Full Reserve Banking Benefits and Challenges

Full reserve banking is a system where banks hold all customer deposits in reserve, rather than lending them out to make a profit. This approach has several benefits.

One of the main advantages is that it eliminates the risk of bank runs, as depositors know their money is safe. They can withdraw it at any time, without worrying about the bank's solvency.

Full reserve banking also promotes financial stability, as banks are less likely to engage in reckless lending practices. This reduces the likelihood of asset bubbles and financial crises.

In a full reserve system, banks earn revenue from interest on loans and investments, rather than from making loans with deposited funds. This can lead to more responsible lending practices.

Banks are required to keep a certain amount of cash in reserve, known as bank reserves, to meet unexpected demands for withdrawals. This reserve ratio has historically ranged from zero to 10% of bank deposits in the U.S.

To prevent panics, banks must hold a minimum amount of cash in reserve, which can be kept in a vault on-site or sent to a bigger bank or a regional Federal Reserve bank facility. The Federal Reserve cut the cash reserve minimum to zero percent in 2020 to help banks meet the increased demand for withdrawals during the pandemic.

Bank reserves are used as a tool in monetary policy by central banks, which can lower the reserve requirement to encourage banks to make new loans and boost economic activity, or raise it to slow down economic growth.

Bank reserves are the minimal amounts of cash that banks are required to keep on hand in case of unexpected demand.

To put this in perspective, think of it like keeping a stash of cash at home. Just like how you might keep some emergency cash hidden away, banks keep a similar amount of cash on hand to meet any large and unexpected demand for withdrawals.

The Federal Reserve dictates the amount of cash that each bank must maintain, and historically, the reserve ratio has ranged from zero to 10% of bank deposits. This means that for every dollar deposited into a bank, the bank must keep a certain percentage of that dollar in reserve.

Here's a breakdown of the reserve ratio:

Banks keep these reserves to prevent the panic that can arise if customers discover that a bank doesn't have enough cash on hand to meet immediate demands. This is a crucial aspect of maintaining a stable banking system.

Bank reserves are a crucial part of how banks work, and they're calculated by multiplying a bank's total deposits by the reserve ratio, which is usually 10%. For example, if a bank has $500 million in deposits, its required minimum reserve would be $50 million.

Banks use their excess reserves to make loans and earn interest, but they have little incentive to hold onto excess reserves since cash earns no return and may even lose value over time due to inflation. Banks typically minimize their excess reserves and lend the money to clients instead.

In a fractional banking system, increasing the monetary base by one dollar will increase the money supply by more than one dollar, thanks to the money multiplier, which is calculated by dividing 1 by the percentage required to be held in reserves. For instance, a 10% reserve requirement would give a money multiplier of 10.

A bank's reserve requirement can be lowered by the central bank to encourage banks to make new loans and boost economic activity. Conversely, raising the reserve requirement can help slow down economic growth. In recent years, central banks have turned to other tactics like quantitative easing to achieve similar goals.

The Federal Reserve obliges banks to hold a certain amount of cash in reserve to prevent bank runs and maintain financial stability. This is why the Fed can lower the cash reserve minimum to zero percent, as it did in March 2020 during the global pandemic.

In a typical firm, assets should be due prior to the payment date of its liabilities, but in a fractional reserve deposit bank, liabilities are due at any point the depositor chooses, and assets are due at a later date. This can make fractional reserve banking fundamentally unsound, according to some economists.

Here's a breakdown of the different types of bank reserves:

Bank reserves decrease during economic expansions and increase during recessions, which can make it harder for banks to lend during downturns.

In full-reserve banking, banks are required to maintain 100% reserves against demand deposits. This is a significant change from fractional-reserve banking, where only a small percentage of deposits must be on reserve.

Banks with full-reserve banking hold deposited currency as 100%-reserve deposits, transferable to third parties. This is one of the two distinct functions of banks in full-reserve banking.

The Federal Reserve sets interest rates based on economic circumstances and how it decides it can best meet its dual mandate of maximum employment and price stability. Interest rates are used to encourage or discourage borrowing and lending.

Banks with a low fractional reserve are vulnerable to bank runs because there is always a risk that withdrawals may exceed their available reserves. This is a risk that does not exist with full-reserve banking.

Here's a comparison of fractional-reserve banking and full-reserve banking:

In full-reserve banking, banks become true intermediaries, transferring funds from savers to borrowers. This separates transaction accounts and investment accounts, as described by Jackson and Dyson (2012).

Banks have historically been required to keep a certain amount of money in reserve, but the exact amount has varied over time. The reserve amount has ranged from zero to 10%.

In fact, since March 26, 2020, banks have been required to keep zero dollars in reserve, a significant shift from the previous requirements.

The reserve amount banks need to keep has historically ranged from zero to 10%. Since March 26, 2020, it has been zero.

Banks are required to maintain an appropriate liquidity coverage ratio, or LCR. This is set by the Basel Accords, a series of banking regulations established by global financial centers.

The LCR requires banks to hold enough cash and liquid assets to cover fund outflows for 30 days. This is designed to help banks keep from having to borrow money from the central bank in times of financial crisis.

Banks must still meet LCR requirements even when the Federal Reserve decreases bank reserve minimums. This ensures they have enough cash on hand to meet their short-term obligations.

In full-reserve banking, depositors may have to pay fees for checking account services because banks won't earn revenue from lending against demand deposits.

Some economists think this would be a major turn-off for the public, but it's worth noting that in economies with zero and negative interest rate policies, depositors are already paying to keep their savings in fractional reserve banks.

Depositors in these economies are essentially paying to have their money stored, which is a stark contrast to the traditional notion of earning interest on savings.

The main criticism of fractional reserve banking is that there are insufficient funds for everyone to withdraw at once. This was witnessed during the Greek financial crisis in 2015, where citizens flocked to banks to withdraw their funds, leading to the banks being forced to close their doors.

Before the introduction of the Fed, the National Bank Act of 1863 imposed 25% reserve requirements for U.S. banks. The Great Depression in the U.S. also saw consumers rushing to banks to withdraw all of their funds, leading to the collapse of New York's Bank of the United States.

The 2008 financial crisis led to banks preferring to hold onto cash reserves rather than lending them out, despite low interest rates. This resulted in a significant spike in excess reserves, with the total amount of excess reserves increasing despite an unchanged required reserve ratio.

The '08 Crisis Impact was a game-changer for banks and the economy as a whole. Prior to 2008, banks earned no interest on their cash reserves, but that changed on October 1, 2008, with the Emergency Economic Stabilization Act.

The Federal Reserve began paying interest on reserves, and interest rates were cut to boost demand for loans and stimulate the economy. This move was a response to the financial crisis of 2008-2009.

The conventional wisdom was that banks would rather lend money out than keep it in the vault, but that's not what happened. Banks took the cash injected by the Federal Reserve and kept it as excess reserves instead of lending it out.

The total amount of excess reserves spiked after 2008, despite an unchanged required reserve ratio. This was a surprising outcome, as the expected result would have been an increase in lending.

Criticisms of fractional reserve banking are numerous, and one of the main concerns is that there are insufficient funds for everyone to withdraw at once, as seen in the Greek financial crisis of 2009 and the Great Depression in the U.S.

This is because banks only hold a fraction of deposits in reserve, and the rest is loaned out, leaving them unable to meet withdrawal demands. In 1863, the National Bank Act imposed a 25% reserve requirement for U.S. banks, which was a step in the right direction.

However, this requirement was not enough to prevent bank runs, as seen in the Greek financial crisis and the Great Depression. In fact, economists like Murray Rothbard argue that fractional-reserve banking gives banks "carte blanche" to create money out of thin air, which can lead to economic instability.

Some critics, like Milton Friedman, have advocated for a 100% reserve requirement for checking accounts, while others, like Martin Wolf, have endorsed full reserve banking, citing its potential to bring huge advantages.

The 2008 financial crisis highlighted the risks of fractional reserve banking, as banks took cash injected by the Federal Reserve and kept it as excess reserves rather than lending it out. This defied conventional wisdom, as banks preferred to earn a small but risk-free interest rate over lending it out for a slightly higher but riskier return.

In fact, the total amount of excess reserves spiked after 2008, despite an unchanged required reserve ratio. This suggests that the current system is not working as intended, and that full reserve banking may be a more viable option.

Some of the criticisms of fractional reserve banking can be summarized as follows:

Full-reserve banking is a system where banks keep 100% of all deposits on hand at all times. This means losing the key benefit of a fractional reserve system, where banks can create more money by lending out deposited funds.

Currently, no country in the world has a full-reserve banking system in place for its deposit-taking institutions, although Iceland has considered it.

Banks might charge customers more for their services in a full-reserve system, as they would no longer be able to pay interest on deposits.

A system backed by precious metals, such as gold, is also prone to the problem of limiting growth potential because there is a finite amount of gold available.

Fractional reserve banking allows a country to grow its money supply to meet the demand for growth, unlike a system that requires banks to hold 100% of deposits.

Fractional reserve banking has a long history, dating back to the era when gold and silver were traded. Goldsmiths would issue promissory notes, which were later used as a means of exchange.

In the U.S., the National Bank Act was passed in 1863 to require banks to keep reserves on hand to protect depositor funds. Reserve requirements for banks under the Federal Reserve Act were set at 13%, 10%, and 7% in 1917.

The Fed had set the reserve ratio as high as 17.5% for certain banks in the 1950s and '60s, and it remained between 8% to 10% throughout much of the 1970s through the 2010s. However, banks with fewer than $16.3 million in assets were not required to hold reserves.

The U.S. government established its banking system with the National Bank Acts of 1863 and 1864, setting reserve requirements at an across-the-board rate of 25%. The Fed dropped reserve requirements in 2020, arguing that money was better used if freed up to lend.

Fractional reserve banking has its roots in the Middle Ages, where goldsmiths issued demand receipts for gold on hand that exceeded the amount of physical gold they had under custody.

The National Bank Act of 1863 required banks to keep reserves on hand to protect depositor funds from being used in risky investments.

Banks were initially required to keep a reserve ratio of 25% until the Federal Reserve Act was passed in 1913, which gave the Fed the power to require lenders to maintain reserves.

From 1913 until 2020, the mandated level of reserves varied from 7 to 13%, depending on the bank and/or type of account.

Canada phased out its reserve requirements in the 90s, while other countries such as the U.K., New Zealand, Australia, Sweden, and Hong Kong also no longer have specific reserve requirements.

The Federal Reserve dropped reserve requirements in 2020, arguing that money was better used if freed up to lend, which would in turn stimulate the economy.

In the early 20th century, classical economics was widely accepted, but by the 1930s, Keynesianism gained prominence as policymakers sought solutions for the Great Depression.

Economists such as Irving Fisher proposed strategies to address financial stability, including full-reserve banking and disconnecting money and credit.

However, full-reserve banking did not become law.

Fractional reserve banking is a complex topic, but let's break down the legality aspect. It is indeed legal in most countries.

Most countries use fractional reserve banking because it provides a reliable profit for banks. Without this system, banks would have to charge extremely high deposit fees to fund their operations.

In essence, fractional reserve banking is the only financial system model that allows banks to earn money on their assets, making it a necessary aspect of modern banking.