The State and 100 Percent Reserve Banking

by | Apr 6, 2012

Free bankers have been fighting a war on two fronts. On one they face champions of central banking and managed money. On the other they struggle against advocates of 100-percent reserve banking.

Free bankers have been fighting a war on two fronts.  On one they face champions of central banking and managed money.  On the other they struggle against advocates of 100-percent reserve banking.  Although the second front is a lot smaller than the first, it’s far from being unimportant, in part because the battle there is being fought against people who generally favor free markets, who might have been expected to join rather than to oppose our cause.

They oppose it for a variety of reasons, one of which is their belief that, in a truly free-market setting, fractional reserve banking wouldn’t survive.  Instead, they insist, 100-percent reserve banks would prevail.  That they haven’t is due, in their opinion, to a banking industry playing field slanted in favor of favor fractional-reserve banks, especially by either implicit or implicit deposit guarantees financed through forced levies upon all banks, and sometimes by taxation or inflation.  In short, fractional-reserve banking has been nurtured by government subsidies.

Free bankers have tried responding to this argument by noting how fractional reserve banking has prevailed under every sort of bank regulatory regime, from the earliest beginnings of banking, not excepting regimes that involved very little regulation, like those of Scotland, Canada, and Sweden, and that lacked even a trace of government guarantees or other sorts of artificial support.  But since some 100-percenters seem unmoved by this approach, I here take a different tack, which consists of pointing out that every significant 100-percent bank known to history was a government-sponsored enterprise, which depended for its existence on some combination of direct government subsidies, compulsory patronage, or laws suppressing rival (fractional reserve) institutions. Yet despite the special support they enjoyed, and their solemn commitments to refrain from lending coin deposited with them, they all eventually came a cropper. What’s more, it was these government-sponsored full-reserve banks, rather than their private-market fractional reserve counterparts, that were the progenitors of later central banks, starting with the Bank of England.

So far as records indicate, the very earliest banks were private institutions that began as sidelines to other businesses.  The very first bankers may have been the trapezites or money-changers of ancient Athens, or their later Roman counterparts.  But the earliest concerning which any details are known were the “banks of deposit” that arose during the 12th century in Italy, especially in Genoa and Venice, and the record clearly indicates that these banks were credit-granting institutions rather then mere coin warehouses.  Indeed, it was almost inevitable that they should have been so, because in order to efficiently undertake to make payments by bank transfer, and so spare their clients the necessity of dealing with the shoddy coins then available, they were bound to promise to return on demand, not the very coins deposited with them, but coins of equal value, which in effect meant becoming debtors rather than bailees.  Moreover, overdrafts were bound occasionally to result in credits in excess of cash reserves, while the interest to be earned from additional lending allowed bankers to reduce the fees they charged for their payment services, and even to occasionally pay interest on their “deposits.”   In any event the lending was never concealed.  In London goldsmith banking took a similar course, though not until the mid-17th century.  In short, so far as records indicate, all of the earliest private banks operated on a fractional-reserve basis.

Banking in the medieval and renaissance period was a notoriously risky business, so despite typically holding reserves of roughly a third of their deposits private banks often failed.  It was partly in response to these failures, and partly out of fiscal motives, that governments first began venturing into the banking business, by establishing so-called “public” banks, which though government-sponsored were otherwise supposed to operate according to what we might call “Rothbardian” principles, offering a combination of payment and metallic-money custodial services, but without engaging in any lending.  The first such bank, Barcelona’s Taula de Canvi, was established in 1401 with the promise that it would be a safe place to store coin.  In fact the government intended from the start to draw on its resources to fund the city’s debt, and merchants saw through the scheme.  The government then responded by awarding the Taula a monopoly of demand deposits.  Still many merchants refused to take the bait, which was just as well since the government eventually drew so heavily upon the Taula that it went bankrupt.

Although Venice’s first public bank, the Banco di Rialto established in 1587, was modeled after the Taula, it actually did operate on a 100-percent reserve basis for some time, and was for some years Venice’s only bank.  But far from having out-competed fractional reserve rivals on a level playing field, the Rialto Bank had its operating expenses, including normal returns, covered by customs duties, and was only for that reason able to offer risk-free payment services in exchange for only modest fees.  Still the bank’s days were numbered when a rival public bank, the Banco del Giro, was established in 1619, and was initially allowed to operate on a fractional reserve basis. The new bank absorbed its full-reserve rival in 1637, and thanks to continued government demands upon it never did manage to convert to a 100-percent reserve basis.  On the contrary: it twice had to suspend payments, in each case for many years.

The most famous of the public 100-percent reserve banks, the Bank of Amsterdam, is also the one most often cited as proof of the viability of that form of banking.  But here again, a close look suggests that the proof is no proof at all.  For starters, in establishing the Bank of Amsterdam in 1609, the Dutch government also banned the city’s private “proto-bankers”—the analogues of Venice’s medieval money changers and London’s 17th-century goldsmiths—essentially giving the public bank a monopoly of non-coin payment services.  The government also required that all bills of exchange worth 600 guilders or more be settled on the new bank’s books.  Finally, rather than being true demand deposits, readily convertible into coin at no penalty, deposits at the Wisselbank could be converted into cash only for fees of up to 2.5% of withdrawn amounts, thus allowing it to cover its expenses while also earning a tidy profit without having to make any loans.

Yet, notwithstanding the widespread contrary belief and its solemn promise to “store” all deposits lodged with it, the Bank of Amsterdam did make loans.  It did so, first of all, by allowing overdrafts.  More importantly, it eventually did so, to a far greater extent, by making advances to the municipal government and to the Dutch East India Company.  During the 1650s, for example, the city of Amsterdam borrowed a whopping 2 million guilders, which it never repaid; and after 1684 loans persistently amounted to 20 percent or more of the Bank’s total assets.  Finally, in 1790, the failure of the bank’s heavy (and, as usual, clandestine) loans to the then-struggling East India Company forced it, in effect, to devalue most of its deposits by 10 percent, while altogether refusing to repay any of less than  2,500 guilders.  At last, when the French invaded Amsterdam and got hold of the Bank’s books, these revealed that its reserves had fallen to less than 25 percent of its liabilities, with the Dutch East India Company alone owing it a grand total of 11 million guilders.  Release of the last statistic at once caused the Bank’s famous bullion “receipts,” which were (since an 1683 reform) the only Bank liabilities that could actually be redeemed, to fall to a 16 percent discount.

The passing of the Bank of Amsterdam marked the end of governments attempts to establish, or to pretend to establish, 100-percent reserve banks, and therefore marked the end of all significant instances of that sort of banking.  Yet it was far from being the end of government involvement in the banking business, for the early “public” banks, and the Bank of Amsterdam especially—thanks in part to the myth of it’s always having been solid—were the direct inspiration for another breed of government-sponsored banks, the prototype of which was the Bank of England.  Where that development has taken us is too well known to be worth restating here.  But let it not be forgotten that it all started with the cry that the public ought not to have to deal with fractional-reserve banks.

George Selgin is a Professor of Economics at the University of Georgia's Terry College of Business. He is a senior fellow at the Cato Institute. His writings also appear on His research covers a broad range of topics within the field of monetary economics, including monetary history, macroeconomic theory, and the history of monetary thought. He is the author of The Theory of Free Banking, Bank Deregulation and Monetary Order, and several other books. He holds a B.A. in economics and zoology from Drew University, and a Ph.D. in economics from New York University.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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