How A Con-Trick Became The Foundation For The Banking System
By John Tomlinson
(The following is extracted and abridged from a 2000 paper by John Tomlinson entitled ‘Why Is It Necessary To Maintain Confidence In Banks’ It is reproduced here without permission as the author seems to be currently ‘out of contact’. Consequently, its appearance here doesn’t mean that the author endorses any of the ideas on this site.)
The following is a brief explanation of the reasons why the design of our modern-day banking system is designed upon a centuries-old con trick.
1. People lodged their gold coins with banks (goldsmiths) for safekeeping. This was a warehousing or storage business and there was a “trust” or fiduciary relationship between banker and depositor.
2. Bankers noted that, between deposits and withdrawals, only the coins at the front of the shelves moved. The remainder gathered dust. They began to use those from the back for their own purposes. They loaned them to borrowers for profit. Initially, this was fraudulent behaviour.
3. The borrowers then used the borrowed coins in exchanges. The recipients of those coins then deposited them in their bank and the banks issued new deposit receipts to them. But, there were already deposit receipts issued against these very coins. Thus a gap was created between the number of coins for which receipts had been issued and the number of coins available to meet these receipts.
4. The receipts, themselves, were also being used in exchanges in lieu of coins and they became the first paper money.
5. The government could see the benefits being derived from these practices of the bankers and, to pay for the First World War, printed an enormous amount of paper claims on its gold and coins whilst, at the same time, it sent a great amount of its gold to America to pay for armaments. The gap between the amount of paper money and the gold available to honour it took a quantum leap.
6. Eventually the discrepancy between the number of coins and the amount of gold for which receipts, claims or paper money had been issued and the number of coins and the amount of gold available to honour them became so obvious that many people were questioning the value of the claims and refusing to accept paper money in any of its forms. The banking system faced a crisis.
7. The fraudulent behaviour won the day. Under pressure from bankers and financiers and aware of its own role in creating the crisis and the resultant weakness of its own position, the government legitimized the fraud. It removed from those who were prudent the security provided by their holdings of real gold. It made the ownership of gold illegal. Instead of chastising bankers and admitting its own role in creating the crisis, the government made ownership of gold illegal – except for governments – and proclaimed its own paper the only valid currency. In essence, it honoured fraud and dishonoured integrity. Those who trusted real gold and coins lost, but the banking system was saved. Banks could continue to make money by issuing more than one receipt against the same deposit. Now, however, these essentially fraudulent practices were made legal.
8. This was the birth of what was known as “the fractional reserve banking system”. Under this system, banks were required to maintain a proportion of their deposits either as cash or as deposits with the Bank of England. The proportion remained at 20% for a long time. Thus, a depositor was assured of at least 20% of his deposit. The other side of this assurance is that the banks could each lend up to 80% of each new deposit. Thus, a bank which received a deposit of £5,000 could lend £4,000 and the bank which received the borrowed £4,000 as a deposit could lend £3,200 etc. So, whilst the individual bank which received the £5,000 deposit was limited to lending only its excess reserves and could create but £4,000 in new deposits, the banking system as a whole could create £25,000 – many multiples of each bank’s excess reserves.
9. In July1988, the Basle Accord removed the fractional reserve system and replaced it with the “capital adequacy system”. Under the capital adequacy system, banks can lend up to a set multiple of its capital. The current rules mean a bank can issue about 12.5 times its capital. Should a bank, which is already fully loaned, wish to lend some more, it can simply issue new capital. By raising £80 million in new capital a bank can lend £1 billion. Of the £80 million, only a small proportion needs to be equity. The rest can be loan stock. In other words, by issuing a certain type of loan a bank can authorise itself to issue a great deal more.
10. Worse, under the capital adequacy system reserves are no longer required except to the extent needed to fund the Bank of England. Reserves are now less than 1% of deposits.
11. In fact, no longer needing to concentrate on maintaining reserves, banks have now become so sophisticated in their operations that they now lend without concern for how much they have on deposit. If they lend more than they have on deposit they add to their deposits by borrowing overnight. Banks have to balance their books every night. Thus, the overnight market has become an essential backstop to bank liquidity and the only real limit on the banks’ ability to create new money is the availability of acceptable borrowers.
12. The British banking system is not different in its fundamentals than other banking systems throughout the world. By 1971 even the American government had to admit that the amount of paper money it had issued against the gold – which governments around the world had allowed themselves to keep in order to maintain at least a tenuous relationship between their own paper money and gold – was far in excess of the gold actually held. President Nixon was being pressed by other governmental holders of dollars throughout the world to exchange them for gold at the rate of $35 per ounce to which all nations had agreed at Bretton Woods in 1944. There wasn’t enough gold in Fort Knox to meet the demand. American industries had borrowed from domestic banks and gone on a spending spree abroad, exporting US dollars. These US dollars had ended up in the central banks of countries all over the world and the central banks were now claiming the gold to which they were entitled. He had to admit that the U.S. didn’t have enough gold to honour its commitments. The American banks had defeated even the American government. Nixon’s closure of the ‘gold window’ – i.e. refusal to honour the Bretton Woods agreement – ended any relationship between paper money and gold. From that moment on the world was on a ‘debt based monetary system’. Paper money was no longer exchangeable for a fixed amount of any commodity. Another constraint to limit the production of new money had been removed.
Here we see a perspective of history which shows how the banks and the governments together have eroded the security of depositors.
From the situation where the bank stored depositors’ money for them in trust and with a fiduciary responsibility – in essence a 100% reserve system, through a 20% reserve system under which depositors became unsecured creditors of the bank and the bank’s fiduciary responsibility towards its depositors became less clear, to the current system of virtually no reserves and the banks having no more responsibility to their depositors than any other company has to its creditors.
This perspective also shows how the banking system’s ability to create new money has increased as the amount banks were required to keep in reserves decreased. This, of course, may be in the best interest of banks but it is not in the best interest of taxpayers, savers, pensioners and others on fixed incomes and society as a whole. Whilst we as citizens authorize our government to create and maintain a money stock for us, the government license banks to create new money for them. The ground rules under which banks operate are drafted in consultation with banks. Most members of the government are not familiar with the intricacies of finance and, therefore, seek the advice of bankers.
The reality is that the ground rules are designed by bankers, for bankers.