“To some extent, commercial bankers lend out their own capital and money acquired by CDs (certificates of deposit). But most commercial banking is “deposit banking” based on a gigantic scam: the idea, which most depositors believe, that their money is down at the bank, ready to be redeemed in cash at any time. If Jim has a checking account of $1,000 at a local bank, Jim knows that this is a “demand deposit,” that is, that the bank pledges to pay him $1,000 in cash, on demand, anytime he wishes to “get his money out.” Naturally, the Jims of this world are convinced that their money is safely there, in the bank, for them to take out at any time.” Murray N Rothbard, ‘Fractional Reserve Banking’.

When my friend Jim asked my reaction to this quote, I said that I didn’t know that he knew Murray Rothbard. Jim replied: “I didn’t know that he knew me, but I think he is making a good point.”

I asked Jim whether he thought most people really believed that banks were like warehouses that kept the money deposited with them until people wanted to withdraw it. Jim said: “Most people know that banks lend the funds deposited with them to other people, but the point is that banks do promise to repay deposits on demand. They know that they can’t keep this promise if everyone wants their money back at the same time. Banks shouldn’t be allowed to make promises they can’t keep.”

I tried to argue that the financial system generally works well even though exceptional circumstances can arise where financial intermediaries make promises that they cannot keep. I suggested that it is very rare for situations to arise when a high proportion of borrowers do not meet their commitments and the value of the security held by banks falls below the value of loans outstanding.

Jim said: “Look, you can’t pretend that these situations where banks can’t keep their promises occur so infrequently that they should be ignored. Democratic governments don’t just look the other way when banks go bust. Do you think that the best solution for this problem is for governments to get involved by offering deposit insurance, guarantees that banks will not be allowed to fail and close supervision and regulation to ensure that such guarantee do not result in irresponsible behaviour? Don’t you see that this government intervention has arisen because banks are allowed to make promises that they can’t keep.”

I asked Jim whether he was suggesting that instead of promising to repay deposits on demand, banks should convert themselves into unit trusts. That would mean that the amount that investors could get back on demand would vary according to the market value of the financial institution’s loan portfolio.

Jim replied: “I don’t think many people would view that system as a good substitute for conventional bank deposits that are repayable on demand. What I have in mind is that a bank would specify in its agreement with depositors that in the event that it could not meet its promise to repay deposits in full within, say, a month of the request being made, then equity holdings in the bank would immediately be canceled and re-issued to depositors in proportion to the nominal value of their deposits. The former depositors could decide whether they wanted to liquidate these equity holdings immediately by selling them on the stock market, or to hold on in the hope that the bank’s financial situation would improve.”

I have been thinking about Jim’s proposal. I do not imagine that the conversion of deposits in a troubled bank into equity holdings would be as quick and simple as Jim envisages. Nevertheless his proposal seems to me to be preferable to the current shambles that has arisen as government regulators have sought to substitute their assurances for dodgy promises that financial institutions are not able to keep.