Mises Wire

UK Proposal for Banking Reform: Fractional-Reserve Banking versus Deposits and Loans

UK Proposal for Banking Reform: Fractional-Reserve Banking versus Deposits and Loans

Austrians and others interested in fractional-reserve banking (FRB) will find of interest a banking reform about to be proposed in the UK. Douglas Carswell, an Austrian economics-informed member of the UK parliament for Clacton, is planning to introduce a so-called “Ten Minute Rule Bill” after Prime Minister’s Questions tomorrow (Wednesday, Sept. 15) that could have significant implications for current centralized FRB practices. The Bill will be supported by Steve Baker, the Member of Parliament for Wycombe, who also serves on the Advisory Board of the Austrian/classical liberal Cobden Centre.

Carswell described the proposal in a post on Friday entitled “How should we reform the banks?,” and Baker promoted it earlier today in “Douglas Carswell leads the way on bank reform,” on CentreRight, the unofficial web site of the Tory Party (widely read by all members from the PM down). Baker’s article provides further elaboration and explanation, as well as a wealth of useful resources, speeches, links related to this issue. Baker is also scheduled to have a column about this in the Wall Street Journal Europe tomorrow [update: see Steve Baker, “A Bill to Fight Crony Capitalism“ [2], Wall Street Journal (Opinion Europe section) (Sept. 15, 2010), full text appended below; and also: Toby Baxendale, “The radical reform that would end boom and bust in banking,” Telegraph.co.uk (Sept. 15, 2010)]. Daniel Hannan, the free market Member of the European Parliament, has also come out in support, in his Telegraph.co.uk column “Instead of subjecting our financial services to Brussels, we should embrace the Baker/Carswell banking reforms.” Finally, Austrian classical liberal entrepreneur Toby Baxendale, who is also Chairman of the Cobden Centre, provides a good explanation of the legal background giving rise to the Bill “What is the Legal Relationship Between the Banker and his Customer?

The proposal involves clarification of the relationship between banks and their customers. In particular, banks would make it clear to the customer whether his funds would be owned by him, or lent out to other bank customers.

At present, as in the US, most of the money “deposited” with a bank may be lent out by the bank, even though the “deposit” is also available and guaranteed to the depositor. This centralized FRB practice of course results in inflation, the business cycle, moral hazard, and so on. Many Austrians also oppose FRB on the grounds that it has been, or tends to be, or inevitably will be, bound up in some type of fraud. Other Austrians–primarily, but not exclusively, those in favor of a private variant of FRB–maintain that FRB need not be fraudulent, and, indeed, that it can be very useful. (For pro-FRB Austrian views, see Selgin & White, In Defense of Fiduciary Media — or, We Are Not Devo(lutionists), We Are Misesians!; for a competing view, see Murray N. Rothbard, Taking Money Back: Part I, Fractional Reserve Banking: Part II, and The Solution (The Freeman, Sept., Oct. & Dec. 1995), The Mystery of Banking, The Myth of Free Banking in Scotland, Aurophobia: or, Free Banking on What Standard? (review of Gold, Greebacks, and the Constitution [1991], by Richard H. Timberlake); Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles; Hoppe, Hülsmann & Block, Against Fiduciary Media; Hoppe, How is Fiat Money Possible?-or, The Devolution of Money and Credit; Hülsmann, The Ethics of Money Production; idem, Free Banking and Fractional Reserves: Response to Pascal Salin; idem, Free Banking and the Free Bankers; idem, Has Fractional-Reserve Banking Really Passed the Market Test?; also see Steve Baker, What is wrong with banking, part 1: the legal nature of banking contracts.)

Steve Baker, M.P.

Steve Baker, M.P.

The economic arguments in favor of FRB and its usefulness seem flawed to me, but in my view it is not necessarily fraudulent, so long as full disclosure is made. (See my post Fractional-Reserve Banking, Contracts of Deposit, and the Title-Transfer Theory of Contract.) But is full disclosure actually made? Are customers aware? Proponents of FRB often say that FRB “depositors” “are” aware of what is done with their money since interest is paid on it. In actuality what they are saying is that such customers are “deemed” to have constructive knowledge of the fact that their money is lent out, since they “ought to” know that this is implied by the earning of interest. But this is assuming too much economic sophistication on the part of the typical bank customer and substituting the legal fiction of constructive knowledge for actual disclosure. It is obvious that most banking customers are not aware of the nature of modern centralized FRB, or of the legal status of “their” “deposits.” One reason for this is modern deposit insurance, which reduces the need for “depositors” to consider the question in the first place. Another is the complexity and subterfuge of the current state-regulated and controlled banking system. As for actual evidence, a recent survey conducted in the UK concludes that most people (74%) think they own the money they deposit in a bank. Which, of course, they do not.

Given the confusion inherent in conflating the services of deposit or safekeeping of money, on the one hand, and lending of money, on the other, why not simply make it clear to the bank customer what his options are? Why not give people a choice: do you want to own your money and have it deposited and safeguarded, or do you want to give up ownership of it and permit the bank to lend it on your behalf, in order to earn interest?

Carswell and Baker’s proposed Bill does just that. As Carswell explains:

Under my Bill, when opening a new bank account, you’d still be free to tick the box that says “it’s fine to lend on my money”. … To be clear, this Bill does not stop banks from treating your deposit as a loan. You just have to make clear that you give them permission to do so. There would, in effect, be two types of bank account; one where it was made clear that you owned the money (and probably paid for banking services in fees), and one where the bank was free to lend on your money like they owned it.

In other words, banks would have to make customers aware of whether it will (a) safekeep the funds to be deposited; or (b) loan out these funds on behalf of the customer (who is choosing to be a lender). It would align the law to mirror what people actually think happens: that they deposit money and it is theirs. It also seeks to allow savers to save in a term deposit which the bankers can then with the saver knowingly and indeed willingly lend out this money to borrowers. This relationship will then be that of a depositor lending to the bank and the bank being the creditor to the lender. (See also the somewhat similar Safety Deposit Current Accounts Bill, introduced in 2008 by the Earl of Caithness.)

The Bill was stimulated by Baxendale, as the result of his setting up the Cobden Centre and talking to Carswell and Baker about this issues, and generally making the mainstream audience more aware of the issue through postings on the Cobden Centre site and other activities. The basic ideas behind Baxendale’s efforts here and the proposed Bill are influenced by the work of the Austrian economist Huerta de Soto, primarily his book Money, Bank Credit and Economic Cycles, which sets out the relevant legal distinctions, drawing on Roman legal principles, and the proposals for reform set out in Chapter 9. Baxendale also approached me for assistance in drafting the initial Bill, based on my Austrian and libertarian background as well as my mixed civil law/common law/Roman law legal background. As Baxendale elaborated in a note to me:

Douglas Carswell came to see me in my North London fish factory in February of this year and talked to me about what he knew or more importantly what he did not know about the Austrian School of Economics. The money and banking things I focused on clearly had an impact and from henceforth we have had a good, productive and interesting dialog. I introduced him to our Cobden Centre website and the articles we put up there focused around banking reform. This culminated with me getting a phone call before the summer saying that he had secured some Parliamentary time in the Autumn to put forward my Banking Bill suggestions. At that point in time I thought he was suggesting the reform I outlined in “Emperor’s New Clothes” article. However, the project Douglas suggested was more focused on just sorting out the property rights of the depositor and the banker in the first instance to be able then to create a more stable environment for wider reform later and giving time for a coalition of support to be built up. As he sits in the public light, only he and his colleagues/supporters can judge the merits of this way forward. I then got in touch with Prof. Guido Hülsmann who I had recently introduced to the think tank community in London for sounding on how to construct the Bill Douglas wanted. He suggested that I contact the American legal scholar Stephan Kinsella. Touching base with Kinsella then led to him drafting a Bill that forms the basis of this Ten Minute Rule Bill.

Interestingly, its supporter in Parliament is one of our founding Directors, Steve Baker the MP for Wycombe. He wrote to Lew Rockwell two years ago now, expressing his interest in the Austrian School and who could he speak to in the UK on these matters. Lew forward him to me saying rather flatteringly “Toby Baxendale is the leading Austrian School advocate in England.” That is praise from a great and inspiring man for sure. Steve coming from a software engineering background took up the project of getting us a web presence with great enthusiasm and vigour. Today what you see on the site is largely down to his initial work; needless to say there are other critical people to our project. Steve has a wonderfully logical mind as you would expect to find in a quality software engineer so his grasp of the logical propositions and necessary key apriori ones is very good. This helps him grasp the core issues very quickly indeed. This is a good time for the Austrian School here in the UK and we will continue boldly forward!

Further background may be found in the links above, including especially Baker’s post, Douglas Carswell leads the way on bank reform and Baxendale’s “What is the Legal Relationship Between the Banker and his Customer?“; the Cobden Centre’s “Primer“; other resources here.

This proposal, if implemented, could help end the state practice of fractional-reserve central banking which causes inflation and the business cycle. It will be interesting to see what happens tomorrow. As Baxendale notes, “I hope this Bill gets a second reading so that Honest Money can become a major taking point in the banking reform debate.” Indeed.


Steve Baker, “A Bill to Fight Crony Capitalism” [2], Wall Street Journal (Opinion Europe section) (Sept. 15, 2010)

A Bill to Fight Crony Capitalism

Our reform measure will give consumers a choice in how banks use your deposits.

If you borrow a friend’s painting and promise that you will give it back on demand, and you then lend that same painting to somebody else, you have committed a fraud. The same rules do not apply, however, to bankers. British parliamentarians have an opportunity to change that today, and I hope they do.

Today, banks enjoy the legal privilege of fractional reserve banking, meaning they may lend out what they already owe depositors. By lending and investing on-demand deposits, banks create money by extending credit. When the bank’s investments turn sour—and investments often turn sour at some point—the bank cannot pay back the deposits and goes bust. Unless it manages to convince politicians that it is too large to fail, in which case it will be bailed out by taxpayers.

This skewed relationship between bank deposits and normal contract and property rights, combined with state interventions like the central planning of interest rates and various guarantees, is what causes boom and bust. Today I will be supporting my colleague Douglas Carswell, member of Parliament for Clacton, as he introduces a bill to phase out fractional reserve banking. Our friends in the U.S. and Europe are watching closely, for the same crony capitalism afflicts the world.

Leading up to the recent financial crisis, banks borrowed (and continue to borrow) at absurdly low rates from central banks. Their salesmen then flogged mortgages on commission to those with no hope of repaying the principal from their income. This junk was pooled and flogged again, this time anonymously, to hapless investors prepared to believe that housing prices could only rise, and that the risk of default did not correlate across their portfolios. This is just one of the errors of contemporary financial capitalism.

Our Regulation of Deposits and Lending bill would allow you, Britons, to choose how your money is used. You would have the choice either to deposit your money for safe-keeping, or to save it for a term to be invested further by the bank. If safe-keeping is your choice, you can have your money back on demand. Your property rights would be intact—you would remain the owner of your deposit. You would probably not earn interest; in fact you may have to pay for the privilege of direct access through branches and cash machines. If, however, you want a yield, you may choose to deposit your money for a term instead. The bank can then invest it further, potentially earning you an income.

Credit would continue to exist, backed by real savings. The saver would be fully aware of the benefits and risks when choosing between depositing money and saving it for a term.

Two years ago the world economy crashed, yet no progress has been made in trying to prevent new crises. Ending fractional reserve banking has been proposed at various times by various economists of the three great traditions —Keynesian, Monetarist and Austrian. One could ask why the call to end the anti-capitalist legal privilege of fractional reserve banking has not come louder and sooner?

Is it outrageous to suggest that bankers rather like the socialization of risk and easy access to others’ money, and that their success in this system requires the ears of the right politicians? In contrast to the heroic entrepreneurs of Rand’s “Atlas Shrugged,” the contemporary financier receives astonishing remuneration for reporting unrealized profits. Meanwhile, he shares in none of the losses inevitable under a system built on fatally flawed models of market behavior. Instead of lending only to people they trust, the current system means contemporary financiers are content to lend to anyone, provided they can pass off the risk to someone else.

Losses have been socialized by the power of the state. Bonuses have been paid at bailed-out banks and support staff think this is justice because they weren’t the ones making the deals. Executives who, in another age, would have lost everything as partners with open liability, have instead retired wealthy.

If there is today a class conflict within capitalism, it is not between workers and owner-entrepreneurs, but between taxpayers, bank executives and stockholders. Stockholders have long since given up control of their property and the small investor finds few returns. Meanwhile, finance capitalists gamble other people’s money on the basis of models and theories that turn out to be nonsense, all while telling us how much value they are creating and deserve to share. That rare breed, the long-term stockholder, has no recourse after losses or poor dividends, and the taxpayer is compelled to pick up the outstanding tab.

This sketch is incomplete and most of the players involved in this system do not intend to exploit others. But exploitation it is when one group is compelled to cover the losses arising from bad bets made by a second group with money belonging to a third. This system of relationships is not healthy. That ancient golden rule, “do as you would be done by,” has indeed been cast aside for “do unto others before they do unto you.” We ought to ask if this is how we want to live.

The enemies of freedom portray the financial crisis as a failure of capitalism. In reality markets do not grant legal privileges such as fractional reserve banking—politicians do. The legal privilege of fractional reserve banking destroys the sound capitalist mechanisms of property and contract law. Today we hope to end it.

Mr. Baker is a Conservative member of the British Parliament for Wycombe.

Update: Toby Baxendale’s Cobden Centre post Support for Douglas Carswell’s forthcoming Bill to reform the banks provides links to various articles and posts in support of the Bill.

Peter Boettke blogs about it in Can Banking Reform End the Boom and Bust Cycle?

Brian Doherty blogs it on Reason‘s Hit & Run in Stop the Real Bank Robbery

Coverage in Spanish on LibertadDigital.com by Huerta de Soto (blogged by Jeff Tucker in Yesterday Was A Historic Day), Manuel Llamas, and Juan Ramón Rallo

And, as noted in First reading of Carswell’s Financial Services Bill, “Douglas Carswell MP yesterday delivered a superb speech in support of his eagerly anticipated Financial Services (Regulation of Deposits and Lending) Bill, introduced as a Ten Minute Rule Motion.”

The video is below. There were no objections; the “second reading” of the Bill is slated for Nov. 19. The full text is available here, and pasted below. Note in particular Carswell’s explicit mention of the Mises Institute:

Since the credit crunch hit us, an endless succession of economists, most of whom did not see it coming, have popped up on our TV screens to explain its causes with great authority. Most have tended to see the lack of credit as the problem, rather than as a symptom. Perhaps we should instead begin to listen to those economists who saw the credit glut that preceded the crash as the problem. The Cobden Centre, the Ludwig von Mises Institute and Huerta de Soto all grasped that the overproduction of bogus candy-floss credit before the crunch gave rise to it. It is time to take seriously their ideas on honest money and sound banking.

Remote video URL



Financial Services (Regulation of Deposits and Lending)

Bill Presented — Savings Accounts and Health in Pregnancy Grant Bill

House of Commons debates, 15 September 2010, 1:28 pm

Motion for leave to bring in a Bill (Standing Order No. 23 )

1:33 pm

Douglas Carswell (Clacton, Conservative)

I beg to move,

That leave be given to bring in a Bill to prohibit banks and building societies lending on the basis of demand deposits without the permission of the account holder;
and for connected purposes.

Who owns the money in your bank account? That small question has profound implications. According to a survey by Ipsos MORI, more than 70% of people in the UK believe that when they deposit money with the bank, it is theirs-but it is not. Money deposited in a bank account is, as established under case law going back more than 200 years, legally the property of the bank, rather than the account holder. Were any hon. Members to deposit £100 at their bank this afternoon or, rather improbably, if the Independent Parliamentary Standards Authority was to manage to do so on any Member’s behalf, the bank would then be free to lend on approximately £97 of it. Even under the new capital ratio requirements, the bank could lend on more than 90% of what one deposited. Indeed, bank A could then lend on £97 of the initial £100 deposit to another bank-bank B-which could then lend on 97% of the value. The lending would go round and round until, as we saw at the height of the credit boom, for every £1 deposited banks would have piled up more than £40-worth of accumulated credit of one form or another.

Banks enjoy a form of legal privilege extended to no other area of business that I am aware of-it is a form of legal privilege. I am sure that some hon. Members, in full compliance with IPSA rules, may have rented a flat, and they do not need me, or indeed IPSA, to explain that having done so they are, in general, not allowed to sub-let it to someone else. Anyone who tried to do that would find that their landlord would most likely eject them. So why are banks allowed to sub-let people’s money many times over without their consent?

My Bill would give account holders legal ownership of their deposits, unless they indicated otherwise when opening the account. In other words, there would henceforth be two categories of bank account: deposit-taking accounts for investment purposes, and deposit-taking accounts for storage purposes. Banks would remain at liberty to lend on money deposited in the investment accounts, but not on money deposited in the storage accounts. As such, the idea is not a million miles away from the idea of 100% gilt-backed storage accounts proposed by other hon. Members and the Governor of the Bank of England.

My Bill is not just a consumer-protection measure; it also aims to remove a curious legal exemption for banks that has profound implications on the whole economy. Precisely because they are able to treat one’s deposit as an investment in a giant credit pyramid, banks are able to conjure up credit. In most industries, when demand rises businesses produce more in response. The legal privilege extended to banks prevents that basic market mechanism from working, with disastrous consequences.

As I shall explain, if the market mechanism worked as it should, once demand for credit started to increase in an economy, banks would raise the price of credit- interest rates-in order to encourage more savings. More folk would save as a result, as rates rose. That would allow banks to extend credit in proportion to savings. Were banks like any other business, they would find that when demand for what they supply lets rip, they would be constrained in their ability to supply credit by the pricing mechanism. That is, alas, not the case with our system of fractional reserve banking. Able to treat people’s money as their own, banks can carry on lending against it, without necessarily raising the price of credit. The pricing mechanism does not rein in the growth in credit as it should. Unrestrained by the pricing mechanism, we therefore get credit bubbles. To satisfy runaway demand for credit, banks produce great candy-floss piles of the stuff. The sugar rush feels great for a while, but that sugar-rush credit creates an expansion in capacity in the economy that is not backed by real savings. It is not justified in terms of someone else’s deferred consumption, so the credit boom creates unsustainable over-consumption.

Policy makers, not least in this Chamber, regardless of who has been in office, have had to face the unenviable choice between letting the edifice of crony capitalism come crashing down, with calamitous consequences for the rest of us, or printing more real money to shore up this Ponzi scheme-and the people who built it-and in doing so devalue our currency to keep the pyramid afloat.

Since the credit crunch hit us, an endless succession of economists, most of whom did not see it coming, have popped up on our TV screens to explain its causes with great authority. Most have tended to see the lack of credit as the problem, rather than as a symptom. Perhaps we should instead begin to listen to those economists who saw the credit glut that preceded the crash as the problem. The Cobden Centre, the Ludwig von Mises Institute and Huerta de Soto all grasped that the overproduction of bogus candy-floss credit before the crunch gave rise to it. It is time to take seriously their ideas on honest money and sound banking.

The Keynesian-monetarist economists might recoil in horror at the idea, because their orthodoxy holds that without these legal privileges for banks, there would be insufficient credit. They say that the oil that keeps the engine of capitalism working would dry up and the machine would grind to a halt, but that is not so. Under my Bill, credit would still exist but it would be credit backed by savings. In other words, it would be credit that could fuel an expansion in economic capacity that was commensurate with savings or deferred consumption. It would be, to use the cliché of our day, sustainable.

Ministers have spoken of their lofty ambition to rebalance the economy from one based on consumption to one founded on producing things. A good place to begin might be to allow a law that permits storage bank accounts that do not permit banks to mass-produce phoney credit in a way that ultimately favours consumers and debtors over those who create wealth. With honest money, instead of being the nation of indebted consumers that we have become, Britons might become again the producers and savers we once were.

With a choice between the new storage accounts and investment accounts, no longer would private individuals find themselves co-opted as unwilling-and indeed unaware-investors in madcap deals through credit instruments that few even of the banks’ own boards seem to understand.

Question put and agreed to.


That Mr Douglas Carswell and Steve Baker present the Bill.

Mr Douglas Carswell accordingly presented the Bill.

Bill read the First time; to be read a Second time on Friday 19 November and to be printed (Bill 71).

All Rights Reserved ©
Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
What is the Mises Institute?

The Mises Institute is a non-profit organization that exists to promote teaching and research in the Austrian School of economics, individual freedom, honest history, and international peace, in the tradition of Ludwig von Mises and Murray N. Rothbard. 

Non-political, non-partisan, and non-PC, we advocate a radical shift in the intellectual climate, away from statism and toward a private property order. We believe that our foundational ideas are of permanent value, and oppose all efforts at compromise, sellout, and amalgamation of these ideas with fashionable political, cultural, and social doctrines inimical to their spirit.

Become a Member
Mises Institute