Fractional Reserve
Banking
An Insight into Coercive and
Legitimate Aspects while Peeking into
the Future of Financial Stability
MIGUEL MALLIA
This article was originally submitted as a seminar paper as part of the
CVL1024 and is being reproduced on the Online Law Journal with the
author’s permission. In it, Miguel Mallia advocates for a novel and
ethically driven banking framework, proposing a theoretical
alternative to Fractional Reserve Banking.
TAGS: Banking Law; Philosophy of Law
Miguel Mallia is currently in his second year of the Bachelor or Law
(Honours) course at the University of Malta.
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1. Introduction
F ractional Reserve Banking is a term given to a banking system
implemented globally, a system that uses ‘high powered money as only a
fraction of its total assets rather than one hundred per cent reserve banking.’1
The elaboration of this definition opens up into a world of contradictions on
aspects of morality, legitimacy, contractual obligations, transparency, and
more, all of which are a central subject of past financial crises leading into the
debate of future financial certainty. Finding its roots in the 1800s, the
Fractional Reserve Banking system allows banks worldwide to pool a large
fraction of the deposits made by their customers to be used for profit-making
in the form of lending and investments, with the deposits that are not utilised
for profit-making left as reserves for immediate customer withdrawal. This
procedure is done all while at the same time guaranteeing that the money is
withdrawable upon immediate request, creating a contractual obligation
between the customer and the bank upon the depositing of funds. The system
within itself was a central topic of the Great Depression of the 1930s and the
financial crisis of 2008 while giving argumentative rise to inflation.
Throughout the course of this paper, research was carried out to explore
legitimate and coercive aspects of Fractional Reserve Banking in relation to
the system’s adherence to the letter of the law. The research presented ranges
from historical to present perspectives of a wide range of jurisdictions but
primarily based in Europe. The paper also presents arguments by various
philosophers and economists arguing the mentioned coercive aspects and the
legitimacy of the present system at hand. The arguments focus on an ethical
and moral perspective while discussing bank-customer obligations and the
system’s actual adherence to the law. With banks losing the trust of customers 2
and with inflation drastically on the rise resulting in a risk of another financial
crisis, it was determined that the system within itself demands a reform. This
paper explores further transparency options on an individual account holder
basis as a preliminary remedy in relation to legitimacy and as a summarisation
of the research presented to promote future financial stability and the
elimination of the extreme fungibility of money.
1
D Rutherford, Routledge Dictionary of Economics (Taylor & Francis Group 2012).
2
Katie Feehan, ‘Nearly a third of people aged 25-34 stash cash at home as they no longer trust banks, study finds’,
(Daily Mail Online, 5 October 2021) <[Link]
[Link]> accessed 12 May 2023.
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2. Coercing the Public into a Banking System
With coercion relying solely on the compulsion of someone to do
something for someone else forcefully or manipulatively, central arguments
on how banks coerced customers revolve around trust. Trust was initially
found in various contradicting judgments, 3 until a precedent in the year 1848
was established in Foley v Hill and Others,4 where it was determined that
the bank was a full owner and in full control of the deposits of its customers.
The full ownership of banks on the money deposited in the bank gave rise
to new risks associated with the system and a possibility to profit immensely
from the money deposited due to the huge amount of capital gained.
However, for the bank to build profit, it needs to build long term trust from
its customers. Philosophers, like Rothbard in the Mystery of Banking,5 argue
that there is coercion imposed by the banks on their customers since money
is created out of thin air by creating two titles on the same property, which
in turn results in using money for loans while still being available upon the
immediate demand of the depositor. Two titles on the same property could
lead to inflation and negative economic outcomes as seen in the Great
Depression between 1930 and 1932 6 and the horrendous investments made
by banks in the financial crisis of 2008. Rothbard argues that the business
of banking presently coerces customers into its use by masking the system
with cash deposit bonuses, interests on deposits, and prizes upon depositing,
making the business inherently coercive while rendering it as the current
social norm. Gorton, in Slapped by the Invisible Hand: The Panic of 20077
argues that it was in fact the government that coerced the banks into
accepting higher risk investments by incentivising those investments, which
eventually led to a crash and the financial crisis of 2008, an argument
supporting Rothbard’s studies on coercion in the business of banking.
Antithetical arguments that do not believe that coercion has a part to play
in the Fractional Reserve Banking system tend to lean towards a more
positivistic approach in supporting current legislation at hand, like the
Directive 2013/36/EU of the European Union, 8 stipulating that deposits are
subject to an agreement of mutual consensus and a customer may choose
alternative financial systems, as was the stance of Rozeff 9 in his critique of
3
D Rutherford (n 1) 91.
4
Foley v Hill and Others [1848] 9 ER 1002.
5
Murray N Rothbard, Mystery of Banking (Blurb Incorporated 2018).
6
Brian Duignan, ‘Causes of the Great Depression’ (Encyclopedia Britannica, 29 June 2018)
<[Link] accessed 11 May 2023.
7
Gary B Gorton, Slapped by the Invisible Hand: The Panic of 2007 (OUP 2010).
8
European Parliament and Council Directive 2013/36/EU of 26 June 2013 on access to the activity of credit
institutions and the prudential supervision of credit institutions and investment firms, amending Directive
2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC [2013] OJ L176/338.
9
Michael S Rozeff, ‘Rothbard on Fractional Reserve Banking: A Critique’ (2010) 14(4) The Independent Review
497
<[Link]
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Rothbard’s research.
Both are justified arguments which can be amalgamated into a need for
further transparency. Coercion cannot be induced into a system of full trust
and open books from both the depositor and the bank. Since the banks do
technically create two titles on the same property, an establishment of co-
ownership needs to be taken in consideration despite past jurisprudential
decisions and reverberations, leading to a path of financial stability while
enhancing the Mutual Consensus Directive stipulated by the EU.
3. Main Regulations on Fractional Reserve Banking: An
Insight into the Legitimacy of the System
To understand the legitimacy of Fractional Reserve Banking, a definition of
‘legitimacy’ must be outlined and delved into to truly perceive the systematic
logic of the mentioned system objectively. The Collins English Dictionary
defines legitimacy as ‘something that is acceptable according to law’10 which is
quite self-explanatory. Hence, in this part of the paper a concise summarisation
of the main legislation concerning this banking system in Malta and the EU in
comparison with other jurisdictions will be established, and ethical dimensions
and banking alternatives relating to transparency will be delved into.
The main Maltese legislative enactments concerning fractional reserve banking
and the business of banking in general are the Banking Act11 and the Central Bank
of Malta Act.12 European Directives and a brief overview of the terms and
conditions of three major banks in Malta will also be mentioned as a direct
contributor to the regulation of the subject matter. The term ‘fractional reserve
banking’ is not seen in any of these Acts, however its definition is implied in the
definition of the ‘business of banking’ in the Banking Act where it is stated that
the business involves accepting
deposits of money from the public withdrawable or repayable on
demand or after a fixed period or after notice or who borrows or
raises money from the public (including the borrowing or raising of
money by the issue of debentures or debenture stock or other
instruments creating or acknowledging indebtedness), in either case
for the purpose of employing such money in whole or in part by
lending to others or otherwise investing for the account and at the
risk of the person accepting such money.13
A question that is immediately raised upon understanding the definition of
the ‘business of banking’ is the question of whether a depositor is an investor.
kmwm9m8%3D&pq-origsite=primo&accountid=27934> accessed 11 May 2023.
10
Collins Dictionary <[Link]
11
Banking Act, Chapter 371 of the Laws of Malta.
12
Central Bank of Malta Act, Chapter 204 of the Laws of Malta.
13
Banking Act (n 11) Article 2.
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With a ‘depositor’ being a ‘person who keeps money in the bank,’14 and an
‘investor’ being a ‘person who puts money into something in order to make a
profit or get an advantage,’15 the distinction between the two becomes
ambiguous in nature when juxtaposed in comparison to the definition of the
business of banking. It is publicly known that a depositor receives interest on
the amount of money deposited in the bank, hence most depositors know that
they will be receiving a profit or advantage for the money deposited, making
it an investment by technical nature. Why is this distinction imperative in this
study? The legislation highlights the importance between the two, providing
much more protection and transparency to investors particularly in European
Union Directives.16 It is a fact that investors invest on a high-risk, high-reward
basis, hence the necessary protection needs to be provided, but a counter-
argument in favour of enforcing and calling out for enhancement in depositor
protection is that there is no information on the percentage of the depositor’s
assets that are being invested, since they are kept confidential by privatised
banks due to business competition. There is no information on how and where,
on a personal portfolio basis, these assets are being invested, creating a high-
risk situation for the individual out of which several financial crises have been
born. As argued by several accredited authors, such as Gary Gorton,17
depositors should be protected as much as investors due to the fact that capital
is still being raised for profit-generation by the bank, regardless of the risk
factor involved in such entrustment of funds.
Another question that arises from this definition is the question whether the
bank can fulfil its contractual obligations to its depositors. According to the
definition in the Banking Act, deposits are to be ‘withdrawable or repayable
on demand or after a fixed period or after notice,’18 creating an obligation to
be followed by the bank to do as such. Rothbard argues that by implementing
a fractional reserve banking system, a deposit bank becomes a loan bank with
the difference of taking money from the depositor’s account for profit-
generation while the depositor is still thinking that it is available on demand.19
The economist and philosopher Rothbard argued that the system was
inherently fraudulent and a Ponzi scheme in its very nature, supported by fake
receipts called ‘cash’ which are circulated and used for trade.20 Rothbard’s
critique on the system goes on to mention that naturally, in support of the
previously presented arguments, fractional reserve banking ‘creates money
out of thin air’,21 rendering a bank inherently bankrupt with the money that
14
Cambridge Dictionary <[Link]
15
Cambridge Dictionary <[Link]
16
European Parliament and Council Directive 2004/109/EC of 15 December 2004 on the harmonisation of
transparency requirements in relation to information about issuers whose securities are admitted to trading on a
regulated market and amending Directive 2001/34/EC [2004] OJ L390/38; European Parliament and Council
Regulation (EU) No 575/2013 of 26 June 2013 on prudential requirements for credit institutions and investment firms
and amending Regulation (EU) No 648/2012 [2013] OJ L176/1.
17
Gary B Gorton (n 7).
18
Banking Act (n 11) Article 2.
19
Murray N Rothbard (n 5) 94.
20
ibid.
21
ibid 98.
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should be available on demand and informed as such by the bank not actually
there.22 Several financial crises evolved over time due to these issues
discussed by the philosopher, as the argument on the banking system presents
a system of inherent fraudulency since the bank cannot meet its legal
obligations to all its depositors simultaneously. This could be seen in the Great
Depression between 1930 and 1932, where customers were fearful of the
bank’s solvency due to the stock market crash of 1929, and withdrew all their
money.23 Throughout the mentioned crises, banks were in a particularly strong
economic position, yet it still resulted in a fifth of the all the banks in existence
to fail,24 displaying a prime historical example supporting Rothbard’s
arguments. Another very recent and local example which supports Rothbard’s
arguments and the flawed system of fractional reserve banking is the recent
case of Kenneth Gauci,25 where Gauci was a bank manager who was employed
by a local bank for 32 years, in which a discovery of €1 million in fraud was
only recently discovered.
A counter-argument to Rothbard’s analysis is that banks do inform their
customers of the risks involved in opening an account, even locally the largest
banks in Malta have a page on their website26 highlighting risk factors while
showing a form of transparency on investments by showing their annual
reports and accounts.27 Therefore, as highlighted in the list of activities subject
to mutual recognition under Directive 2013/36/EU of the European Union28
the risk of the agreement is mutually recognised by both the depositor and the
bank. Michael S. Rozeff also counter-argues the inherent fraudulency
presented by Rothbard by basing his argument on the promotion of the
principles of liberty and the free market.29 The philosopher and finance
professor emphasises the importance of these principles in relation to the
reciprocal will of trade of the depositor and the bank. 30 The author goes on to
criticise Rothbard and his systematic believers while emphasising the lack of
criminality from fractional reserve banking by going into depositor property
rights. He argued that “Rothbardians” cannot prove their case due to a
22
ibid 99.
23
Brian Duignan (n 6).
24
ibid.
25
Jacob Borg, ‘How an HSBC Manager Perpetrated a Modern-day “€1 million” bank heist’ (Times of Malta, 30 April
2023) <[Link]
accessed 12 May 2023.
26
‘Managing Risk’ (HSBC) <[Link]
accessed 12 May 2023; ‘Deriving Value out of Managing Operational Risk’ (BOV Group)
<[Link] value-out-of-managing-operational-risk> accessed 12 May 2023; ‘APS Bank
Chairman Panellist at IFS Seminar’ (APS Bank 2022) <[Link]
panelist-at-ifs-seminar/> accessed 10 April 2023.
27
‘Annual Report’ (HSBC 2023) <[Link] announcements/annual-report>
accessed 12 May 2023; ‘Financial Reports’ (BOV) <[Link] accessed 23
May 2023; ‘Financial Information (APS Bank 2023) <[Link]
accessed 12 May 2023.
28
European Parliament and Council Directive 2013/36/EU of 26 June 2013 on access to the activity of credit
institutions and the prudential supervision of credit institutions and investment firms, amending Directive
2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC [2013] OJ L176/338.
29
Michael S Rozeff (n 9) 497-498.
30
ibid.
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transitioning of depositor assets to a depositor account where its property
rights do not necessarily include the storage of depositor assets in relation to
the free market and liberty.31 Rozeff proposes a full-consensus system where
the depositor has the final word hence eliminating the fraudulency of the
creation of money or money under two titles presented by Rothbard.32 Yet
there is another step – a step which should be implemented globally to mitigate
financial crime and even the simple temptation to do so – transparency on an
individual portfolio basis.
4. Transparency on an Individual Portfolio Basis: A Peek into
the Future of Financial Stability33
Transparency on an individual portfolio basis and actual legislation relating
to the issue could bring a borderline illicit and inflationary system tempting
financial crime into a legitimate and practical system in which a possibility
that the antithetical arguments presented by Rothbard and Rozeff could find
common ground from a philosophical, economic, and legal perspective. This
system could even justify the depositor compensation scheme,34 a borderline
unethical legislation providing untaxable compensation of up to €100,000
from taxpayer money if a bank system fails, while not forgiving customer
debts. By implementing ‘Individual Portfolio Transparency’, the bank can still
pool deposits but in a way where each customer deposit account is informed
where the money is being pooled for the individual investment to be made,
obliging mutual recognition to a further extent and reaching a common ground
while fortifying the principle of mutual consensus. This would justify
Rozeff’s, Rothbard’s and all other contrasting philosophers’ arguments on the
subject.
Counter-arguments include the amount of extra work administratively
involved in ensuring full compliance with the transparency guaranteed and
regulating business competition with other banks. The former counter-
argument is justified to a certain extent and an enormous backlog is at risk,
yet how is this system not even being discussed upon the recent
implementation of AI technology? And for the latter, if regulations and
legislation are all the same for all banks, then business competition is
eliminated by default on the subject matter, basing bank competition on
investment results and incentives provided. This systematic transparency can
eliminate any grey areas relating to fractional reserve banking which arose
throughout history and promote financial stability in a reciprocal and mutual
31
ibid 498-499.
32
ibid 499-500.
33
An implementation discussed with Dr Neville Gatt upon which the professor immediately approved yet stated that
it was ahead of the present time. The proposal for the formula necessary to maintain the operation of this system not
to mention the heavy bureaucratic process involved were deemed by Dr Gatt to be ahead of our present time, yet if
implemented, a common ground between the antithetical argumentations of the philosophers mentioned is
argumentatively attainable.
34
Depositor Compensation Scheme Regulations, S.L. 371.09.
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agreement where there is complete adherence to the law while resulting in
minimal temptation of embezzlement due to immediate detection. The system
in a way shares property rights, a sort of co-operative on individually
deposited money. It is a justified way for the ownership rights to be
established since the money needs to be available on demand contractually
upon request while being invested.
From the information presented in this paper, one can see how this
alternative presented can lead to financial stability and a banking system
shifting away from its grey and daunting past, with all its initial reverberations
and repulsions on implementation.
5. Conclusion
By the research provided in this paper, it has been determined that banks
have not necessarily used coercive tactics to gain trust from customers to
deposit their money but arguments on coercion have arisen due to an
illegitimate system, both in adherence to law in its written nature and from a
legitimate perspective. Banks are unable to fulfil their full contractual
obligations in the present system as seen throughout history, hence
determining the business illegitimate from this paper’s perspective. Yet with
the theoretical proposal of individual portfolio transparency, a glimmer of
hope is presented in a market which has no alternatives for the customer, the
fungibility of money is mitigated and a balance of the law is reached with the
doctrine of proportionality being implemented directly. With individual
portfolio transparency being the bridge between obedience and legitimacy and
also cutting out completely arguments on coercion in banking, contractual
obligations will be fulfilled completely while financial stability will be at its
peak upon implementation. The implementation of individual portfolio
transparency provides a differentiation from several critics of fractional
reserve banking whereby, instead of providing an alternative, critics tend to
choose between a 100% reserve system or a fractional reserve one, which was
not done throughout this study. The rationale for this being that a 100%
reserve system is never going to be implemented completely as a deposit
method with the vast majority of the public being used to the current banking
system and the ‘guaranteed safety’ that it provides.
