Legislating Banking Confusion through Conflicting Laws

What do the following road signs share in common?




You probably answered that they are all confusing, and I would agree. Some of you would have answered that they all involve conflict, and that too is correct. The most astute would have said that some involve conflicts of privileges (as in the privilege to walk your pet or use a sidewalk in a certain area), and others are conflicts of obligations (as in the case of being obliged to not make a right-hand turn, while also being obliged to turn right).

At best if you saw these signs in real life you would probably laugh and take a picture. At worst you would be paralyzed with fear, not knowing which is correct and what the punishment is for choosing incorrectly one over the other. Alternatively, and probably like most people, you would choose one or the other, and you would plead your case if caught by the authorities.

Modern banking laws suffer from a similar conflict. Depositors are told that they have access to their funds at all times (i.e., on demand), and that they will get back the exact same amount as they put into their account (i.e., the deposit will be redeemed at par value). Bankers have a different set of privileges. They are allowed to make use of these funds, and hopefully they will not be set upon by too many depositors asking for their funds at the same time.

There is a clear conflict created by such banking laws. Depositors have continual access to their funds, while bankers also are allowed to have access to these funds. There are too many simultaneous claims to money at any one time. Or stated differently, since money is only usefully to buy goods, there is too much money and too few goods.

This system functions so long as the depositors do not redeem too many of their deposits at once. The system breaks down (shockingly fast, as recent events can attest) when a critical mass of depositors asks simultaneously for the money which is rightfully theirs. At this moment the conflict becomes apparent, as the bank has invested or lent these deposits to a third-party, and there is an insufficient amount left in reserve to honor these redemption requests by depositors.

This is the case of the increasingly common bank run. It is at this moment that the conflict created by banking laws becomes apparent, with bankers and depositors each claiming that they are the rightful claimant of the money in question.

Although I have titled this article “legislating confusion through conflicting laws”, it should be clear that the conclusion is much worse than a mere confusion. Confusion is annoying at worst, and can even be comical at times. The result of the conflict in banking laws is angst and ire. In most situations we can determine, without too much trouble, who is right and who is wrong when conflict develops. The way the laws of modern banking are structured we are left with two people in the right, both doing what the law says they are allowed. But the result – bank runs or bank insolvencies – signals that there is most definitely a conflict.

Even worse is that there is no good solution to the conflict as long as it persists. The most recent spate of bank insolvencies has been solved via one of two ways. Either the bank in question has been bailed out, in which case innocent bystanders have had to pay for the problems of others. In this solution, the conflict between banks and their depositors has not been paid by either party, but has been papered over via a wealth transfer from other citizens. Alternatively, bail-ins (e.g., converting depositors into equity holders) have changed the rules of the game midstream. Depositors were told that they had a claim to their money at par value and on demand, and deposited it in good faith of that fact. Now they find out that they can have their money after waiting for the mess to be sorted, and only at whatever the market values it at. This solution too is an injustice.

There is an easy alternative solution. Change the laws to remove the original conflict. Depositors will have a claim to their deposit at all times, similar to what they presume to be true today. In its place, banks will have to renunciate their claim to using these deposits. Such a shift will not imperil the world of finance – equity investments and loans are still available, though the latter will not be financed with deposits. Bank runs will be removed from the scope of potential events, and events such as have become the norm over the past five years will become a thing of the past.

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5 Responses to “Legislating Banking Confusion through Conflicting Laws”

  1. Jerry says:

    "Would it help to make several stepwise increases in the percent of reserves required? "

    Doubt it. As soon as the monetary screws are tightened the public would become agitated and politicians would take the opportunity to repeat what has been happening for years. Another cycle of boom/bust. It will continue until hyperinflation sets in with a vengence. It's anybody's guess when that will happen, but likely quite a few years away yet. Probably about the same time we'll find out just how much gold is held by the Fed and Treasury.

  2. "There is an easy alternative solution. Change the laws to remove the original conflict."

    This suggests the monopoly remains in place; one set of government determined and enforced rules under-which all banking must comply. Yet the biggest problem in banking today is the monopoly, not the fractional reserve.

    There is an easier solution – end the monopoly. Allow for private contract, not government laws, to define the relationship.

  3. Patrick Barron says:

    One small quibble with this otherwise excellent and easily understood structural problem with the fractional reserve banking system. Dr. Howden states that "This system functions so long as the depositors do not redeem too many of their deposits at once." This ignores the effect of bank credit expansion on the time structure of production. Fractional reserve banking creates something for nothing; i.e. credit without real savings. This triggers the Austrian Business Cycle, whereby not all investments can be profitably completed. Then, even if depositors do not wish for their funds simultaneously, there are insufficient funds to pay off all depositors.

    • David Howden says:

      I stand corrected… the fractional-reserve banking system cannot continue unabated even if depositors do not redeem their deposits en masse. It sows the seeds of its own destruction by promoting a more general economic problem (i.e, Austrian business cycle) which in turn triggers the bank run.

      Thanks for keeping me in line, Pat!

  4. David Howden says:


    good question on the process to get to 100% reserves. I don't think there is a distinction to be made between large and small banks – the profit source is the same, and we're only talking of the magnitude of profits each can earn. I don't think velocity or spending would be impacted by a "sudden" shift to 100% reserves.

    You walk into the bank on Monday morning and are told that effective immediately you are charged a fee for your deposit account, let's say it's 0.25% of the total deposit per year. There are other financial products available to you, some from your banker – short-term loans of several months, for example. The depositor considers how much cash to withdraw and keep on hand, and how much to keep in the fee-charging deposit account (presumably less than was originally the case). The rest gets invested somehow. Spending still continues unabated, and banks don't need to necessarily write-off any loans. In the interim they might need to waive fees or make them sufficiently low that clients don't completely run off with all their cash, but that might just be "just desserts" for all these years of making profits off other peoples' money.

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