Banking safety was a big issue in the past as banks acted as the custodians of their customer's money. In fact, in common law holding an individual's money and utilizing as if belongs to you with the person's consent is fraud. A license provides banks with legal exemption from criminality charges in pursuing regular fractional reserve banking business. It makes it clear that you as the customer are agreeing to be one of the bank's creditors rather than the bank acting on your behalf as custodian of your money.
In the banking sector, there have been two distinctively different types of financial activity throughout history in what we call banking today. The first type was safely storing monetary deposits for merchants to protect their money from the daily inconvenience and risks of holding sums of money in their possession.
As coinage was developed, in the form of silver and gold fungible units, it enabled banks to make payments according to their customers' instructions through utilizing coins that did not necessarily have to be the original ones that were deposited.
And given the fact that the main business of merchants was the transportation of goods from one location to another, being able to make payments that were drawn against the funds of a merchant developed into one of the extensions of depository banking.
Deposits with London goldsmiths allowed them to issue notes to depository customers, which represented their deposits in part of the whole, and those notes start circulating between merchants in place of physical payments. Possessing a depository note showed evidence of ownership and circulation of the notes was the forerunner of paper money that is used today.
The second type of activity was when banks used either capital of their own or capital that was collected from others for the function specifically of making loans to merchants and farmers to facilitate the delivery and production of goods. There is a very important distinction between lending money and holding deposits. Lending money was loan finance, and holding deposits was a custodial function.
Loan finance doesn't have to be a banks function. In Roman and Grecian times, it was more commonplace for masters to lend money to individuals, and throughout the middle ages feudal superiors, or friends and family would do the lending.
Therefore, the main banks function was custody of money and expediting its use. However, as is always true with trust and money, the temptation for using the deposited money for different purposes without the owner's consent has been a recurring issue throughout banking history.
First of all, there was an underlying fraud, when a banker would take customer deposits and then lend them out for his personal enrichment. There could be substantial profits made this way, but there was always the risk that a customer may request a big withdrawal and the bank could not be able to meet it and the banker's action would be discovered.
When governments seized on the potential offered by banks for satisfying their continuous need for money, the fraud became even more complex. Governments pushed bankers into the loan the state money.
Bankers were given privileges by governments, which insulated them from legal consequences of their fraudulent behavior. Periodically, repeated government bankruptcies would force bankers to reform their actions and behavior, and return to sound money practices.
However, it never lasted, and the relationship between the banks and law-creating governments allowed the banks to operate in ways that fluctuated between deceit and honesty.
The foundation of our current government-sponsored system is the 1844 Bank Charter Act. The note-issuing function was transferred gradually to the Bank of England from private banks, which ceased all of its commercial activities. This Act instituted strict controls on note issues from the Bank of England and required gold to back every each extra pound sterling.
At this point in time, bank credit expansion was not viewed as increasing quantity of money. It was only much later that monetary economists came to that consensus. As a consequence, there wasn't any credible challenge mounted to banks that issued credit that was not backed by gold, which did not have the same gold restrictions that the note issues from the Bank of England's hand. Therefore, both unsound and sound money existed right next to one another with little distinction being made between the two.
So, based on precedence and ignorance, fractional reserve banking evolved as Britain and its empire's operational standard. Given that international trade during the second part of the nineteenth century was dominated by Britain, it emerged as the international standard as well for the entire world's banking industry and is still current.
The important distinction of making loans and taking deposits being fundamentally different functions has been lost on modern day banks service. In order for sound-money to exist, there has to be a separation between those two functions. This separation was lost after the 1844 Act.
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