Index

Deposit Banking - Introduction 3

Origins 4

Demand deposits 6

Time deposits 7

Fractional-reserve Banking 8

Full-reserve Banking 10

Bibliography 13

Deposit Banking - Introduction

Having money is not always as easy as it seems. Why keeping it at home when there are much safer institutions out there? But, bringing the money to a bank requires knowledge of how to deposit it and of what the bank is actually doing with it. Deciding between the possibility of withdrawing everything or even generating money by investing it for a longer period of time should be a crucial question for every investor. Moreover, the process of depositing it raises disputed questions on who is proprietor and on the possessor’s privilege to handle it.

Bank deposits developed and changed throughout history. Farmers, looking for a place to protect their grains from theft, stored their harvest in warehouses in exchange for a receipt and the possibility to get it all back after redeeming it. Later on, owners of gold and silver used the same idea to store their more fungible goods at banks. At the beginning, those deposit banks obtained gain by demanding a fee for the time the good was deposed there. The depositor’s assets remained untouched. It is not difficult to imagine that those institutions succumbed to the temptation of taking them and loaning them away in order to expand their sources of income. This kind of activity is called embezzlement. It means to use entrusted goods in order to generate personal gain. In the case of the warehouse system it becomes problematic because the real owner of the good could demand his property back at any time. Consequently the warehouseman is in trouble if he cannot return the demanded good. (Rothbard, 1983)

There are two different forms of deposits. Either you deposit a specific or a general object. The general object is a fungible good, that is identical to every other object from the same type, for example grains. The procedure of the warehouseman is to mix all the same objects together and to calculate how many persons actually will ask for their goods the next months or year. With the rest he will speculate or lend out and try to generate a profit. Because the warehouse receipts serve as a legal surrogate for the stored goods, the warehouseman will, instead of removing the product physically, hand out additional prints of the receipts in excess of what is really in deposit. This means that if a warehouseman receives 10 tons of grain, he will hand out receipts totaling a claim of 20 tons when he actually holds only 10 tons of grain, for instance. (Rothbard, 1983)

It’s the same principle with money in deposit banks. With the exception, that the temptation to embezzle is even higher than in a warehouse. The deposited goods in the warehouse are sooner or later exhausted in order to use them. But for money there is any application, it’s only needed for the exchange. If the banks do not loose their reputation for being honest and trustable there will be no reason to claim one’s money back. Consequently, the banker will estimate who will want one’s money back in the near future. With the rest he will try to make more money by loaning it out without fearing that he will be discovered.

Origins

Illustrating the origin of deposit and reserve systems by the simplified example of grain (Rothbard, 1983) can be used to show the needs and the risks within.

If a farmer has an above the ordinary crop and its granaries are full, he needs to find a solution to deal with the excess.
For this example we assume the ceteris paribus principle, which means that all other factors in the example given stay as usual. So the harvests of other farmers were not over the average amount and no other incident influences the demand and offer rate.
First of all the farmer could try to look for a way to exchange with other farmers, offering them grain in exchange for some other good of which he is in need or he asks for a exchange-service, so he could gain a personal profit out of his excess. A second possibility would be to try to raise the sale of grain, but there is basic barrier to it. The short-term nature of demand of grain is stable. It makes part of the staple goods and is consumed in an evenly amount in the ordinary life, so it turns out difficult to convince customers to buy larger amounts and to store them. If the demand can’t be increased, the farmer could try to create a preference for its grain by the purchasers. But as grain is a fungible good, which means that there is no individual quality about grain distinguishing it from any other grain, the only accessible parameter is the price. So the farmer would have to reduce the price of its product to make it more attractive to customers in comparison to offers by other farmers.
This would definitely cause two main results. First, by dumping the price he would take parts of the market which before belonged to others. This would certainly provoke a reaction of the competitors - they probably would answer by lowering their prices too (skip the ceteris paribus here). So a price battle starts and destroys the anterior balance. Bearing in mind that the example takes place in an ancient time, the other farmers could probably react otherwise and just satisfy their need for self-administered justice and stopping the farmer by force.
Secondly, the value of its own product would decrease by selling it cheaper, knowing that he could probably sell the grain the next year to the normal price. Grain is storable without loss of quality, plus it is to take into consideration, that in the next years the harvest could not be as successful as the present is. So the loss of the differential of selling the grain to a lower price in the “big year” in comparison to the normal price in the following year needs to be estimated as opportunity costs in the calculation.
Both results are not desirable to the farmer and he would certainly discard the idea of dumping the price of its grain.
As shown, the best solution would be to store the grain to have certainty for the following years. This is where the warehouse comes into play, with its offer of storing goods for clients. The farmer can take the offer of a warehouseman to store its grain in his stocks. In return the farmer gets a warehouse receipt assuring him to get the “tantundem” which signifies returning the “same number of units of the same sort and quality as those received” (Huerta de Soto, 1998), at any moment later. As a matter of course the warehouseman will be asking a fee for its service, so the farmer needs to consider these costs into his calculation. But surely the warehouseman will calculate his price in a way both participants will profit of the deal, to ensure that the farmer decides to go for the offer.
Understanding the risk of the deposit needs to recall the fact that grain is a fungible good which cannot be handled individually, meaning that it is impossible to distinguish one grain from another. Supposing that there will be grain from other farmers in the warehouse too, leads to the assumption that the warehouseman won’t store the grains from different farmers in different bins, but mix them all in the same bin, because it is much more convenient to him (Rothbard, 1983). Once mixed up, it is impossible to keep one grain deposited apart from another and the “temptation to embezzle has increased enormously” (Rothbard, 1983, p.91). Warehousemen were able to speculate with the whole amount of grain in the stock, not by distributing the grain to others, but by filling in faked warehouse receipts, which at the time served as means of exchange. This possibility was extracted by the non-existence of any law punishing this behavior of warehousemen until the 20th century (Rothbard, 1983).
This example of the grain deposit is just exemplary for any fungible good, such as money, a $10 bill is indistinguishable to another, so was a gold coin in the ancient times. This leads to the “money warehousing” (Rothbard, 1983, p.89) which was the very early form of our today’s banking system, of course with a lot of adaptations and changes through the time from the early 13th century[1] to our days. Admitting that the main motivation of deposit banking is the requirement of safekeeping of the money, rather than the problem of storing space.
Different forms of deposit and reserve banking, arose through history, can determine a fixed lapse of time for the storage or not, or variable costs for the depositor, in terms of fees or interests, or various levels of risk included in the contract.

Demand deposits

The main sense of demand deposits is that the depositor is able to withdraw money from his account whenever he wants. No interest rates are paid on these accounts except some special situations (where a large dormant bаlancе is kept which cоuld otherwise be transferred to the savings bank department). In these types of accounts, interest rates are not very high. So, these deposits would be the best option for people who need money in a few days or months. So, long term investors should find other types of deposits in order to maximize the amount of money they have. If the depositor does not pay for his demand deposit account, the bank makes a nominal charge for carrying small checking accounts.

There are 3 types of demand deposits:

Money Market Accounts: Here the interest paid to the depositors is never fixed and can change every day. The return is higher but this kind of account is more risky because of these changes.

Checking Accounts: Checking accounts don’t pay interest to the depositors and the fees charged for such accounts are usually high. This kind of accounts is usually used in the US and these accounts are perfect for people who need immediate funds for cоmpleting transactions to purchаse goоds.

Savings Accounts: Savings accounts are the most popular type of demand deposits. Interest is paid at a fixed rate for these accounts which is lower than that on time deposits.

Time deposits

Time deposits are the deposits for a fixed period of time. The interest rate is fixed as well. In time deposits, it is not possible to withdraw money before the stipulated time of investment and if it has to be done, then the depositor has to pay a penalty to the financial institution. The depositor also has to give a written notice to the financial institution when he wants to withdraw his money from the deposit. The longer the time of deposit, the higher the interest rate. When the duration of the term deposit is over, you can either withdraw your money or opt for the deposit scheme again. The rate of interests earned in these deposits is more than on savings accounts, and less than that earned through long term equity investments.

There are 3 types of time deposits:

Traditional Certificates of Deposits: The investment period of the traditional certificates of deposits can be between one month to five years. You cannot withdraw money before maturity, otherwise you would have to pay a penalty by the financial institution. The Federal Deposit Insurance Corporation insures certificate of deposits issued by banks.
Broker Bought Certificate of Deposits: They are first bought by brokers from banks and are then sold to the common customers. In such Certificate Deposits, you have options of keeping money invested.

Liquid Certificates of Deposits: Depositors can withdraw their money at any time without penalty charges. So, this instrument is very flexible. The amount of money which you can withdraw without penalties is decided by the banks.

Fractional-reserve Banking

Fractional-reserve banking is a banking system in which banks reserve only a portion of the customer’s deposits which are available for withdrawals.
“Banks make money by literally creating money out of thin air, nowadays exclusively deposits rather than bank notes”. This sort of counterfeiting is dignified by the term "fractional-reserve banking," which means that bank deposits are backed by only a small fraction of the cash they promise to have at hand. (Rothbard, 1995)
The history of fractional-reserve banking goes back to the time when goldsmiths realized that depositors would not withdraw the gold with the warehouse receipts. They may lend some of the deposited gold to somebody else. Moreover, they would make fake warehouse receipts and lend them out. According to Rothbard (1983), “the deposit banker has suddenly become a loan banker, the difference is that he is not taking his own savings or borrowing in order to lend to consumers or investors, but taking money he does not own. Consequently, banks do not cover all their liabilities with cash in their vault. For that, only a small fraction is available. This fraction is in some countries regulated by the central bank, in some it is not. It is the central bank of every nation or every economic area that fixes the percentages of reserves that have to be kept in the bank’s vault. Like that, a central bank is able to control a country’s interest rates of borrowings and also the increase and decrease of inflation.
Image 1 (Source: http://cynic.me/tag/fractional-reserve-banking/)

As an example, have a look at Image 1: The deposit of $1.000 in a bank. The bank will keep a fraction of the amount of money, depending on the central bank’s instructions. In this case 100$. It will then take the other part of it and lend it out or invest it. Like that, $900 were created “out of nothing”. At this moment in time, in our simple system, there are $1.900. Those steps repeat itself and create more money that has not been there at the beginning. More money in the economic cycle means higher spending power and therefore higher prices. The result of which is inflation. In fact, it is possible to determine the amount of inflation if given information about the bank’s reserve ratio. The expression “money multiplier” comes with a formula.

Naturally, the result of the formula does not have to occur in real life. In our case, the reserve ratio is 10%. So the formula amounts 10. This means the original amount of $1.000 would be $10.000 in the end. Like that, fractional reserve banking represents different values in the real and the monetary world. It turns out that at a higher reserve ratio, the effect on inflation is decreasing. If the reserve rate would be at 100%, this would be full reserve banking.
From a more liberalistic point of view, Friedrich August von Hayek explains in his book “Denationalization of Money” that certain central banks are often connected to the needs of their governments. In fact, they increase the volume of money depending on the economic situation. Furthermore, money currencies are distinguished by country or economic zones like the Euro. He supposes that if every bank had their own currency, the intensity of up and downs in the economy would be reduced because inflation would decrease.

Full-reserve Banking

The full-reserve banking is also known as 100% reserve banking and has its origin, as any deposit and reserve system, in the ancient tradition of warehouse trading. As seen in the introducing example, warehousing consisted of the service by the warehouseman to take in charge a specific good as deposit and giving in return a warehouse receipt to the depositor, which enables him to get his goods back. Supposing a proceeding without fraud this system implicates, that every receipt has a reel value. But as history showed fungible goods were often abused by the warehousemen to create faked-receipts, hoping that not all depositors will come at the same time to get their goods. The banking system doesn’t depose goods, but money, nevertheless fraud has been present in the banking system since the beginning.
So ideas of prevention have been created to assure, that the banking system works well. Exemplary is the gold standard, a monetary system in which the banks have to secure the money they distribute by a certain amount of gold in their stocks. The main goal of this system is to avoid an escalating creation of bank money, which threatens the economic system. Quite the same idea is expresses by the 100% reserve banking. The decisive element of full-reserve banking consists of the fact that the deposited money has to be fully available to depositors at any moment given. This means that “the demand deposits would literally be deposits, consisting of cash held in trust for the depositor” (Fisher, 2011) by the bank.
In fact it is an opposing system to fractional reserve banking, which we treated just before. It bars the banks from working with the deposited capital from depositors. This is the main reason, why this kind of banking isn’t used anywhere in the world anymore. But history gives us an example for full-reserve storing of money, even if it is missing a happy end. Until 1638 English merchants use to appreciate the offer by their king to keep their profits of gold coins in the tower of London for safekeeping. As it was the safest place in the empire, protected by the king’s guards. But then in 1638, King Charles I was in need of gold, due to the starting Civil War and took 200.000 £ of the merchants’ deposits. This caused a loss of confidence by the merchants and so this institution of full-reserve keeping got out of consideration (Rothbard, 1983).
The positive effect of the 100% reserve banking is the prevention of bank crisis and the resulting absolutely security of the money given to the bank, as it prevents the lack of liquidity (Huerta de Soto, 1998). Furthermore customers can rely on the system, as money stays where it is, because unlikely to Charles I, banks in this system don’t spend money.
On the other hand the today’s banking establishment is interested in earning money by investing or transferring a huge part of the deposited amount, to create reserves and capacities for further loans. If the money deposited on bank accounts is not transferred and invested by the bank, then the only earnings would be the fees the customers pay and those are much lower than the earnings of investment plus the capacity of the transferable amounts. Without the gains of investment and the possibility to transfer money from the banking accounts, the bank won’t be able to give any loan to customers, as no capacities remain.
Strictly seen this 100% reserve ratio of a bank system includes demand and time deposits at the same level, leading to the following equation:

| |The money held by the bank | |
|Reserve ratio = |[pic] | |
| |The money deposited in the bank by its customers | |

Source: http://www.fullreservebanking.com/def.htm

But there’s a hugely spread opinion which condemns this strictly applied full-reserve banking method as completely wrong. At any rate, it is a grave error to suppose credit would disappear in a banking system governed by a 100-percent reserve requirement. Quite the opposite is true. Banks would still loan funds, but only those funds previously and voluntarily saved by economic agents. In short, the proposed system would guarantee that only that which has been saved would be lent.[2]

In other words, even in the 100% reserve banking system, loan would be possible, because demand and time deposits need to be differently considered. As explained in an earlier part, time deposits are determined to a fixed lapse of time. This offers to bankers the opportunity to use this money during the given period, without risking a sudden withdrawal by the depositor. This changes the way of calculating the reserve ratio, but the quotient still is 100%:

| |Reserve ratio = |The money held by the bank | |
| | |[pic] | |
| | |The money that the customers currently have the legal right to withdraw | |

Source: http://www.fullreservebanking.com/def.htm

So the full-reserve banking can be seen as a saver alternative to the fractional reserve banking, which includes a certain portion of risk. As shown in the upper part of the text, within the fractional reserve banking, money is artificially created in excelling the current potential liabilities of the bank. Nevertheless it is still the chosen system, because it maximizes the profit and at the same time minimizes the opportunity costs, which leads to agreeable interest on credits.

Bibliography

Rothbard, Murray N. - Mystery Of Banking (1983)

Mishkin, Frederic S. - The economics of money, banking and financial markets (2004)

Soto, Jesús Huerta de - Money, Bank Credit, And Economic Cycles (1998)

| |

Patterson, E. L. Stewart - Banking Principles And Practice (1917)

Hayek, Friedrich August von - Denationalisation of Money - The Argument refined (1976)

Fisher, Irvin (2011)

http://fisher-100money.blogspot.co.uk/2011/10/100-money-short-outline.html?view=sidebar (13/11/11, 10 am)

http://www.fullreservebanking.com/def.htm (13/11/11, 7 am)

Charlie, S. (2011). Types of Time Deposit

http://www.buzzle.com/articles/types-of-time-deposits.html (12/11/18pm)

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[1] “Deposit banking, or money warehousing, was known in ancient
Greece and Egypt, and appeared in Damascus in the early thirteenth century, and in Venice a century later. It was prominent
[pic] | !"#?@AB`ab|}~€?ïÚÓËÇË´¦?¦‡´wl]lK]l]´#[2]?j}[pic]?hÍr/U[pic]mHnHu[pic]j?hÍr/U[pic]mHnHu[pic]?hÍr/mHnHu[pic]h6
`hÍr/0JmHnHsH u[pic]*[3]?j[pic]h6
`hÍr/0Jin Amsterdam and Hamburg in the seventeenth and eighteenth centuries.“ (Rothbard, 1983, p.89)

[4] Huerta de Soto, 1998, p.762 (also compare: Fisher,2011; http://www.fullreservebanking.com/def.htm 13/11/11, 10.00 am)