Legal Character of Bank Obligations
The character and substance of bank obligations under contracts such as bank notes and customer deposits determines whether or not fractional or 100% reserves are required. This is helpfully captured by Barnett and Block (B&B) in their framing of the two possible types of banks:
'some banks in such a system would attempt to act not as bailees (100 percent reserve banks), but rather as depositories (fractional-reserve banks), their obligation being limited merely to redeeming on demand, and in specie, any demand notes or deposits they had previously issued to customers.' (emphasis added)
Thus B&B characterise the type of banking they favour, i.e. '100% reserve banking' as being legally structured as bailor-bailee relationships, i.e. the customer is the bailor and the bank is the bailee, thus the bank is obligated to hold the money separately from its own assets, and store it rather than invest it in interest bearing assets. Alternatively, fractional reserve banks they characterise as debtors, with the position of the customer being that of unsecured creditor.
This structuring of the controversy is most helpful: it shows two legally recognised forms of contract, and enables us to resolve the issue by examining the legal form of bank notes and customer deposits on current account and determine which treatment should be applied. It also implicitly favours the rights of banks and customers to choose the transaction type that they believe will better meet their needs.
Bank notes are the bearer form of bank-issued money and can be used to facilitate transactions where interaction with the bank is either not desired or more costly for the parties to the transaction and/or the bank. As with metallic coins, bank notes pass from hand to hand as consideration for goods or services or as settlement for debt (if accepted), however unlike metallic coins, bank notes are not legal tender for debts.
Bank Notes are Promissory Notes
Bank notes have traditionally been documented in the form shown in the image below:
Examples of this and similar wording can be found on the bank notes of all the present note issuing banks in England (Bank of England), Scotland, Northern Ireland and Hong Kong, as well as almost all historical examples.
The important elements of the document text are: An unconditional promise in writing signed by the maker engaging to pay a sum of money on demand to the bearer of the document.
These elements cause the document to fall within the definition of a promissory note:
A promissory note is an unconditional promise in writing made by one person to another, signed by the maker, engaging to pay on demand, or at a fixed or determinable future time, a sum certain in money to or to the order of a specified person or to bearer. (Bills of Exchange Act 1908(NZ), section 84 (1) see http://legislation.govt.nz/act/public/1908/0015/latest/DLM138268.html#DLM138268)
Contemporary bank notes may omit some of the elements above:
• The document may not be specifically payable to bearer, however under negotiable instrument law if the payee is fictitious or non-existent person, the instrument is payable to bearer
• The document may not state when it is payable, however under negotiable instrument law if no time is specified for payment, the instrument is payable on demand
• be described simply as a note, without the ‘promise to pay’ which is nevertheless implied
Nevertheless they normally retain the instrument in writing, signature, maker’s name and amount payable.
What makes a bank note different from other promissory notes? A bank note is:
1. issued and made in regular denominations
2. issued or made by a bank rather than a non-bank
3. payable on demand, and
4. payable to bearer.
Support for this definition can be seen from the Banking Ordinance 1960 (Samoa):
"Bank note" or "note" means the instrument commonly known as a bank note, that is to say: a promissory note (in whatever form or by whomsoever drawn or made) issued by a bank and entitling or purporting to entitle the bearer or holder thereof, without endorsement, or without any further or other endorsement than may be thereon at the time of the issuing thereof, to the payment on demand of the sum named therein, not exceeding the sum for which the bank may lawfully issue any such note; (see http://www.paclii.org/ws/legis/consol_act/bo1960125/)
The reasons for each element of the definition are:
1. it has to be a issued and made in regular denominations so that it will be easy to count and make change,
2. it has to be issued or made by a bank because of economies of scope between account and cheque banking and the business of issuing notes to circulate as money, and because banks can have the required credit standing to achieve circulation of their notes
3. it has to be payable on demand so that its commercial value is anchored at par with coin
4. it has to be payable to bearer so that it can be negotiated by mere delivery, without the need for indorsement (an older spelling of endorsement still used in law).
Promissory Notes in Law, Credit and Commerce
Promissory notes are very well known to the law, and the rights and obligations of their makers, indorsers, payees, bearers, holders in due course etc. are likewise very well known and established, as settled law, with very little differences between jurisdictions, and codified in the Bills of Exchange Acts of practically every country, in order to support domestic and international credit and commerce.
Financiers and borrowers are also familiar with the instruments for use ranging from short term finance to mortgage notes for long term housing loans. Promissory notes are primarily used in commerce to document loans that can then more easily be bought and sold, since the rights to payment run with possession of the document, and the payee can negotiate the note by indorsing it to make it payable to a new owner, and delivering it to the new owner.
Promissory notes are unheard of as instruments to warehouse, store or safe-keep goods, whether fungible or not. For example, when a shipper takes a shipment he will issue not a promissory note engaging to return the goods to the holder of the note; instead he issues a bill of lading, which acts as a document of title for the goods he holds or ships. Warehouses of fungible goods such as grain issue warehouse receipts, not promissory notes.
Obligations on the Makers of Promissory Notes
‘The maker of a promissory note, by making it,—
• (a) Engages that he will pay it according to its tenor:
• (b) Is precluded from denying to a holder in due course the existence of the payee and his then capacity to indorse.'
(Bills of Exchange Act 1908(NZ), section 89)
There is no common law or statutory obligation on makers of promissory notes to do anything other than to pay it according to its tenor: the maker does not, as a result of being a maker only, grant any security interest in any of his assets or covenant to restrict his rights to deal with his assets as he may please. This leaves the holder of the note in the position of unsecured creditor, unless the note itself 'contains also a pledge of collateral security, with authority to sell or dispose thereof' (Bills of Exchange Act 1908(NZ) Section 84(3)) or the maker or some other party grants a security interest in any assets or property, or enters a covenant to maintain certain financial ratios or other restrictive terms.
Negotiable instrument law and usage allows for or employs instruments that are payable on demand. These include cheques, defined as bills of exchange payable on demand and drawn on a bank, as well as bank notes, although there is no restriction on non-banks acting as makers or drawees for like instruments. In the same way that the drawer of a cheque is not undertaking to maintain funds in his account with the bank to pay the cheque, the bank itself, as maker of its bank notes on issue, is not undertaking to maintain funds to pay its notes, instead the bank is merely liable to pay on presentation of the note for payment and the drawer of the cheque is merely undertaking to ensure that the cheque is honoured when it is presented for payment. In the same way that drawing a cheque does not operate as an assignment of funds with the drawee, the maker of a promissory note does not operate to assign his own funds to the payee.
Thus in the case of bank notes, the document absolutely and conclusively shows that the bank's position is as a debtor only, and that the bank is only responsible for paying the notes on presentation, and not for maintaining any particular reserve or other financial policies. The idea of mandatory 100% metallic reserves consequently can be conclusively dismissed.
Before moving on to current account/cheque banking it should be noted that 100% metallic reserve bank notes are perfectly possible to draft: the bank would a) grant a first ranking security interest in its metallic reserves in favour of all note holders collectively and b) enter a restrictive covenant to maintain a 100% metallic reserve ratio financial policy and appoint a debt security trustee to monitor its compliance with the terms of the covenant and to take enforcement action to remedy any breach. The notes would read something like '[bank name] promises to pay the bearer on demand the sum of $10, secured by first ranking charge over our coin reserves, and covenants to maintain aggregate coin reserves sufficient to pay all notes payable on demand, [signed].' Although this would not create a bailor-bailee relationship, and note holders would not gain title to the bank's coin reserves, it would utilise a proven legal framework for the objective of 100% reserve banking.
Customer deposits with banks are the book-entry form of bank-issued money and can be used to facilitate transactions where interaction with the bank is either desired or less costly for the parties to the transaction and/or the bank. Unlike bank notes and metallic coins, customer deposits can pass from person to person through intra-bank book entry or through inter-bank clearing. Although debts can be discharged by cheque, if accepted by the creditor or allowed by the contract, the discharge is conditional on the cheque being honoured, and cheques are not legal tender for debts.
Customer Deposits are on Current Account
The term ‘customer’ in banking law has a specific meaning. Not every person the bank provides services to is its customer, for example if the bank provides a person with foreign exchange services or a personal loan, that person is not a customer of the bank, as a bank, but a customer of the bank as a provider of other services. ‘A person is a customer of a bank from the moment the bank opens a current account or deposit account in the person’s name’ (Alan L Tyree, Tyree’s Banking Law in New Zealand, p 71, referencing Warren Metals Ltd v Colonial Catering Co Ltd  1 NZLR 273 at 276). For this reason a person who has only a term deposit with a bank is not a customer and the deposit is not a ‘customer deposit.’
The language used in banking in respect of customer deposits is not restricted to those two words. Customer deposits are commonly referred to as ‘current accounts’ ‘cheque accounts’ ‘bank accounts’ or simply ‘accounts’. Thus it is not controversial to say that customer deposits are kept ‘on account’ or more properly ‘on current account’ as the customer can currently draw on the balance by cheque or by withdrawal. This contrasts with a ‘fixed deposit’ or ‘term deposit’ that, although it may be able to be broken early if the bank agrees, is otherwise not available for drawing on.
A bank is defined at common law as a person who:
1. conducts current accounts;
2. pays cheques drawn on him; and
3. collects cheques for his customers. (United Dominions Trust Ltd v Kirkwood, English Court of Appeal, 1966 2 QB 431)
This further illustrates that customer deposits are on current account, since it is the function of a bank, as a bank, to keep current accounts for its customers, in addition to its functions paying and collecting cheques.
Current Accounts in Law, Credit and Commerce
Current accounts are commonly maintained by people who have regular or mutual dealings. Examples are:
1. A closely held company may borrow money from its shareholder or shareholders and conduct current accounts to record the financial position between company and shareholder, separate from its account of shareholder equity. (Current accounts can also, of course, record loans that the shareholders have taken from the company.)
2. A family trust in New Zealand typically borrows money from its settlors on current account because of New Zealand Gift Duty. For example, Mr and Mrs Smith own a freehold house and wish to establish a trust of which they are the trustees. If they gift the house to the trust in one transaction gift duty will be attracted so instead they sell the house to the family trust on credit, the credit being recorded in the trust's current account. They then proceed to forgive the loan over the succeeding years in amounts below the threshold for gift duty.
3. Merchants typically offer to sell goods to regular customers on credit, whereby they will send an account statement showing the charges for the goods that the customer pays, normally within a month or two. For this purpose, for each such customer, the merchant keeps a current account, recording the purchases and payments and thereby showing, at any time, the financial position between the two, and periodically sending the customer a statement of account. Also applies to service providers such as telephone companies and electric power companies.
4. Credit card lenders and other non-bank lenders also make loans of money on current account, such as house equity lines of credit secured by second mortgage. The lender keeps a current account for each customer showing drawings, repayments, and accrual of interest and fees. Bank overdrafts are the same, and important evidence that the debtor-creditor relationship goes both ways, i.e. the customer can be the debtor and the bank can be the creditor under the same legal device, however the bank normally requires security from the customer.
Thus in commerce it is common for current accounts to be kept showing the financial position between the account keeper and its customer. In most cases these current accounts record simple unsecured debts, however they can also be secured. Normally they are repayable on demand, although it is common for merchants selling goods on credit to have explicit deferred payment terms, e.g. 14 days net, however in practice such terms are normally not strictly applied or complied with, i.e. customers normally pay when they can or want to, and interest, penalties and cancellation of credit limits is normally only applied to customers who are well outside the supposed credit terms (normally the customer relationship is more valuable than the strictness of credit terms).
Obligations of Debtors On Current Account
Unlike bank notes, the contractual terms of current accounts of customers with banks are not fully and explicitly specified in a single document, instead the key terms of the contract are implied terms.
'A term will not be implied into a contract unless two conditions are satisfied. First the term must be necessary for the contract to work. Secondly, the term must be so obvious that it goes without saying, and is capable of clear and uncontroversial exposition' (Alan L Tyree, Tyree's Banking Law in New Zealand, second edition, p 58, quoting Dovey v Bank of New Zealand (2000) 6 NZBLC 102,953, at 102,965, per Tipping J).
I have collected the documented terms and conditions of the major banks in New Zealand for their customer deposits and examined them to see whether or not they set out the legal terms as between the bank and the customer concerning the balance on the current account, and I have not found a single case where the bank makes explicit that it is the customer's debtor in respect to the funds, or even that the funds are repayable on demand. Evidently the banks and their lawyers do not feel such terms need to be clarified, modified or made explicit, instead relying on the terms implied by law -- they are so obvious in the business of banking that they go without saying.
The implied terms of the bank-customer contract are:
'3.2 Implied Terms
The key implied term of the banker-customer contract established in the landmark case of Foley v Hill is that, in relation to a customer's deposit with a bank, the bank is the debtor of the customer, not a trustee of the funds. Lord Cottenham said:
'Money, when paid into a bank, ceases altogether to be the money of the principal; it is then the money of the banker, who is bound to return an equivalent by paying a similar sum to that deposited with him when he is asked for it. Money paid into a bank is money known by the principal to be placed there for the purpose of being under the control of the banker; it is then the banker's money; he is known to deal with it as his own; he makes what profit he can, which profit he retains to himself. He has contracted, having received that money, to repay to the principal when demanded a sum equivalent to that paid into his hands.'
Accordingly, when a banker receives money from a customer or from a third party for the account of a customer, the banker does so as a borrower, not as a trustee, bailee, or agent. The bank obtains title to the money and the income it generates. On the insolvency of the bank, the customer ranks as a mere unsecured creditor and at best can expect the return of a fraction of the original deposit.' (Alan L Tyree, Tyree's Banking Law in New Zealand, second edition, p 59, footnotes omitted).
The status of customer deposits with banks as debts of the bank can also be seen from their accounting treatment by banks: they are disclosed as the bank's liability, and in maturity analyses they are disclosed as being repayable on demand (some banks have an 'on demand' maturity bucket while others would group them with other short term liabilities due within, say, 30 days, for financial reporting purposes).
The status of customer deposits as debts of the bank can also be seen from regulatory laws imposed on banks and similar issuers of securities. For example in New Zealand registered banks are exempt from the registered prospectus and debt security trustee requirements for debt securities issued by them, and this applies to customer deposits with registered banks, i.e. no prospectus is registered and no security trustee is appointed.
The bank’s obligations on the current account, in respect of the balance, is to repay to the customer’s order or demand. Unless and until such an order or demand is made the debt remains dormant and not due for repayment.
As with bank notes, there is nothing stopping banks from offering their reserves as security for amounts owing to customers on current account deposits, and covenanting to maintain a 100% metallic reserve ratio, and appointing a debt security trustee under a trust deed empowered to enforce compliance with the financial covenant. As with bank notes on similar terms, the relationship would still be a debtor-creditor relationship, and the customer would not get title to the reserves, however the 100% metallic reserve ratio could be established and enforced. However such arrangements are practically unheard of and not commercially successful when compared with normal banking practice.
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