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How Banks Really Work

By reasonable auditing standards, high street banks are insolvent...

A KEY QUESTION in the debate over fractional reserve banking is the extent to which people know that banks lend their deposits out to others, writes Toby Baxendale of the Cobden Centre.

People must accept that, if they all went at once to get back their deposits, the banks would not be able to pull in all the money they have lent out, and the system would collapse.

The fact is that not everyone wants their money back at the same time, so the scheme works fine and allows interest to be paid. But I have always held that people would be horrified if they knew what was actually done with their money. Which is why, in the absence of any empirical data, the Cobden Centre commissioned a group of students at ESCP Europe – working under our Founding Fellow, Dr Anthony Evans, and with the market research company ICM – to survey the views of 2000 people.

Anthony has written an informative and useful summary. The report considers the key questions of solvency and liquidity, and concludes that "by reasonable auditing standards, high street banks are insolvent..."

A healthy solvency ratio is typically seen by generally agreed accounting principles as about 20%. Of the six high street UK banks that we analyzed the average is just 0.18%. Although these banks have a positive asset/liability ratio, 20-40% of those assets comes from derivatives and possible "toxic" assets.

Furthermore, the general population is highly uninformed about the banking system, misunderstanding the legal status of their deposits and unaware of what banks do with them. According to our survey:

  • 74% of people think that they are the legal owner of the money in their current account, as opposed to the bank;
  • 66% of respondents answered "don't know" when asked what proportion of their current account was used in various ways by their bank;
  • Only 33% of the general public favour the existing policy of government-backed deposits and a lender of last resort.

My take is that people are confused. 74% think they own their money, when of course they do not, the bank does. Fifteen per cent want safe keeping, and 67% want easy access. Easy access implies safe keeping to me, as there is no access if you have a bank run. I do feel that clarity, more so than ever, is required to start clearing up this mismatch between what a bank actually does and what people think it does. This can only be resolved by a change in law.

At the same time, our fractional reserve free banking colleagues may take comfort from our finding that 61% of those surveyed do not mind having their money lent out so long as the lending isn't reckless. This strengthens the position of allowing FRFB between consenting adults. The debate will roll on. We hope this will add an empirical edge that will sharpen the focus of some of the best thinking Austrian economists.

I am minded to return at a later date and commission a further survey that helps spell out to the public the actual bank credit creation multiplier as this is not brought out by our questions, and see what the empirical data throws back at us. I suspect that hairs will stand up on the back of necks, with a general sense of horror, but these are my prejudged views and I would be interested to see the evidence.

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Built on anti-Corn Law radical Richard Cobden's vision that "Peace will come to earth when the people have more to do with each other and governments less," the Cobden Centre promotes sound scholarship on honest money and free trade. Chaired by Toby Baxendale, founder of the Hayek Visiting Teaching Fellowship Program at the London School of Economics, the Cobden Centre brings together economists, businesspeople and finance professionals to better help these ideas influence policy.

Cobden Centre articles

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