Money in the bank is not like money in the bank

[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.

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[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).