked by gold, unlike the gold restriction on the Bank of England’s note issues, so sound and unsound money existed side by side with little distinction. Therefore, based on ignorance and precedence, fractional reserve banking became the operational standard for Britain and its empire. Since Britain dominated international trade in the second half of the nineteenth century, it also became the international standard for the world’s banking industry, and remains so to this day.

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