There are two ways we can entrust our
money to a bank:
These are two very different types of transactions. They are quite
different in nature and have a different legal basis.
The Demand Deposit
When I get paid, my salary goes into my cheque account. I do not want
to lend my salary to the bank, because I intend to spend most of my pay
in the fortnight before I next get paid. I want to be able to spend that
money whenever I choose, for whatever I want to buy, so I choose a
When my salary goes into the bank, I have not transferred the
ownership of that money to the bank. The money is mine. It does not
belong to the bank.
The current accounting process is that the bank records the cash it
has received as an asset and records it responsibility to me as an
liability. This is wrong. The cash does not belong to the bank. It
belongs to me. The cash will be an asset on my balance sheet, so it
should not be an asset on the bank’s accounts at the same time. An
asset cannot have two owners.
Consider a parallel example. If I am going out of town for a while, I
may engage a warehousing company to store my dining suite until I
return. The warehouse will charge a fee for providing this service. When
my dining suite goes into the warehouse, its ownership does not change.
The dining suite still belongs to me. The warehouse owner cannot do what
he likes with the table. He cannot bring it out and use it when he has
guests for dinner. He cannot dance on the table top or use it for
playing table tennis. The warehouse owner cannot decide how the table
will be used, because he has no ownership rights to it. He has a duty to
care for my dining table in the way specified in the contract.
If I decide not to return, I can write to the warehouse and ask that
the table be delivered to my daughter and the chairs to one of my
friends. The warehouse owner will do this, provided I pay the cost of
transport. He cannot refuse to carry out my request, because he has
relatives staying and is using the table. If this happened, I would
accuse him of misappropriating my dinning suite. If he has moved it to
his own home, I could accuse him of theft. Everyone would understand
that he has done something immoral.
If the word got out about what he had done, his warehouse would soon
be empty, because people would stop trusting him. The service that he
offers is skill at caring well for things that belong to other people.
This service only has value to customers, if they can trust him to
provide the care that he has promised. He is really selling trust, so if
he proves to be untrustworthy, his service has no value and people will
be unwilling to pay for it.
The warehouse owner does not record the things stored in his
warehouse on his balance sheet. The only asset on his balance will be
the warehouse that he owns. He does not include the contents of the
warehouse, because he does not own them. They are not his assets. The
only way that they will appear on his balance sheet is through a
contingent liability for inadvertent damage that might be done to
something that is in his care.
When I put my salary in the bank, I am really just putting it in a
warehouse for safekeeping. This was obvious in the days when gold coins
circulated. Keeping the coins at home would be too risky, if I could not
afford a safe. I would be very vulnerable to being robbed. Putting my
gold coins in a bank for safe keeping would make good sense. The bank’s
service would be even better, if it would act on my instructions to make
payments to other people on my behalf when required. The bank would
simply transfer the ownership of the right number of coins to the person
to whom I was making a payment.The bank is just providing a warehouse
role for the gold coins. The ownership of the coins does not shift to
the bank, when I deposit them. The coins are still mine. They only
change ownership, when I instruct the bank to make a payment to someone.
At that point the ownership of some of the coins transfers to the person
paid. The bank never owns the coins. Therefore the gold coins should
never be recorded as an asset on the banks balance sheet. All that
should appear on the banks balance sheet is any contingent liability for
coins that are lost or stolen.
Bank of Amsterdam
The bank of Amsterdam operated in this way for more than 150 years
from 1609 to 1779. Very few banks have remained sound for this length of
time. The integrity of this bank was noted by David Hume and Adam Smith.
The latter made the following comments.
The Bank of Amsterdam professes to lend out no part of what is
deposited with it, but, for every guilder for which it gives credit in
its books, to keep in its repositories the value of a guilder either in
money or bullion. That it keeps in its repositories all the money or
bullion for which there are receipts in force, for which it is at all
times liable to be called upon, and which, in reality, is continually
going from it and returning to it again, cannot well be doubted...... At
Amsterdam, however, no point of faith is better established than that
for every guilder, circulated as bank money, there is a correspondent
guilder in gold or silver to be found in the treasure of the bank.....
The bank is under the direction of the four reigning burgomasters who
are changed every year. Each new set of burgomasters visits the
treasure, compares it with the books, receives it upon oath, and
delivers it over, with the same awful solemnity, to the set which
succeeds; and in that sober and religious country oaths are not yet
In 1672, when the French king was at Utrecht, the Bank of Amsterdam
paid so readily as left no doubt of the fidelity with which it had
observed its engagements. Some of the pieces which were then brought
from its repositories appeared to have been scorched with the fire which
happened in the town-house soon after the bank was established. Those
pieces, therefore, must have lain there from that time.......
The bank cannot be debtor to two persons for the same thing
Inquiry into the Nature And Causes of the Wealth of Nations, 1776).
The last sentence is the key to the longevity of the Bank of
Unfortunately, during the 1780s, the bank began to violate this
principle, when the city of Amsterdam demanded that surplus deposits be
loaned to the city. This marked the end of the bank's success.
What applies to gold coins applies to all forms of money. I get my
salary paid into a bank account because I do not want to carry around a
whole lot of notes and coins. I put it there for safekeeping. I also use
the bank because it provides an easy way of making payments to other
people, by cheque or electronic transfer.
I am very clear about one thing. My money belongs to me, even when it
is in the bank. I want to be able to spend it whenever I want. My cash
in the bank is my asset. It does not belong to the bank. Therefore the
bank should not record my cash on its balance sheet as an asset, even if
also records a liability to me. My cash does not belong to the bank.
This is the heart of the problem with the modern banking system.
Banks claim ownership of the cash that has been deposited by their
customers. They record this cash as an asset on their balance sheet.
They treat the cash as if they owned it. This is problematic because the
cash now has two owners. I think that I own it, while the bank acts as
if it owns it. (For a full analysis of the nature of money, see the
Having on asset with two owners might be fine for a while, if the
real owner does not want to use the asset immediately. However,
eventually problems will arise. If the owners of money in the bank want
to withdraw it and the bank has done something else with the money, the
conflict is obvious. If too many people want to withdraw at the same
time, the problem compounds. A bank run can occur, and the bank might
end up defaulting on its obligations.
This problem does not arise with a warehouse. If all the people with
stuff stored in a warehouse decided to take it out on the same, this
would not matter. The warehouse owner would be very busy handing out
stuff and he might be worried about his future income, but every person
would get back what they owned. There is no reason why a bank should be
The solution to this is quite clear. If the warehouse owner claimed
ownership of the stuff stored in his warehouse, he would be accused of
misappropriation or theft. If a bank claims ownership of money entrusted
to its care, the same applies. It has appropriated something that does
not belong to it. It has stolen money that it does not own.
The Bible is clear that a thing cannot have two owners. If two people
claim the same thing, the case should be resolved by judges.
In all cases of illegal possession of an ox, a donkey, a sheep, a
garment, or any other lost property about which somebody says, 'This is
mine,' both parties are to bring their cases before the judges. The one
whom the judges declare guilty must pay back double to his neighbor (Ex
If I say of my demand deposit ,'This is mine' and the bank is also
saying, 'This is mine,' something is wrong. This is an issue that should
be resolved by judges. If they find that the bank has claimed something
that does not belong to it, the bank pay back double to the depositor.
The warehouse owner will keep an inventory of everything that is
stored in his warehouse. He records the identity and contact details of
the owner of each item. He can even transfer the ownership to another
person, if instructed by to do so by the owner. However, this recording
system will be separate from his asset register.
Banks should really be doing the same thing. They should be keeping
an inventory of all the money being stored and the identity of the
owners. This should be separate from their financial accounts. The money
stored should not be able to creep onto the banks asset register.
Some defenders of the modern banking system have argued that a bank
is different from a warehouse, because money is fungible. A fungible
good is one that becomes mixed when it is stored with more of the same
good. An example is wheat. If my wheat is added to a silo containing
wheat owned by other people, I will not be able to get my particular
grains of wheat out. All that the silo owner is required to do is return
wheat of similar quality to what I put into a silo.
Oil is another example of a fungible good. Having a separate storage
tank for each owner of oil would not be very efficient. It is better to
store all the oil of a particular type in one tank. The operator of the
tank will always be able to return oil to the person who put some in
when he wants it, however he will not get exactly the same molecules of
oil that he put in. He will be quite happy as long as he gets oil of the
The defenders of modern banks argue that money is a fungible good
too. This is true. If you deposit gold coins in a bank, you may have an
attachment to a particular coin, because you like the face that is
printed on it, but most people will happy to get back any coin, as long
it contains gold of the same weight and purity. Likewise, I don’t
really care what bank notes I get when I with draw money from the bank,
as long as they are not scruffy. I do not care, if I don’t get back
the ones that I put in.
Money is a fungible good, but the argument still has a fatal flaw.
The defenders of modern money argue that when a fungible food is put
into a silo or tank, the ownership of the good passes to the owner of
the storage. They say that the same applies to demand deposits at the
bank. Because money is a fungible good, ownership passes to the bank.
This logic is not correct.
When oil is put in a silo, or oil into a tank, the ownership should
not pass to the owner unless he buys it from the people putting it in.
If I put wheat in a silo along with wheat that belongs to eight other
people, I still own some wheat. The difference is that whereas,
previously I owned my own wheat, I have now own a share of silo of
wheat. The wheat in the silo does not belong to the owner of the silo.
It is owned jointly by the other people who have put their wheat into
the silo. The owner of the silo is not entitled to take some of the
wheat for his own use, even if he puts some other wheat back, before the
owners demand it back.
Likewise, when several people put their oil into the same tank, the
ownership of the oil should not transfer to the owner of the tank.
Rather they have swapped ownership of a specific volume of oil for a
share in a larger volume of oil. The owner of the tank can only claim
ownership of oil if he has actually purchased the oil. He has no right
to take the oil for his own use, even if he puts some oil volume back
into the tank later. The owner of the tank or the silo has a duty of
care to those who are paying a fee for the storage. That does not give
him a right use what is being stored.
The same applies to money deposited in a bank. Although the money is
fungible, ownership does not transfer to the bank. Rather the depositors
own a share of all the money in the bank. This is true regardless of the
form of money. If gold is deposited in the bank, the depositor changes
ownership of a particular piece of gold, for a defined share of all the
gold in the bank. He can always get his gold back, because the amount he
has put in has been added to the total amount in the bank. Each
depositor’s share of the total amount of gold is equivalent to the
amount that they put in.The same applies if the money is notes and coins
or electronic money. All the money in the bank is jointly owned by the
depositors. Each one owns a share of the total, which is equivalent to
the amount they deposited. If the money has depreciated in value, the
loss is shared by all depositors. The important point is that none of
the deposited money is owned by the bank.
This is a biblical principle.
If a man gives his neighbor silver or goods for safekeeping and they
are stolen from the neighbor's house, the thief, if he is caught, must
pay back double. But if the thief is not found, the owner of the house
must appear before the judges to determine whether he has laid his hands
on the other man's property…. The one whom the judges declare guilty
must pay back double to his neighbor. (Ex 22:7-9).
When someone takes the
goods of another for safekeeping and it goes missing, he is accountable
for the loss. If the thief is found, the thief must make restitution. If
not, the person caring for the property is accountable for the loss. He
must make restitution to the owner, because his neglect is the
equivalent of theft.
The other important thing to note is that the Bible refers to the
valuables presented for safekeeping as the “property” of the
depositor, even when they are in the house of the other person. This
confirms the principle that the ownership of property does not transfer
to person who takes it for safekeeping. The owner of the property
remains the owner, until the goods are actually sold.Applying this
principle to banking, the bank that treats money that has been deposited
for safekeeping as its own asset has misappropriated something that does
not belong to it. It has “laid its hands on the other man’s property”.
If it was taken before the judges, it would have to pay back double to
the owner. Paying back the amount that was deposited is not enough.
There are limits on the duty of care that must be provided. The
person providing safekeeping is not accountable for events beyond their
If a man gives a donkey, an ox, a sheep or any other animal to his
neighbor for safekeeping and it dies or is injured or is taken away
while no one is looking, the issue between them will be settled by the
taking of an oath before the LORD that the neighbor did not lay hands on
the other person's property. The owner is to accept this, and no
restitution is required. But if the animal was stolen from the neighbor,
he must make restitution to the owner. If it was torn to pieces by a
wild animal, he shall bring in the remains as evidence and he will not
be required to pay for the torn animal (Ex 22:10-13).
The principle remains the same. The owner is the owner. The neighbour
providing care is never the owner. If the animal is stolen, the
neighbour must make restitution to the owner. If the animal is killed by
wild animals, the neighbour does not have to make restitution, because
this event was beyond his control.
The same applies to a bank. If it claims money that has been
deposited as its own asset, it has committed theft. If the bank is
robbed, it must make restitution to the depositor. However, if the money
is destroyed by a fire or war, the bank is not liable for the loss,
because it was beyond the bank’s control. A bank must provide the best
care possible for money deposited, but it is not accountable for events
beyond its control.
Banks that operate according to these biblical principles will not be
able to make money from accepting money on deposit for safekeeping.
Therefore, it will be quite appropriate for them to charge a fee for the
services that they provide. Depositors will look for banks that provide
the best service for the most reasonable fee. They will be able to
choose the level of service. Banks that provide better security and a
wider range of transactions will be able to charge more.
Banks should not be expected to pay interest on demand
Term Deposits or Loans
Sometimes when I receive my salary, I will not need to spend it all
in the next fortnight. I might build up the size of my deposits in the
bank to the level where I have a couple of thousand dollars that I do
not want to spend until some time in the future.
In this case, I might want to put the money on a term deposit, so I
can earn interest as a reward for not using it immediately. This is a
different type of transaction. I am agreeing to let the bank have the
use of the money for a specified time. I am allowing the bank to decide
how to lend the money. I expect them to do this in a way that will keep
my money safe, while earning a good return.
This is different from the demand deposit, so the analogy of the
warehouse does not apply. This transaction is more akin to someone who
leases a piece of machinery. If a person owns a tractor, but has no way
to make use of it, the tractor brings them no benefit. If they can find
a farmer who needs, a tractor, they can lease it to the farmer for use
on his farm. The farmer is better off because he has the use of a
tractor. The tractor owner is better off, because his tractor now earns
him some income.
The same applies with cash sitting in demand deposit for month after
month. If I do not want to spend it immediately, I am better to lease it
to someone else who can use it productively. They are better off because
they have capital that they did not have. I am better off, because they
will pay me for the use of the money. This is the nature of a term
deposit. I am making a loan to someone who can use it more efficiently
in return for interest. The interest is really just the rent or lease
for the use of the money.
Ownership and Risk
Some defenders of the modern financial system would argue that money
loaned to the bank belongs to the bank. This is not correct. The money
loaned still belongs to the person who saved it. The bank just has the
use of the money for a specified time.
This is obvious in the case of the tractor. When a farmer leases a
tractor, it does not become the property of the farmer. What he buys is
the right to use the tractor for a specific time. The farmer will not
list the tractor as an asset on his balance sheet. Rather he will record
the rent paid for leasing the tractor as an expense in his Profit and
Loss Account. Ownership of the tractor does not pass to the farmer
(except in the case of a lease to buy agreement).
The difference from the warehouse situation is that the owner can not
demand the tractor back whenever he chooses. He can only demand it back,
when the lease has expired. The other difference is that the farmer can
use the tractor how he likes, provided that he complies with the
conditions of the leasehold agreement. The lease may place limits on the
load he can pull and specify regular maintenance that must be done, but
provided the farmer complies with these conditions, he can use the
tractor how he pleases.
The principles for leasing productive equipment are confirmed in the
If a man borrows an animal from his neighbor and it is injured or
dies while the owner is not present, he must make restitution. But if
the owner is with the animal, the borrower will not have to pay. If the
animal was hired, the money paid for the hire covers the loss (Ex
This refers to a productive animal. Even when it has been lent to a
neighbour it still remains the property of the owner. The owner is till
Although the animal was leant for a fee or lease, the neighbour is
required to take reasonable care. However, if something unexpected goes
wrong, then he does not have to pay compensation. The lease fee will
have included something to cover the risk of the animal dying. The owner
must carry the risk of the animal dying. He would not lease the animal
unless the fee was sufficient to compensate for that risk.
Applying this to a tractor, the person leasing the tractor remains
the owner, even after it has been leased. The person leasing the
tractor, has control over its use, but does not have ownership. If the
engine unexpectedly blows up, the person leasing it is not responsible
(unless the lease specifies something different). The owner of the
tractor carries the risk of the tractor not performing as was expected.
The lease fee should compensate for that risk. If it did not, then the
owner would be foolish leasing the tractor.
These principles apply to a bank loans. When I loan money to a bank,
I still own the money. Therefore the bank should not record the money as
an asset in its balance sheet. The bank should pay interest for the use
of the money. Although the lender still owns the money, they cannot
demand the money back at any time. The lender must weight till the end
of the term for the money returned (unless he pays to break the
The bank has responsibility for using the money wisely, but this
cannot prevent problems occurring. Every transaction that involves the
future has uncertainty, so risk is unavoidable. The owner of the money
must bear this risk. The interest received should compensate the lender
for this risk. If it does not, then the lender would be better to leave
the money on demand deposit, so the banker carries the risk.
Money loaned to the bank is also fungible. When a person deposits
money in a bank, it will mix the money up with money deposited by other
people to make it more productive. This does not shift ownership of the
money to the bank. It just means that the depositor has shifted from
ownership of a specific amount of money, to ownership of a share of a
larger pool of money. The share of the money jointly owned will be equal
to amount of money deposited.
The important point is that ownership of the money does not transfer
to the bank. However the bank does have the right to use the money as it
chooses, provided it complies with the conditions of the deposit
agreement. Ownership is not transferred, but the right to control the
use of the money is transferred to the bank for a specific time.
The depositor owns the money, but the bank controls its use. It can
lend the money to someone else, but not for a longer period than the
loan agreement specifies. The loan agreement may also specify they types
of uses for which the money can be loaned by the bank. Provided these
conditions are met, the bank can decide how the money is used. If the
bank can get a higher interest rate than it agreed to pay to the
depositor, it can keep the difference to cover its expenses and provide
a profit to the bank owners. The bank cannot loan the money for a longer
term than the term agreed with the owners of the money, because it does
not have control over the money beyond that time. It only has control
for a specified time. When that period is complete, the bank loses this
control and must return the money to the owners.
Borrowing Short and Lending Long
Modern banks tend to borrow money for a short term and lend it for a
longer term. For example, most mortgages have a term of 15 to 20 years,
but much of the funding comes from term deposits with a term of less
than a year. This creates problems, because banks are lending money that
they do not own or control. If the bank only controls the money for 6
months lending it for a twenty year term is rather odd. We need to think
more clearly about this.
The depositor is in a strange situation. They have lent their money
to the bank for six months. The bank has taken this money and lent it to
someone for twenty years. It has taken this action knowing that it will
not get the money back from the borrower, when the term deposit is due
to be repaid. Unless the bank has other mortgages that will to be repaid
at that time, it will have to obtain the money to repay the depositor
from some other source.
A term deposit at a bank is supposed among the safest things that a
person can do with their money. This is not true. The reality is that
the bank is making a commitment to return the depositor’s money at the
time when the term is complete, without knowing where or how they will
obtain the money to fulfil this commitment. Most of this risk rests with
the bank. In normal times, they should be able to get the finance from
another source, but they cannot guarantee the future. Economic
conditions might have changed dramatically by the time the term deposit
matures. If the economy has deteriorated, the bank might have to offer a
much higher interest rate to get the finance they need.The security of a
term deposit depends on the ability of the bank to guess what will
happen in the future. A prudent bank might be able to manage the risks
involved, but if it guesses wrong about the future, it might face
significant losses. If the bank really gets thing wrong, and the losses
are greater than the banks capital, the depositors will bear the loss
and lose some of their money.
When a bank accepts a term deposit and lends the funds for a longer
term, it does not know where the funds will come from to repay the
depositor when the term is complete. It is committing to obtain money in
the future without knowing whether this will be possible or what the
price will be. It is making a commitment to return something that it
currently does not own.
A market where people buy and sell entities, which they do not own,
is called a futures market. Futures markets exist for a number of
commodities and for a variety of financial instruments. Such a market is
legitimate for people who want to speculate on or hedge against future
changes in price. All participants in the market understand that the
person who is promising to sell at a future date does not currently own
what they are promising to sell. There is a risk that when they try to
buy what they have agreed to sell; the price may have risen so high,
that they cannot afford to buy it. If that happens they might default on
their agreement. Everyone in the market understands this risk.
Futures markets are inherently unstable, as prices can fluctuate
rapidly and players default if unexpected events occur. This is fine for
investors who understand the nature of market and are prepared to take
on the risks involved. However, this type of arrangement will rarely be
appropriate for people making term deposits in a bank. They put their
savings in term deposits at a bank because they want their money to be
safe. They are generally willing to get accept lower interest rates in
return for higher security. They are not choosing to lend to an entity
that is speculating in a futures market. Depositors might be able to get
a higher rate of interest from a term deposit for a bank that borrows
short and lends long, bit if they understood the risk, most would prefer
a safer option.
Trust and Honesty
If bank depositors understood the risks involved, they would not have
so much confidence in the banks. If the farmer who borrowed the tractor
for six months lent it to a contractor for 10 years, the owner would get
a bit upset. He has lent his tractor to a farmer who does not know how
he will be able to return the tractor when the six months is up. The
farmer might be able to borrow or buy an equivalent tractor, but that
might quite costly. The owner of the tractor would become quite nervous
and would regret leasing the tractor to this farmer. He would probably
consider the farmer to be dishonest.
Depositors should view banks in the same way. Why should they trust a
bank that has taken money on deposit for six months, and lent it to
someone else for 10 years? Why should depositors trust the bank, when
the bank does not know how it will repay the money when the term of
their deposits are complete? Why are banks that behave in this way not
labelled dishonest? We should demand better behaviour from the banks
that care for our money. We should not trust organisations that behave
Most depositors would prefer to deposit their money with a bank that
only makes loans for a term that matches the term of their deposits.
Every loan issued by the bank would be matched by a deposit or group of
deposits with the same term. All loans would be for a fixed term and the
bank could only make loans with a term matching the terms deposits
already received by the bank. This is a much safer policy, as the bank
would know that borrowers will be repaying their loan when the term
deposits come to maturity. The bank would know where the money that
belongs to the depositors has gone and it would know when it will be
coming back. This would be a much safer way to operate, as much of the
risk is eliminated.
This policy of matching loans would have the effect of raising
interest rates on longer term deposits. This is reasonable, as the
longer the term of the loan, the greater is the risk of loss. Very long
term loans would probably disappear altogether. This might also be a
good thing. The Bible suggests that Christians should not take loans
with a term of more than seven years. The reason is that we do not know
what the future holds. Making commitments to do things in twenty or
thirty years time is very unwise, as we simply do not know what our
situation will be that far into future. Limiting loans to a maximum of
seven years would be a sensible policy for a bank.
Depositors need greater choice. A bank that only made loans for terms
that are matched by the terms of deposits they have received from
depositors would be much safer. A bank that is serious about providing
services to their customers should provide this service. People choose
bank term deposits, because they prefer security to high returns. I
expect they would prefer a bank that matches the terms of loans and with
the terms of deposits.
The interest rate for deposits with matched loans might be lower, but
the risk would be lower as well. If more people demanded this service,
some banks might start offering it. They would essentially become loan
brokers. They would be pooling deposits and matching these up with
borrowers wanting funds for the same term. They might charge a fee for
this service, or they might take add a margin on to the interest rate
paid to the depositors.
Risk of Default
Matching the term of the loan to the term of the deposits does not
eliminate all risk. The person who borrowed the money may abscond or
make bad business decisions. They might not be able to repay the money
they have borrowed when the term is complete. The bank is to should be
skilled in assessing the creditworthiness of borrowers and putting
appropriate security measures in place.
The more risky the loan, the higher the interest rate will have to
be. Depositors should be able to choose the level of risk they want to
take on, but I suspect that most depositors would specify that their
money only be lent to creditworthy borrowers.
The bank could also provide insurance against the borrower
defaulting. This does not eliminate the risk, but it spreads the cost
across all depositors, rather than leaving all the risk with the few
depositors affected by the bad loan. Most depositors would prefer a
slightly lower interest rate, if they knew that the cost of any default
would be spread across many depositors.
The person borrowing from a bank that lends long and borrows short
also faces uncertainty. They have agreed to a mortgage with at twenty
year term, with a bank that has only organised the finance for the first
six months of the loan. The bank presumes that it will continue to be
able obtain the money as it is needed. This is probably true, but the
bank does not know what rate of interest rate it will have to pay to
obtain the money in the future. That is why most banks will generally
not hold mortgage interest rates fixed for more then about two years.
They do not know how the interest rates will move in the future, so they
pass the risk on to the borrower.
The adjustable or floating rate mortgage is the solution to this
problem. The adjustable rate mortgage is really a series of short-term
loans. The bank is implicitly saying to the borrower, I can only loan
you this money for a couple of years. At then end of that term, I will
renew the loan, but I do not know what the interest rate will be. I will
always be able to borrow some money, but I cannot control the interest
rate. I will have to adjust the interest rate that you pay to allow for
this. So really an adjustable rate mortgage is really a series of short
term loans with different interest rates, but with the same security
remaining in place.
If the borrower is willing to take the risk of committing to a twenty
or thirty year mortgage, without know what the interest rate will be,
that is their business. However, taking on an unknown risk in this way
is not very wise. The Bible suggests that we should not make commitments
beyond five years. Making a commitment to make payments in thirty years
time is serious enough. The fact that you do not know what the amount
you have to pay will be makes the uncertainty even worse.
When Banks borrow short and lend long, depositors do not benefit.
Borrowers do not benefit either. The benefits all go to the bankers and
not their clients.
However, this policy is also risky for the bankers. The practice
works as long as the flow of withdrawals and deposits roughly match each
other. In a time of uncertainty or panic, a large number of people may
try to withdraw their deposits. As there is an advantage in getting in
first, there may be a run on the bank. If the bank cannot call up all
its loans it may run out of reserves. This could push the bank into
bankruptcy and many people would lose their money. Bank panics have been
common throughout the history of banking.
Modern banks are not very clear about the contracts they offer. Some
savings accounts pay interest, but have a variable term allowing the
money to be withdrawn on demand. Some cheque accounts offer interest on
positive balances. The problem with these bank accounts is that it is
not clear whether the money is being deposited for safe keeping or being
loaned for a fixed term. The distinction between demand deposits and
term deposits has become blurred. In reality they are two different
The two types of account are different for the bank and have
different legal consequences. The bank is entitled to lend money in a
term deposit to someone else for the term of the deposit. It has a duty
to lend the money in away that will minimise risk of loss. The situation
with a demand deposit is very different. If the bank lends money
deposited in a demand deposit, or even records it as an asset in its
accounts, it is stealing something that does not belong to it. To avoid
being guilty of theft, an honest bank should be very clear about what
type of account it is offering.
Understanding the two types of account is also important for the
person making the deposit. When making the demand deposit, they are
giving their money to the bank for safekeeping. Security and convenience
is their priority, so they will be willing to pay a fee for that
service. They also expect to be able to go to the bank and be absolutely
certain that their money will be there.
When a person makes a time deposit, they understand that their money
will no be available to them for the length of the specified term. They
understand that the bank will be lending the money on to someone who can
use it effectively. They expect the bank to be careful and lend the
money wisely. However, they know that there is some risk that the person
borrowing the money may default on the loan. This risk is shared with
other term depositors at the bank and with the owners of the bank, so a
small default will not affect them. However, if defaults become
widespread, the risk to the depositor may increase. The interest paid on
the term deposit is in part compensation for this risk. Generally this
risk premium will be quite small.
Imagine two banks.
Bank No 1 says,
We will store your money and keep it safe. We will not use your money
as if it belonged to us. We will deliver it to any person, as you
instruct us. To cover the cost of providing this service, we will charge
a small monthly fee, but you can be sure that your money will be here
when you want it.
Bank No 2 says,
We will look after your money for you and we will deliver it to
anyone according to your instructions. However, if we see that you are
not using your money, we will lend it to someone who can make use of it.
The interest will compensate you for the risk.
The risk you run is that when you want your money, the person who
borrowed it may not have returned the money back to us. We will have to
borrow the money from some else to repay you, so you may have to wait to
get your money. If for some reason a whole lot of people all decide to
withdraw their money at the same time and there is a run on the bank,
many of you could lose your money. This risk is unlikely and the benefit
is that you will have no fees.
Which bank would people choose?
I do not care which bank people would choose. They can work out the
risks and the benefits and do what is best for them. If they prefer the
cheaper option, they are free to choose it, provide that they do not
expect me to rescue them, if things go wrong.
The problem today is that we do not have a choice. Most people think
that they are dealing with Bank No 1, whereas there bankers believe they
are Bank No 2. There is a dangerous disconnect between the understanding
of risks and expectations.
Before assuming that Bank No 2 is the preferred option, read this
If John returns from overseas and puts $10,000 in his check account,
the balance sheet of the bank shows an increase of $10,000 under cash.
If John were the first client of the bank, its balance sheet would look
It is true that the bank also records a liability to John. However,
because the bank has control of the cash, it has a stronger position.
John is a creditor of the bank, so he is very dependent on the bank
honouring its obligations.
If the bank thinks that John is unlikely to withdraw its money, it
may make a loan to Pete. Its balance sheet would no look like this.
Pete buys a truck from Bill, who deposits the cash he received in the
bank. The bank’s balance sheet now looks like this.
The banks cash to asset ratio is fifty percent, so the bank now
complies with the Basel Accords. It easily meets the standards set by
governments all over the world.
Despite this compliance, we now have a strange situation where the
bank only has $10,000 cash, yet both John and Bill think they have
$10,000 in the bank. If they both try to withdraw their cash out at the
same time, they will not be able to get it. The bank cannot call in the
loan from Pete, because he no longer has the cash. He has brought a
Bill and John’s cash is not lost, but they cannot get hold of it
when they demand it. The best the bank could do is to give $5,000 to
both Bill and John and make them wait for the rest of their money. The
bank could force Pete to repay his loan, but if he has to sell the truck
quickly, he might only get $5,000 for it. John and Bill would then be in
trouble, as one of them would have lost $5,000.
Who Should Decide
Who should decide if money in a cheque account is not being used and
is available for lending to someone else? In the modern system the bank
makes this decision. However, the bank cannot read the minds of its
depositors, so it does not know what they are planning to do with their
money, or when they will want to spend it. Banks can only work on
average behaviour and past experience. Neither are good predictors of
The person who is best placed to decide whether money is available
for lending is the depositor. They know their plans for the money. They
know what they are planning to do. They are best placed to decide how
much they need to hold back to deal with unexpected expense.
If banks only paid interest on term deposits and there was a small
fee for the operation of an account where the money is available on
demand, then people would respond to these incentives. They would
quickly identify money that they do not need immediately and transfer it
into a term deposit that paid interest. The bank would then know that it
was available for lending to others, without having to make guesses
about the depositor’s intentions.
The banking system would function better if banks stopped deciding
when money was available for lending and left these decisions to
Some people think that I should not worry that the bank recording my
deposit as an asset on their balance sheet. They do not under the nature
of modern banking law. When a person deposits money in a bank, they
change from being an owner of an asset into a creditor of the bank. They
give up a property right in exchange for a contractual right. They swap
the ownership of an asset for a promise to receive repayment on demand.
Owning an asset is generally better than being a creditor. If I get a
3 year loan of $30,000 from General Motors, I can buy a new truck. My
balance sheet looks like this.
Before making the sale, the truck was on the General Motors balance
sheet, as part of its inventory. Once they have sold the truck to me, it
becomes my asset. I can drive wherever I like in the truck. I can paint
it bright blue, if I choose. General Motors have lost control of the
truck. They cannot control its use it any more.
General Motors has swapped the truck for a credit contract for the
money that I have borrowed. They cannot demand it back until the three
years are complete. A contractual right is less certain than a property
right. When they owned the truck they knew exactly what they had. The
credit contract is more risky, because they cannot be certain that they
will get their money back when it is due. I may have got into financial
trouble and be unable to repay the loan. The bank has the uncertainty of
a credit contract, whereas I have a property right in the truck. The one
holding the property right is in a better position than the one holding
the credit contract.
In the same way, holding cash provides more security than holding a
credit contract. Being a creditor of the bank is not the same as being
the owner of cash. If I demand repayment and the bank fails to pay me, I
cannot charge it with theft. All I can do is sue the bank for breach on
contract and demand payment of damages. If the bank defaults, my
contract right is converted into a claim in bankruptcy. I have to line
up with other creditors and take my chances.
All that a bank depositor “owns” is the right to enforce the bank
to keep its promise. I believe that most people want better security for
their money. We need banks that offer a different option.
Bailment is an important legal concept.
Bailment is the process of placing personal property or goods in the
temporary custody or control of another. The custodian or holder of the
property, who is responsible for the safe keeping and return of the
property, is know as the bailee. The person who delivers or transfers
the property to the bailee is known as the bailor. For a bailment to be
valid, the bailee must have actual physical control of the property. The
bailee is generally not entitled to the use of the property while it is
in his possession, and a bailor can demand to have the property returned
to him at any time (Lawyers.com)
A bailment is not the same as a sale, which is an intentional
transfer of ownership of personal property in exchange for something of
value. A bailment involves only a transfer of possession or custody, not
of ownership. A bailment is created when a parking garage attendant, the
bailee, is given the keys to a motor vehicle by its owner, the bailor.
The owner, in addition to renting the space, has transferred possession
and control of the vehicle by relinquishing its keys to the attendant (Free
The main distinguishing feature of a bailment is that possession of
the property is transferred to the bailee, but ownership remains with
the bailor. Trusting my furniture to a warehousing company for storage
is an example of a bailment. The warehouse has possession my furniture,
but I am still its owner.
The second feature of a bailment is that the bailee is not entitled
to use the property for their own purpose. The warehouse company is not
entitled to use my furniture.
If a deposit in a cheque account is a bailment, then the bank could
not record the cash as an asset on its balance sheet. It could not use
the cash for its own purposes.
During the 19th century, the British Law Lords ruled that a demand
deposit is not a bailment. This decision has since between adopted by
courts all over the world.
In a case in 1811, Sir William Grant ruled that money paid into a
bank is not a bailment, but a loan. The banker is not a bailee, but a
debtor (Carr v Carr). In a subsequent case, he said, “The money paid
into a banker immediately becomes a part of his general assets and he is
merely a creditor for the amount (Devayne v Noble).
Lord Cottenham summed up the early decisions in
v. Hill and Others.
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....
According to modern law, a bank deposit is not a bailment, so the
bank is entitled to record the deposit as an asset on its balance sheet.
Bailment not Bailout
That is the situation under law, but there is not reason why the
relationship between a bank and a depositor should be decided by judges.
Banks are providing a service to their customers. The customers are
entitled to demand whatever service they want. If enough customers
demand a particular service, an astute bank would provide that service.
If enough people demanded a different service, some banks would start to
Many people will be happy to accept the service provided by banks
under the current legal arrangements. They are happy for the bank to
take control of their money and use it as they please, provided they can
get good interest and no fees on their cheque account. If that is what
they want, that is fine.
However, many other customers will want a different account. They
will prefer a bailment-type cheque account in which their money does not
get transferred to the balance sheet of the bank, but remains the
property of the depositor. Many customers do not want to become
creditors of the bank. They want to be the owner of their money.
Modern banking law does not prevent banks from contracting with
depositors to provide a bailment-type account. The money in this account
would not become an asset of the bank. It would not be available for the
bank to use. It would be stored in the same way as a storage warehouse
stores my furniture.
When my salary goes into my cheque account, I want it to be available
when I demand it. I do not want to the bank to treat my money as its own
property. I do not want the bank to loan my money out to someone else.
If the bank provides this service well, I am happy to pay a small fee
for that service.
I do not want the bank to decide when I am not going to use my money.
I am capable of doing that myself. If I do not need some of my money for
a time, I will move it into a term deposit, so the bank can lend it out
for a time, but I do not want the bank just deciding it can lend the
money in my cheque account whenever it chooses. I do not want the bank
treating my money in the way described by Lord Cottenham above. I want a
cheque account that is a bailment. If enough customers were to demand
this service, some innovative bank should provide that service.
We should stop talking about bailout of banks and start demanding
bailment from banks.
Clarity and Separation
Banks and their customers should be very clear about the service that
is being offered. The problem is that most modern bank accounts operate
their demand deposit accounts as if they were term deposits. Depositors
have accepted this blurring, because they want interest on their money,
even when it is stored for safe keeping. However, they are allowing
banks to commit theft with their money, in return for an interest
payment. Depositors should be much clearer about what they want from a
bank. Do they want safe keeping or do they want interest?
Banks should keep these two types of transaction quite separate.
Demand deposits should be kept separate from funds that that have been
deposited as term deposits. In practice, it would be better if there
were two types of bank. Some banks would provide a safe-keeping and
payments service. They would do this for a fee. The money should always
be available on demand, so they will not pay interest.
Other banks will become loan brokers. They would pay interest, so
they would only accept term deposits. All those dealing with this type
of bank would understand the risks involved in lending money to other
Distinguishing between true demand deposits term deposits would allow
people to make explicit choices about which service they want. Some will
choose to keep their money safe. Others will choose to put some of their
money in time deposits, so they can earn interest.
Changing the System
Modern banking practices are largely shaped by government policies.
Governments have supported the common practice of moving demand deposits
onto their own balance sheets. We should not count on governments to
resolve this problem. Fortunately, individuals can resolve this problem
without waiting for their government.
We should start asking our banks who owns our demand deposits. They
will tell us that that the money belongs to us. We should respond by
asking them why it appears on their balance sheet, if it belongs to us.
They will respond with “weasel words” about modern banking practice
and banking laws and deposit insurance. However, if enough people
persist in asking these questions, banks will start get concerned.When
there is sufficient demand for a true safekeeping service, some banks
will start to provide it. A bank that has an eye for opportunity will
see an opportunity to get a head start in a niche market.
The customer is king. Once a few banks start offering this service,
people who want a genuine safe-keeping service will switch their
business to those banks. If enough people are serious about honest
banking, the other banks will get worried about losing business. Many
will start offering a true safe-banking service, so that they do not
lose customers. Some will set up separate institutions in attempt a
significant share of this business.
Power to the People
Depositors should also start asking banks what they will do with
their term deposits. They should ask if the money will be loaned for a
longer term than the term of the deposit. If the bank says yes, they
should ask how the bank will repay their money when the term of the
deposit has ended. The bank will say that it will obtain deposits from
other people or borrow the money from other institutions. This kind of
questioning will expose the dangers in what the banks are doing.
If enough people ask for a different service, an innovative bank will
be able to get an advantage by providing that service. If consumers
start enquiring about a bank that matches the terms of it loans with the
terms of its deposits, a bank should emerge to provide that service. If
that is what most depositors really want, then that bank should grow
quickly. As more and more depositors choose this service, other banks
will have to start providing it, so that they do not lose market share.
The power to change the banking system lies with depositors. If
enough people demand a better service, banks will have to change their
practices. All that is need is for one bank to provide an alternative
service. Depositors can then use the power of their money to reward that
bank and punish those that refuse to change. Power rests with those who
own the money and the money is owned by the depositors, not the banks.