Full-reserve banking

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Full-reserve banking (also known as 100% reserve banking) is a proposed alternative to fractional-reserve banking in which banks would be required to keep the full amount of each depositor's funds in cash, ready for immediate withdrawal on demand. Funds deposited by customers in demand deposit accounts (such as checking accounts) would not be loaned out by the bank because it would be legally required to retain the full deposit to satisfy potential demand for payments. Proposals for such systems generally do not place such restrictions on deposits that are not payable on demand, for example time deposits. [1]


Monetary reforms that included full-reserve banking have been proposed in the past, notably in 1935 by a group of economists, including Irving Fisher, as a response to the Great Depression. [2] More recently, there has been renewed interest following the Great Recession. [3]

Currently, no country in the world requires full-reserve banking. Banks operating under a full-reserve ratio generally do so by choice or by contract, although the governments in some countries such as Iceland and the US have considered implementing full reserve banking to avoid future financial crises. [4] [5] In 2018, Switzerland voted on the Sovereign Money Initiative which has full reserve banking as a prominent component of its proposed reform of the Swiss monetary system. [6] The measure was overwhelmingly rejected. [7]

The Existing System

The Federal Reserve, being the central bank of the United States of America, sets the reserve requirement, which is the percentage of a bank's deposits that it legally must have available as funds on hand. The reserve requirement must be heeded by commercial banks, savings banks, savings and loan associations, and credit unions. [8] By reducing the reserve requirement, the Federal Reserve exercises expansionary monetary policy, and exercises contractionary money policy by increasing the reserve requirement. Decreasing the reserve requirement increases liquidity and the velocity of money, with the intention of promoting economic growth. [8]

Required reserve balances divided by total commercial deposits, overall loan delinquency rate. EffRR: effective reserve ratio. DR: Delinquency Rate. Reserves Required as fraction of Total Deposits and Loan Delinquency Rate, 1984-2019.png
Required reserve balances divided by total commercial deposits, overall loan delinquency rate. EffRR: effective reserve ratio. DR: Delinquency Rate.

In the United States, Europe, and other modernized economies, roughly 95 percent of the money supply is held privately by banks as demand deposits. [12] Under a fractional-reserve banking system, banks are only required to keep a given percentage (currently 10% for large banks, 3% for banks with $16.9 million to $127.5 million on deposit) [8] of deposits in reserve to deliver money to those that wish to withdraw. The Money Multiplier, being the reciprocal of the Reserve Ratio, dictates the factor by which the initial deposits can be multiplied, allowing for banks to "create" money to meet demand for loans. [8] The most common circuit today, being initiated by the issuance of a mortgage by a bank to a lendee, [13] may be illustrative of conspicuous consequences of such a system. With such an abundance of available mortgage capital, prospective homeowners are therefore able to adapt their willingness to pay to discount their actual ability to pay. [14]

Martin Wolf, Chief Economics Commentator at the Financial Times , argues that many people have a fundamentally flawed and oversimplified conception of what it is that banks do. Laurence Kotlikoff and Edward Leamer agree, in a paper entitled "A Banking System We Can Trust", arguing that the current financial system did not produce the benefits that have been attributed to it. [15] Rather than simply borrowing money from savers to make loans towards investment and production, and holding "money" as a stable liability, banks in reality create credit increasingly for the purpose of acquiring existing assets. [16] Rather than financing real productivity and investment, and generating fair asset prices, Wall Street has come to resemble a casino, in which trade volume of securities skyrockets without having positive impacts on the investment rate or economic growth. [15] The credits and debt banks create play a role in determining how delicate the economy is in the face of crisis. [16] For example, Wall Street caused the housing bubble by financing millions of mortgages that were outside budget constraints, which in turn decreased output by 10 percent. [15]


In favor

Economist Milton Friedman at one time advocated a 100% reserve requirement for checking accounts, [17] and economist Laurence Kotlikoff has also called for an end to fractional-reserve banking. [18] Austrian School economist Murray Rothbard has written that reserves of less than 100% constitute fraud on the part of banks and should be illegal, and that full-reserve banking would eliminate the risk of bank runs. [19] [20] Jesús Huerta de Soto, another economist of the Austrian school, has also strongly argued in favor of full-reserve banking and the outlawing of fractional reserve banking. [21]

The financial crisis of 2007–2008 led to renewed interest in full reserve banking and sovereign money issued by a central bank. Monetary reformers point out that fractional reserve banking leads to unpayable debt, growing economic inequality, inevitable bankruptcy, and an imperative for perpetual and unsustainable economic growth. [22] Martin Wolf, chief economist at the Financial Times , endorsed full reserve banking, saying "it would bring huge advantages". [3]

Money supply problems

In The Mystery of Banking , Murray Rothbard argues that legalized fractional-reserve banking gave banks "carte blanche" to create money out of thin air. [23] Economists that formulated the Chicago Plan following the Great Depression argue that allowing banks to have fractional reserves puts too much power in the hands of banks by allowing them to determine the amount of money in circulation by changing the amount of loans they give out. [24]

Is fractional-reserve banking fraud?

Deposit bankers become loan bankers when they issue fake warehouse receipts that are not backed by the assets actually held, thus constituting fraud. [23] Rothbard likens this practice to counterfeiting, with the loan banker extracting resources from the public. [23] However, Bryan Caplan argues that fractional-reserve banking does not constitute fraud, as by Rothbard's own admission an advertised product must simply meet the "common definition" of that product believed by consumers. Caplan contends that it is part of the common definition of a modern bank to make loans against demand deposits, thus not constituting fraud. [25]

Balance sheet fundamentals

Furthermore, Friedman argues that fractional reserve banking is fundamentally unsound because of the timescale of a bank's balance sheet. [26] While a typical firm should have its assets be due prior to the payment date of its liabilities, so that the liabilities can be paid, the fractional reserve deposit bank has its demand deposit liabilities due at any point the depositor chooses, and its assets, being the loans it has made with someone else's deposits, due at some later date. [26]


New fees

Some economists have noted that under full-reserve banking, because banks would not earn revenue from lending against demand deposits, depositors would have to pay fees for the services associated with checking accounts. This, it is felt, would probably be rejected by the public [27] [28] although with central bank zero and negative interest rate policies, some writers have noted depositors are already experiencing paying to put their savings even in fractional reserve banks. [29]

Shadow banking and unregulated institutions

In their influential paper on financial crises, economists Douglas W. Diamond and Philip H. Dybvig warned that under full-reserve banking, since banks would not be permitted to lend out funds deposited in demand accounts, this function would be taken over by unregulated institutions. Unregulated institutions (such as high-yield debt issuers) would take over the economically necessary role of financial intermediation and maturity transformation, therefore destabilizing the financial system and leading to more frequent financial crises. [30] [31]

Writing in response to various writers' support for full reserve banking, Paul Krugman stated that the idea was "certainly worth talking about", but worries that it would drive financial activity outside the banking system, into the less regulated shadow banking system. [32]

Misses the problem

Krugman argues that the 2008 financial crisis was not largely a result of depositors attempting to withdraw deposits from commercial banks, but a large-scale run on shadow banking. [33] As financial markets seemed to have recovered more quickly than the 'real economy', Krugman sees the recession more as a result of excess leverage and household balance-sheet issues. [33] Neither of these issues would be addressed by a full-reserve regulation on commercial banks, he claims. [33]

Further reform

Kotlikoff and Leamer promote the concept of limited purpose banking (LPB), in which banks, now mutual funds, would never fail, as they would be barred from owning financial assets, and their borrowing would be limited to financing their own operations. [34] By establishing a Federal Financial Authority, with the task of rating, verifying, disclosing and clearing all LPB mutual funds, there would be no need to outsource such tasks to private entities with perverse incentives or lack of oversight. [34] Cash mutual funds would also be created, holding only cash tied to the value of the United States dollar, eliminating the threat of bank runs, and insurance mutual funds would be established to pay off the losses of those that own part of the mutual fund, as insurance companies are currently able to sell plans that purport to insure events for which it would be impossible for them to pay off the entirety of the losses experienced by the insured parties. [34] The authors contend that LPB can accommodate any conceivable risk product, including credit default swaps. [34] Under LPB, liquidity would increase as such funds become publicly available to the market, which would determine how much bank employees would be paid. [34]

Most importantly, what limited purpose banking won't do is leave any bank exposed to CDS risk since people, not banks, would own the CDS mutual funds. [34]

Could mutual funds be the answer?

Such proposed mutual funds are already in existence, in the form of tontines and parimutuel betting. However, others claim that despite being quite popular in the early 20th century, tontines fell from public prominence after several scandals. Tontines, even during their popularity, were seen by many as off-putting, as those that invested in tontines would see larger regular payments as other investors died. [35] However, a modern tontine might still be a viable future alternative to other retirement plans, as they provide continuing payment based on the number of years the investor continues to live. [35]

See also

Related Research Articles

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