The bank account: a surprisingly complicated financial instrument

The bank account: a surprisingly complicated financial instrument

This topic isn’t related to any particular share, but I thought it might be worth a blog post nonetheless.

It’s a topic which most people, even within finance, don’t give much thought to. The topic is: what is a bank account?

You know what I mean: the humble current account, or the instant-access savings account.

To the man on the street, it’s a place to put your money for safekeeping, until you need to use it for something.

This is sort of true. But it’s incomplete. It might even be a misunderstanding, and occasionally a tragic one.

What everybody should understand (but they don’t) is that the money you put in your bank account is not yours: it’s the property of the bank. Indeed, the £100 that you put in your bank account isn’t there. It’s been lent out to somebody else, is being used to fund the construction of a bridge somewhere, or was given out to a banker for their Christmas bonus.

All you have is a piece of paper, or an online statement, saying that the bank owes you £100.

When you put it like that, it sounds less attractive, doesn’t it?

And furthermore, there are conditions attached to repayment. If you try to move large sums of money via ATM, online, or even in your local branch, you might find that there are delays and complications.

Indeed, crossing over a transfer limit this week is what got me thinking again about this topic.

Economists of the Austrian School (see here) are inclined to argue that the practice of fractional reserve banking is inherently wrong. They argue that banks should have 100% reserves, i.e. that when you put money in a demand deposit, it should not be used by the bank. Instead, it should be kept secure for the  benefit of the account holder. The legal term for this is bailment.

While I see some merit to this point of view, I can’t fully endorse it. The fact that mainstream banks engage in fractional reserve banking is not hidden. It is easily discoverable by anyone who chooses to look into it. There is no promise of a “bailment” when you open an account with a mainstream bank.

I concede that banks could be more open about it. But I still don’t think it’s right to say that bank customers are being hoodwinked. They might not entirely understand the nature of the product they are using, but the same could be said of many products. Fractional reserve banking is not exceptional in that sense.

Austrians will argue that there has been no “meeting of the minds“, since banks know that they operate a fractional reserve, and many of their customers do not. They therefore believe that the agreements between banks and their customers in relation to current accounts are legally void.

What do I think? Rather like I said in my recent article on insurance, I believe that knowledge is power. We need to understand the nature of the contracts we enter into, so that we can make the right decisions.

So here’s a working definition for current accounts (assuming that they aren’t overdrawn) and other types of demand deposits. The borrower is the bank, and the bank customer has the put option:

“A demand deposit is a puttable loan of no fixed maturity, which may be extended to the borrower in any quantity and at any time, and whose put option may be exercised in any quantity and at any time in exchange for par value (subject to certain terms and conditions, as defined by the loan agreement).”

Unfortunately, this exact definition won’t be much use in explaining the topic to the man on the street.

But in simple terms, a demand deposit is just a loan to your bank.

What’s special about it is the put option: the right to get rid of it in exchange for cash, i.e. to sell it back to your bank, whenever you wish.

That’s how a put option always works: you have the right to sell the thing, if you want. But you don’t have to. You can let the bank have the loan for as long as you wish. It’s entirely up to you.

I think all of us can agree that a bank account is a surprisingly complicated financial instrument. But I’m interested to know what you think. Let me know in the comments!



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    All you have is a piece of paper, or an online statement, saying that the bank owes you £100.

    When you put it like that, it sounds less attractive, doesn’t it?

    Except that that “loan note” is backed by the government up to £85,000 – which is why so many have to go through the rather silly process of opening multiple bank accounts with unconnected banks to, hopefully, ensure that their deposits really are safe.

    I’m not convinced that there are many people who think their money is somehow ringfenced and 100% safe when deposited with any bank (remember all those queues outside Northern Rock). Hopefully anyone with more than £85,000 in cash is sufficiently financially astute to appreciate the risks involved, even if many might consider those risks slim.

    As for problems in moving large sums – I’m rather glad that there are hoops to be jumped through – at least if my account is hacked or card(s) stolen the amount I might lose (even if only temporarily) is limited.

    Off topic:- is there a way to see the formatting of posts before submitting? The above should have some paragraphing but I can’t see it. Hopefully it might appear as meant.

    • comment-avatar

      Great points, Laughton. Thanks for the input.

      On your off-topic point: our developers are (as we speak) researching a new comment system, which should give us a much nicer view of comments when we are typing. This has been requested before and I hope to deliver.


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