Deposit and Loan Banking
The real villain in the piece is fractional reserve banking which we will come to next but to understand it properly we first need to examine banking itself in more detail. There are two distinct types to discuss, or should I say were - unfortunately thanks to a landmark ruling in the UK in 1811 (Carr vs. Carr) the lines have been muddied enormously and has allowed the monster that is fractional reserve banking to evolve into its modern incarnation.
Deposit Banking
Most people imagine banking to be the safekeeping of money and the provision of banking services we need such as electronic payment systems, ATMs, changing money and converting currency and "traditional" deposit banking fits that description pretty well. Originally bank deposits were bailments and the banks were simply money warehouses. They were paid to look after their customers' money and to provide useful services. The bank had absolutely no claim whatsoever on that money - if they went bust their creditors had no claim on that money either. The customers held title to it at all times. Deposit banking provided a very legitimate and useful service.
Loan Banking
Generally when people save they want to put some of those savings to work and make them grow. Most people want to save for retirement or a holiday or a new car or their children's future; they are not gamblers or entrepreneurs. Risking all their money on one venture is out of the question. What most people want is a nice steady return on their money with only a little risk. Loan banking provided that by being the middle man and, to some extent a safety net, between borrowers and lenders.
The loan bank places itself between lots of people wanting to borrow on one side and lots of people wanting to lend on the other. What makes it work is that each lender effectively only lends a small fraction of their money to each of the many borrowers, which spreads their risk considerably. What actually happens is the lenders lend money to the bank and receive an interest payment in return for the loan. The bank then re-lends the money and charges more to borrowers than they pay lenders. If a loan goes bad, the bank takes the loss. If many loans go bad and the bank suffers or even fails, the lenders take the loss.
By spreading risk across many loans, with differing repayment schedules and interest rates relating to the risk profile of the borrowers, it's possible for banks to earn a decent return. Because the bank is on the hook for losses it means they endeavour to engage in prudent lending, something that was perverted by the introduction of financial products such as Mortgage Backed Securities (MBS) and Collateralised Debt Obligations (CDO). The loan officers of the bank must do their homework. How likely are the borrowers to repay? What assets can be secured as collateral against the loans? By protecting themselves they protect the lenders. Banks that make too many mistakes quickly fail so customers looked for prudent banks with a good track record. It's very unfortunate then that deposit insurance has almost fully removed that safety valve from the system these days but we'll discuss that later.
What's important to note is that historically the lenders knew they were actually lending out the money and therefore couldn't spend it after handing the money over. Their money was encumbered in a similar way to a bond or a time deposit that requires notice of withdrawal.
Two Become One
Saving and lending are vital components of the modern age and actually the concept of banking has been critical in improving the living standards of everyone. Money was a technology made better by banking, allowing it to fulfil its potential of facilitating our lives by improving communication between us. Unfortunately it has always been been entwined with corruption and power as the scourge it has become today can deeply attest. There really is nothing inherently wrong with honest banking. But honest banking requires the depository and lending functions to be separate or, in the case of freebanking all the layers and layers of regulations and protections must be removed. In an environment like that, honesty and risk would become part of the considerations people make when choosing a bank. In a freebanking environment, a 100% reserve bank would quickly attract a lot of custom and money would flow to them, forcing the other banks to tow the line. That will be discussed in more detail later.
The problems start when deposit and loan banking are merged and the customers think their money is on deposit and ready to be withdrawn when actually it is out on loan.
I'll hand you over to Austrian school economist Murray Rothbard...
"Thus, in England, the goldsmiths, and the deposit banks which developed subsequently, boldly printed counterfeit warehouse receipts, confident that the law would not deal harshly with them. Oddly enough, no one tested the matter in the courts during the late seventeenth or eighteenth centuries. The first fateful case was decided in 1811, in Carr v. Carr. The court had to decide whether the term "debts" mentioned in a will included a cash balance in a bank deposit account. Unfortunately, Master of the Rolls Sir William Grant ruled that it did. Grant maintained that since the money had been paid generally into the bank, and was not earmarked in a sealed bag, it had become a loan rather than a bailment. Five years later, in the key follow-up case of Devaynes v. Noble, one of the counsel argued, correctly, that "a banker is rather a bailee of his customer's funds than his debtor... because the money in... [his] hands is rather a deposit than a debt, and may therefore be instantly demanded and taken up."
But the same Judge Grant again insisted - in contrast to what would be happening later in grain warehouse law — that "money paid into a banker's becomes immediately a part of his general assets; and he is merely a debtor for the amount."
The classic case occurred in 1848 in the House of Lords, in Foley v. Hill and Others. asserting that the bank customer is only its creditor, "with a superadded obligation arising out of the custom (sic?) of the bankers to honour the customer's cheques," Lord Cottenham made his decision, lucidly if incorrectly and even disastrously:
"Money, when paid into a bank, ceases altogether to be the money of the principal; it is then the money of the banker, who is bound to an equivalent by paying a similar sum to that deposited with him when he is asked for it... The money placed in the custody of a 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 a hazardous speculation; he is not bound to keep it or deal with it as the property of his principal; but he is, of course, answerable for the amount, because he has contracted."
Thus, the banks, in this astonishing decision, were given carte blanche. Despite the fact that the money, as Lord Cottenham conceded, was "placed in the custody of the banker," he can do virtually anything with it, and if he cannot meet his contractual obligations he is only a legitimate insolvent instead of an embezzler and a thief who has been caught red-handed. To Foley and the previous decisions must be ascribed the major share of the blame for our fraudulent system of fractional reserve banking and for the disastrous inflations of the past two centuries.
Even though American banking law has been built squarely on the Foley concept, there are intriguing anomalies and inconsistencies. While the courts have insisted that the bank deposit is only a debt contract, they still try to meld in something more. And the courts remain in a state of confusion about whether or not a deposit - the "placing of money in a bank for safekeeping" - constitutes an investment (the "placing of money in some form of property for income or profit"). For if it is purely safekeeping and not investment, then the courts might one day be forced to concede, after all, that a bank deposit is a bailment; but if an investment, then how do safekeeping and redemption on demand fit into the picture?
Furthermore, if only special bank deposits where the identical object must be returned (e.g., in one's safe-deposit box) are to be considered bailments, and general bank deposits are debt, then why doesn't the same reasoning apply to other fungible, general deposits such as wheat? Why aren't wheat warehouse receipts only a debt? Why is this inconsistent law, as the law concedes, "peculiar to the banking business"
Pg 91-94 - The Mystery of Banking - Murray N. Rothbardhttp://mises.org/books/mysteryofbanking.pdf
If banks pretend the money out on loan to other people is actually available for immediate withdrawal, they run the significant risk of going bust should enough people actually withdraw their money. These bank runs would have to be stopped with emergency loans to the failing bank and it's for this reason central banking was created to be the lender of last resort. We'll go into that in more detail later.
In monetary systems anchored to a commodity like gold, the breaking point is when the bank runs out of gold and can no longer borrow enough to meet its obligations. Under a irredemable fiat currency, the limit is the amount the bank is legally required to hold on deposit as reserves. In either case, the insidious and troubling thing is that when a bank is engaging in this behaviour and managing to maintain the illusion, the money supply has expanded.
In either case, through the fractional reserve banking system born of this new legal distinction, the commercial banks lend money into existence and charge interest on it. They actually lend the promise of money they don't have and it's at the point when those promises are called upon via spending or withdrawals that the money springs into existence. Few people would lend money just to leave it deposited in a bank account so most of these promises are in fact exercised.