Money in the bank is not like money in the bank

November 28, 2012 § 9 Comments

[UPDATE: Also see this more recent post].

I often see it asserted that fractional reserve banking – the practice of taking in deposits and lending them out in the form of asset-recourse loans[1], without keeping enough cash on hand to return every cent to every depositor on demand at any time – is morally wrong.  I don’t agree.

Bank deposits are in fact not actually cash, but a kind of share in the operations of the bank.  They are similar to what are called preferred shares.  When preferred shares in a business operation are redeemed you first get your original money back[2]; then you split[3] the profits[4] of the business operation with the owners of common equity.

“Debt”, when it is asset-recourse as opposed to person-recourse, is really just a specific kind of preferred share[5].   When profitable interest-bearing debt has recourse to a person rather than to specific contractual assets for recovery of principal – that is, when it is strictly speaking what the Magisterium defines as lending for profitable interest in moral theology – it is usury.

When a business fails, preferred shareholders get first claim to assets before the common equity owners get anything.  Some kinds of preferred shares take priority over other kinds of preferred shares: “debt” generally speaking gets the highest priority, at least in terms of recovery of the initial investment (“principal”).  So “owning” the business, or what we call common equity in the capital structure, is generally far riskier than owning preferred shares.  It can also, generally speaking, be much more profitable when the business succeeds.

When you open a savings or checking account at a bank, this is the kind of business relationship you are initiating.

Credit unions (as opposed to banks) do use more honest language to portray what is going on: you write “share drafts” not checks, for example. FDIC insured shares are still just shares, not cash.

There isn’t anything intrinsically wrong with this arrangement, and I don’t have a lot of sympathy for people who “put money in the bank” – that is, buy these kinds of shares – in 2012 without understanding the possibility of bank runs and FDIC insurance and such.

Mind you, I’d be the last person to give a free “honesty” pass to the actual marketing practices for financial products in 2012. My statements should not be taken as a blanket defense of all such practices.

But there isn’t anything intrinsically wrong with the business arrangements we call “savings accounts” and “checking accounts”, nor with their connection to fractional reserve banking, nor with the fact that they only remain liquid as long as operations stay within a normal range. In the Google Age anyone who makes those business arrangements with a bank without understanding them – at least to the extent of understanding that under extreme circumstances deposits might not be immediately available, and may disappear entirely unless the government makes good on FDIC guarantees – has only himself to blame.

——————————————————–

[1] In practice a great deal of the lending is person-recourse (like credit cards) as opposed to asset-recourse (secured non-recourse, for example loans to a corporation or non-recourse home equity loans), which makes it usury.  This is morally wrong because it is usury though: it doesn’t have anything to do with fractional reserve lending per se.

[2] You may label the redemption of the amount of your initial investment “principal” if you like.

[3] Profits are not split evenly, generally speaking, although they could be: contract terms vary widely.  In a typical example preferred shareholders might be entitled to  a fixed percentage return over the investment period before the remainder becomes a big (or small, or nonexistent) pot to be split based on ownership percentages.

[4] You may label your portion of profit “interest” if you like.

[5] To argue semantics with myself, the difference between preferred shares and debt is that after all of the debt and preferred redemptions have happened the preferred shares typically convert into common shares (under some conversion ratio) to participate in splitting up the remainder of the pie, while debt typically does not.   Debt is typically only entitled to return of principal and some time based fixed-percentage profit.  A bankruptcy judge might recapitalize and convert the debt holders into common equity in some new entity that takes on the assets of the failed business; but at that point we are past contractual terms anyway and are just trying to make the most of the remains of a failed business.

(This post is an expanded version of a comment from this thread).

§ 9 Responses to Money in the bank is not like money in the bank

  • vishmehr24 says:

    But you have not explained how and why
    “Bank deposits are in fact not actually cash, but a kind of share in the operations of the bank.”

  • Zippy says:

    That bank deposits are not in fact cash should be uncontroversial: the very reason that fractional reserve banking is proposed to be immoral is that the bank does not keep 100% of the cash from deposits on hand. If deposits aren’t cash stored in a vault, but the bank nevertheless has a fiduciary duty to depositors, they must be some sort of contract: a property interest.

    When it comes to bank deposits I’ve found that a curious inversion seems to take place. People who ordinarily would have a tendency to hold individuals responsible for knowing what they are doing when they freely enter into contracts become outraged that a specific kind of contract – bank deposits – work the way that everyone knows they work. These folks seem to want to buy a profit producing contract with an absolute guarantee of return of capital, and express outrage that the market doesn’t offer such a thing: that the market isn’t offering them something for nothing.

    In my view that attitude represents a few centuries of cultural acclimation to usury.

  • tz2026 says:

    The distinction is the rather loud advertising that says you can write a check and as long as YOUR account has enough cash to cover it, it will not bounce.

    If people believed there was risk at any one bank, there would be an immediate run and it would be illiquid but not insolvent (the latter can be a problem as well).

    Mutual funds can suspend redemptions for usually any reason. Some have draft privileges.

    So I tend to agree with you to this extent – stop saying it is a bank account and make it clear that they can freeze deposits, if you have more than the FDIC amount you could lose it (and the FDIC has a finite insurance fund), and even if not, you may have to wait a long time to get the money out.

    For that matter, we can drop the FDIC insurance.

    It also goes back to goldsmiths that said they had the depositors actual gold, but spent it confident that as long as they had enough for redemption they would never get caught.

    But there is a line. You are intelligent and informed enough to look beneath the hype, marketing, and veil to see the essence of what banking is.

    You are also careful about putting the best construction on a statement, so when a bank advertises, and the people within VERBALLY insist that the money is safe and that they are representing things very different than the reality, who is at fault? Those who were slow to think these people were lying or committing a fraud (think Catholic Credit Union), or those who are suspicious and given the lack of any return prefer to keep the cash at home “under the mattress”.

    If your mother or aunt or grandmother or some other elderly lady was the victim of the pigeon drop or other classic bunko operation, would you similarly blame them for being stupid and trustful?

    Vernon Savings and loan was probably before your time, but they had these fancy displays in front and target seniors with non-FSLIC investments that paid slightly more interest, but with the logo, the verbal assurance “as safe as”, and other things to lure them to invest.

    In the Inferno, Frauds were considered more evil than violence. Violence is at least direct. Frauds destroy trust and dissolve and divide society. If you only received one out of every three items as described from amazon or ebay you would stop buying, or you would only buy after going through great effort to verify (and often failing either with too little information or false positives).

    That you can always get your money from a bank and that it is safe there is probably more widely believed by adults than Santa Claus is believed by the kids. The Federal Government and FDIC tend to put it in those terms. Ignorance can be addressed, but then most people wouldn’t have any reason to have their deposits at the banks, so most would fail.

    I would wryly note the same is said of the social security trust fund, which is now full of IOUs (non-negotiable US treasury bonds) that need to be redeemed with the lowered payroll tax. Everyone expects to get full SS and Medicare too. That is not merely fractional, the reserves are now negative.

  • Zippy says:

    tz2026 :
    If people believed there was risk at any one bank, there would be an immediate run and it would be illiquid but not insolvent (the latter can be a problem as well).

    Personally I doubt it. I think most people understand that there is some risk, but that it is very low: that things would have to get very bad for their funds to become inaccessible, kind of like the risk of having your house destroyed by a hurricane. A difference is that when things go wrong there are generally human decisions to point to rather than raw forces of nature (though I suppose a hurricane could itself make deposits unavailable for a time). I’m sure that if Long Islanders had an embodied Sandy to scream at bloody murder they’d be doing so.

    We are probably not that far apart in this though. I’m not going to defend in general the marketing practices of firms which offer financial products. I actually was around during the S&L crisis, though I was something of a youngster.

    I could criticize the marketing of all sorts of products though, and I don’t see an essential difference here. People should know what they are getting into and stop acting as though savings accounts are something they are not. Part of my goal here is to educate the relatively few people who are listening (more on the moral aspect than the financial, but you’ve got to understand the one to understand the other), and most likely the message someone reading this blog needs to hear is not a choir-preaching “blame it on the evil banksters!” but rather a dispassionate analysis of the nature of the products they are voluntarily buying.

    That you can always get your money from a bank and that it is safe there is probably more widely believed by adults than Santa Claus is believed by the kids.

    I agree, but that is not entirely the product of fraudulent marketing. People are hearing what they want to hear, and become morally outraged when reality turns out to be different from their wants. By now most people really ought to know better.

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