Part 2 – Is your bank honest, or fraudulent

Lee Friday

I recommend reading Part 1 before reading this essay

When the free market had a large degree of control over money, the nature of a bank was much different. A bank performed two functions. One function was to provide a secure storage facility. Customers brought their gold (or silver) to a bank for safekeeping. The bank put the gold in the vault, charged a small fee for the service, and gave each depositor a paper receipt (aka ‘bank note’) for the amount of gold deposited. Each receipt represented a claim on the gold by the bearer (whoever is in possession of the receipt). This was known as a demand deposit.

The receipts were fully redeemable, meaning anyone could simply present a receipt to the bank at any time and retrieve (demand) the quantity of gold specified on the receipt. However, people seldom redeemed their receipts because they were able to use them for payment of goods and services. It was easier to carry receipts in their pockets rather than the heavier gold coins. This idea developed on the market and it was a good idea, but it only worked if people were confident they could retrieve their ‘money’ (gold) any time they wished. It is important to remember that gold was money, and paper receipts were ‘money substitutes’.

The second function of the bank was to make loans, but only if a depositor agreed, in writing, to surrender her gold for a specific period of time – a time deposit (a loan to the bank). The depositor was promised a portion of the loan interest which the bank would receive from the borrower, but would not be given a paper receipt, obviously giving up the right to retrieve her gold until the loan was repaid. The depositor also understood the gold could be lost if the loan was not repaid, but would take this risk if she had faith in the banker.


It was a very efficient system, but the world is not perfect and some bankers were dishonest. Some of them made loans through the issuance of gold paper receipts, but without the gold in the vault to back it up. No one had made ‘time deposits’ of gold to allow for these loans. Thus the quantity of ‘money substitutes’ in circulation exceeded the quantity of money (gold) in the bank vault. The banker was no longer capable of redeeming all the paper receipts because he did not have enough gold reserves in the vault.

This fraudulent action came to be known as ‘fractional reserve banking’, otherwise known as counterfeiting. A dishonest banker did this because he figured he could easily steal interest on gold that did not exist, because he knew that people rarely brought receipts to the bank for redemption. When he saw that his scheme worked, the banker increased his fraudulent loans. The inflated supply of his paper receipts eventually resulted in higher prices for goods and services, exactly like today when banks create new fiat money by making loans (to be discussed in Part 3)

When the market controlled money, people quickly figured out the cause of rising prices, identified the culprit and hurried to the bank to redeem their receipts. This is called ‘a run on the bank’. The bank returned all the gold it had in the vault, but latecomers did not get their gold back, which meant the banker might be faced with an angry mob. He would be prosecuted or run out of town, if he was lucky.

The lesson is that when the market has control of money, people are more aware of what constitutes honest money, enabling them to detect incidents of counterfeiting, address the problem and move on. Some people lose money, but ‘market control’ minimizes the damage and encourages development of new safeguards.


Government has only two choices in the matter. It can morally support the market or it can immorally support the bankers. There is no moral compromise. Banks had a contractual obligation to redeem their receipts on demand. When a bank issued a receipt without the metal to back it up, the contract was broken. When the theft was discovered, the moral role of government would be to enforce contracts, thereby protecting citizens’ property. Prosecution of bankers through the justice system in order to obtain compensation for victims would not only repair the harm done, but also discourage the counterfeiting activities of other banks. In fact, this is supposed to be the raison d’etre for all democratic governments – the protection of the lives and property of citizens.

However, throughout history many governments frequently granted banks the right to refuse redemption and continue doing business. The government’s motivation was clear. They wanted to legalize counterfeiting[1] in exchange for a share of its fraudulent benefits – the public be damned! As economist Jesus Huerta de Soto wrote in Money, Bank Credit, and Economic Cycles:

. . . the gradual discovery authorities made of banks’ immense power to create money explains why, in most instances, governments ended up becoming accomplices to banking fraud, granting privileges to bankers and legalizing their improper activity, in exchange for the opportunity to participate, directly or indirectly, in their enormous profits. In this way they established an important alternative source of state funding. Furthermore, this corruption of the state’s traditional duty to define and defend property rights was encouraged by governments’ enormous, recurrent need for resources, due to their historical irresponsibility and lack of financial control. Thus, a more and more perfect symbiosis or community of interests was formed between governments and bankers, a relationship which to a great extent still exists today.[2]

Economist/historian Murray Rothbard recognized the State’s complicity when he wrote about the supposed failure of free market banking:

. . . the banks realized that they need have no fear of bankruptcy after an inflation, and this, of course, stimulated inflation and “wildcat banking.” Those writers who point to nineteenth century America as a horrid example of “free banking,” fail to realize the importance of this clear dereliction of duty by the states in every financial crisis.[3]

This is a classic bait-and-switch. Banks advertised their receipts as being fully redeemable (the bait). Then they used the force of government to fraudulently inflate the quantity of receipts (the switch). This reduced the value of money in the hands of the masses, while benefiting the banks and government.


Banks accept deposits and extend loans.

We deposit most of our money in a bank because we don’t want to keep it in our wallets or under the mattress. We expect banks to keep our money secure and safe, and we should expect to pay a fee for this service. The bank is performing a simple safekeeping service; or to put it another way, you are paying a fee to the bank for the use of its vault. This is called a ‘demand deposit’ – you may demand the return of your money at any time and the bank will oblige. You may pay additional fees for other bank services, such as the processing of checks and electronic payments in and out of your account. The crucial point is that the total amount of cash in the bank vault must always be equal to or greater than the total amount of money recorded in all customer deposit accounts at the bank.

If you wish to receive interest on your deposit, this becomes possible only if the bank has a customer who wishes to borrow money. Let’s assume the bank has such a customer, as is often the case. In this scenario you are not depositing your money for safekeeping, so you do not pay a fee. You are making a ‘term deposit’, which means you are lending money to the bank for a specified term. This term will match the term of the loan to the bank’s customer. You will not have access to your money until the end of the term when the loan is repaid to the bank. The bank collects interest from the borrower, retains a portion of this amount, and repays your money plus the amount of interest you were promised.

The bank acts as a financial intermediary (broker) when it contracts for loans and term deposits. All parties sign contracts specifying the terms of their respective loans. A wise banker with a keen understanding of the business world would experience very few loan defaults, thereby enabling him to repay all ‘term depositors’, plus interest, while still making a decent profit. That’s how a banker builds a good reputation and attracts customers. The banker is engaged in a legitimate occupation which helps to redirect the savings of some people into the productive activities of other people.

That describes the operations of an honest bank. A banker who deviates from these practices, such as using money from ‘demand deposit’ accounts to make loans, pay expenses, or for any other reason, is not an honest banker – he is guilty of theft!

Honest banks have enjoyed prominence at various times throughout history. Unfortunately, it is virtually impossible to find one today.


Banks accept deposits and extend loans. The particular execution of these activities is what defines a bank as either honest or fraudulent. We have seen how an honest bank conducts business according to simple concepts. The operations of a fraudulent bank are more complex – necessarily complex given the inherent fraud. In other words, the fraud requires a degree of complexity, and the complexity helps to disguise the fraud.

There is more than one way to create a deposit. One method involves a customer walking into a bank to deposit cash or a cheque into her account.

The other method is through the making of a loan. Most people are unaware that banks are legally permitted to create money – fiat money – out of thin air.  When a bank makes a loan, it creates money which did not previously exist.[4] When the borrower repays the loan, the bank keeps the interest and extinguishes the principal, as if it never existed. That is how banks operate in Canada, and that is how they operate in most other countries.

When a bank makes a loan, it makes two bookkeeping entries:

The first entry is a debit entry (the asset entry) in the loan account of the borrowing customer

The second entry is a credit entry (the liability entry), as a deposit in the checking account of the borrowing customer.

When the loan is repaid, the bank makes a ‘credit entry for the principal amount’ in the loan account of the borrowing customer. Thus, the money is extinguished. Destruction of the principal amount is logical given the nature of the fraud. The banker did not borrow this money from anyone. The money was initially conjured up, and now it disappears. The whole point of the scheme is to fraudulently extract interest from the unsuspecting borrower – when the loan is repaid, the bank keeps the interest, which it records as income.

The bank has created money out of thin air, or if you prefer, it created a deposit out of thin air, and a deposit created out of thin air is obviously not balanced by an equal quantity of cash in the bank’s vault. Therefore, the bank still wants, and needs, our deposits of actual cash. Banks need to hold enough cash in their vaults in order to satisfy occasional customer requests for cash withdrawal; however, vault cash represents only a tiny fraction of total deposits – an obvious effect of creating deposits out of thin air.

Banks are not permitted to print physical cash. This function is usually reserved to the Central Bank,[5] which limits the supply of physical cash, an arrangement which suits the commercial banks just fine because all these players are part of the same monopoly, together with the government.

Bankers do not go around bragging about how they earn enormous profits through the creation and destruction of money. To be sure, they announce their profits on a quarterly basis, but they never speak about how the government sanctions their magical tool of money creation. However, the mechanics of their devious scheme are easily discovered by anyone wishing to do the research – it is commonly included in economics textbooks, but you don’t even need the textbooks. There are many sources on the internet. Despite the fact it is not a well kept secret, the general public – including many branch managers of banks – remains largely unaware that fraudulent activity is the main occupation of bankers.

I encourage you to do your own research, but it should suffice to research your own memory. The proof lies in the memories of most adults if they take the time to reflect on their personal banking experiences. Many people have been denied loans from banks because they lack sufficient collateral, or a job which provides enough income to cover the monthly payments. Loans may also be denied when banks adopt more stringent lending standards, a typical response when there have been many loan defaults during tough economic times. However, have you or anyone you know ever been denied a loan because there is not enough money available? Has a bank ever said “You qualify for the loan and we would like to give you the loan, but we do not have the money because we have not received enough customer deposits.” No one alive today has ever heard a bank loan officer give this explanation for refusal of a loan. If you qualify for a loan, the bank will create the money.

A bank is technically insolvent if the cash in its vault is less than the total quantity of money recorded in the deposit accounts of its customers. This describes the status of virtually every bank today. If all bank customers requested cash withdrawal, no bank would be able to comply. Banks promise to return our cash but it is an empty promise. It is a promise based on their expectation that very few of us will actually request cash withdrawal. In other words, banks expect only a few of us, not all us, to hold them to their promise, yet they make the promise to all of us. This is fraudulent banking sanctioned by the state.

Fraudulent banking generates enormous profits for bankers. However, other than their inability to honour cash withdrawal requests from all depositors, how exactly do banks’ fraudulent activities harm the general public? This is an important question, as the harm to the general public is considerable. We will address this in Part 3.

Perhaps you are not concerned about insufficient cash in the bank vault because you are covered by government deposit insurance, which is administered through the CDIC in Canada, and the FDIC in the U.S. Such government insurance creates a false sense of security. This will also be addressed in Part 3.

Go to Part 3


[1] Of course this required governments to redefine counterfeiting in order to pursue and prosecute those who dared encroach on the government/bankster ‘legalized’ money monopoly turf.

[2] Jesus Huerta de Soto Money, Bank Credit, and Economic Cycles (Third English edition, Ludwig von Mises Institute, 2012) p. 39

[3] Murray N. Rothbard What Has Government Done to Our Money? and The Case for a 100 Percent Gold Dollar (Ludwig von Mises Institute, 2005) p. 79

[4] Banks also borrow money which they in turn lend to others, although the terms often do not match. They are notorious for borrowing on a short term basis and lending on a long term basis. This is an irresponsible, risky activity. The bank must attempt to renew the short term loan when it matures, or borrow money elsewhere. If the interest rate on the new short term loan is higher than the long term loan, the bank faces a considerable loss, which can trigger a bailout at taxpayer expense. Such risky activity is widespread in the banking business. However, this is not the type of activity which we are presently considering. Our focus at the moment remains with the loans where the bank creates money which did not previously exist. This activity is also widespread, and massive.

[5] Some of the Central Banks: Canada – Bank of Canada; U.S. – The Federal Reserve; U.K. – Bank of England; 19 Eurozone countries – European Central Bank

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