CHAPTER V: BANKING

We are now going to introduce the topic of banking practices and the development of the central bank, its reason for existing, and the effects of it.  One of the biggest effects however, the business cycle, will be postponed until a later chapter.

1. The Concepts of Banking

Two conceptually distinct functions are bound together under the term banking.  These are:

·        Deposit banking – a bank stores the money belonging to an individual for safekeeping.  The bank will issue bank notes, which are receipts for the stored money.  It may issue the depositor with an open-book account on which cheques can be written.  In any case, deposits are redeemable on demand to the holder of the account or bank note.  The actual money (cash - gold or paper) deposited at the bank is not a loan to the bank, but a bailment; the money remains the property of the depositor at all times and the bank may not use the money. 

·        Loan banking – a bank lends out saved funds to borrowers.  This requires capital, either from individuals (as in merchant banking), shareholders, or savers, who have deposited money at the bank not as a simple bailment, but as a loan, which will be loaned out by the bank (hence the money is not available on demand).  The saver receives a return on his savings. 

 

In the first case, a bank is functioning merely as a money warehouse, for safely storing money that people are not comfortable storing in their own homes.  The depositor pays the bank a fee for the trouble of storing the money in their vaults.  The bank provides a moderately useful function in society, but little more than any other warehouse does.

 

In the second case, the bank is redistributing money.  It makes profit from the interest income it receives on its loan, minus the interest paid out to the saver.  This can be more lucrative for the bank, so long as it chooses wisely who to lend to.  This is a vital function of the free market that this type of bank provides.  It enables capable entrepreneurs to attain the money they need for improving the structure of production.  It ensures that capital is allocated in the most efficient way possible.  The development of banking was an essential prerequisite for the Renaissance in Europe. 

 

In modern banking, these two distinct concepts have become blurred, and this has tempted bankers to practice what is known as “fractional reserve banking”.  As we shall see, it is plainly fraud, a clear violation of property rights, and yet has been “legal” for well over a century in most countries and is practiced by almost all modern banks.  It is a government-endorsed scam. 

 

In a libertarian society, fractional reserve banking would be banned.  However, even if the bankers are allowed to get away with it, there are severe limitations on how effectively it can be done in a system of “free banking”.  Free banking refers to a banking system where there is no government involvement, whether or not the practice is treated as fraud.  For this reason, banks and governments allied to gradually remove the market limitations on the practice.  This is the development of central banking.

 

But we are getting ahead of ourselves.  Let us know take a closer look at each of the two different functions of banking: deposit banking, and loan banking.