A Challenge to Banking

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SECTION ONE - Dishonest Money

The Mechanics of Misrepresentation

A hundred years ago, a Mr Goldsmith opened Anybank. His first depositor, Mr Sure, came in to lodge a gold coin for safekeeping. Mr Goldsmith gave him a receipt. Mr Short then came in, to borrow a gold coin, to buy a horse from Mr Trainer. In exchange for his horse, Mr Trainer accepted the gold coin from Mr Short. He took it to Anybank, and lodged it with Mr Goldsmith, who gave him a receipt. A normal set of transactions when the gold standard existed.

The strange thing about this story, however, is that Mr Goldsmith had issued two receipts, yet he had only one gold coin. Both receipts were available for use in the market-place. Yet only one gold coin actually existed against which Mr Trainer and Mr Sure could validly claim. The market-place will, therefore, have been led to believe that there was one more gold coin in existence than there was in reality. So the mechanisms of misrepresentation are created.

Let me take you back to the beginning of banking, to see better how this came about. Our present system is a direct descendant from the money-lending practices of the early goldsmiths. Suppose we were back in the days when trade was in its infancy, and the gold standard was just beginning, and you had some gold you wished to store. You would have several choices.

You could keep it on your person at all times: with one gold coin this would pose no serious risk. If, on the other hand, you were a wealthy goldsmith, who had large quantities of gold to store, you might require and could, perhaps, afford to build a strong-room. But, if you were in the middle, and had too much gold to carry with you at all times, but not enough to warrant constructing your own strong-box or strong-room, you might well choose to arrange with a goldsmith to store your gold on one of the shelves in his strong-room. (In those days a shelf was known as a 'bank', hence the derivation of today's word.) The goldsmith concerned would then issue you with a receipt: a valid claim against your portion of the gold in that goldsmith's strong-room.

This, of course, is what happened historically. It was, then, a natural step for holders of goldsmiths' receipts to begin to use them in exchanges, rather than using gold itself. It avoided the risk of carrying gold to the marketplace. To facilitate trade the goldsmiths - or "bankers" as they became known - began to issue standard receipts for specified amounts of gold. These receipts were issued for amounts known commonly to be used in exchanges. So, when anyone took his gold to be stored he would be given a number of small value receipts for it.

The integrity of the banker was crucial to the acceptance of these receipts: the banker had to intend to, and be able to, honour each receipt. If he had issued receipts for more gold than he possessed, he would be unable to honour all the receipts issued. Some holders of his receipts would then not be able to retrieve the gold they claimed, or all would receive less than the full value of their receipts.

No paper claim or receipt is valid without this fundamental relationship. If the gold is not there, then the face value of the paper becomes irrelevant. Similarly, if the issuer's intent is suspect, then so is the claim, and that suspicion will be reflected in the way that the market-place receives his receipts.

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Invalid claims

Yet there are many factors which can cause a goldsmith's receipt to be worth less than it claims to be. One is a robbery. Robbery will result in insufficient gold to meet all claims. Genuine robbery cannot be held to be the goldsmith's fault. There are, however, four factors which can be a result of the goldsmith's deliberate actions:

1. The goldsmith might have created receipts against which no gold had been received, and used for them personal exchanges in the market-place.
2. He could have used some of the gold, against which receipts had already been issued, for personal exchanges in the market-place.
3. He could have created receipts against which no gold had been received, and lent these receipts to someone else.
4. He could have lent somebody else some of the gold against which receipts had already been issued.

Each of these actions would clearly have led to an imbalance between the amount of gold actually available to honour receipts and the amount for which receipts had been issued. In each of these cases, the action of the goldsmith would have been self-serving and deliberate. No doubt some goldsmiths tried each.

The difficulty, of course, lies in knowing when they do it. If one has no access to the goldsmith's accounts, changes in the goldsmith's personal spending patterns would be the only indication that he might be using the client's gold for personal benefit. Depositors, therefore, had to remain alert to spot any significant changes in a goldsmith's lifestyle. Should any such change cause a doubt to arise, the only way of proving the goldsmith's ability to meet his issue is for all of his receipts to be presented at the same time. If they are honoured, his good faith will be proven.

Loans, however, have always been treated as confidential matters. It is not as easy, therefore, to observe the changes in a goldsmith's behaviour when he is using other people's gold to make loans, or lending receipts created without a gold deposit behind them. Such arrangements would only be of direct concern to the borrower and the goldsmith. Provided that the goldsmith behaved in a very circumspect manner, the only immediate change in consumption patterns would be in those of the borrower. (To avoid runs on their deposits which might test their ability to meet all of the receipts which they had issued, goldsmiths and their descendants, now known as bankers, have cultivated a reputation for circumspect and prudent behaviour.) The goldsmith would, however, have both betrayed trust and directly benefited.

Lending lies at the heart of current misrepresentation. The pattern of effects which flows from the practice of money-lending can be very insidious indeed. The practice itself warrants closer examination.

One of the most immediate effects of lending is that the market-place is led to believe - unjustifiably - that there is more gold available to serve its needs. If we look again at what happened when Mr Short wanted to buy a horse, Mr Trainer and Mr Sure each held a separate receipt against the same gold coin: a misrepresentation of fact. This misrepresentation is obscured by a normal accounting practice:

The books would thus have appeared to balance, whereas in reality Mr Goldsmith would have issued receipts for one more gold coin than in fact he had. This imbalance would have been clearly identified had the accounts read:

The nature of any collateral held by the bank is irrelevant. Whatever it is, it will not be a gold coin, or the loan would not have been necessary. Nor can it become a gold coin. At most it can be exchanged for a gold coin. But an exchange does not produce another coin. It merely changes ownership of an existing coin.

So, it is clear that a fault exists in the money-lending function of the banking system. The very mechanics of the lending process produces misrepresentation: it is dishonest. Yet it has become an accepted practice. It has been legitimised.

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