FULL
RESERVE BANKING - ECONOMY
News:
Full-reserve banking:
where banks act solely as custodians of customers’ money
What's
in the news?
● Under
a 100% reserve banking system, banks are prohibited from creating loans without
actual cash in their vaults to back these loans.
Key
takeaways:
● However,
opponents believe that such a banking system unnecessarily restricts bank
lending.
Full
Reserve Banking:
● Full-reserve
banking, also known as 100% reserve
banking, refers to a system of banking where banks are not allowed to lend out
money that they receive from customers in the form of demand deposits.
○ Demand
deposits are deposits that customers can withdraw from the bank at any point in
time without any prior notice.
● So,
under full-reserve banking, banks are mandated to hold all money that they
receive as demand deposits from customers in their vaults at all times.
Charging
Depositors Money:
● In
the reserve banking, banks simply act as custodians to depositors money and may
charge a fee from depositors for the service of safekeeping that they offer to
the depositors.
Only
Lend Time Deposits:
● Under
a full-reserve banking system, banks can only lend money that they receive as
time deposits from their customers.
○ Time deposits
are deposits that customers can withdraw from the bank only after a certain
period of time that is agreed upon between the bank and its customers.
● This
arrangement gives banks the time to lend these deposits to borrowers at a
certain interest rate, collect repayments from the borrowers, and finally repay
depositors their money along with a certain amount of interest.
Difference
between Current Banking System and Reserve Banking System:
|
Current Banking System (Full Reserve Banking) |
Fractional Reserve Banking System |
|
1. Banks pay
interest to customers on their demand deposits.
|
1. Under
full-reserve banking, banks are expected to hold reserves backing 100% of
their liabilities in the form of demand deposits. This is to ensure that
banks can successfully meet redemption demands from depositors, and thus
avoid a run on the bank even if all depositors someday decide to come asking
for their money at the same time. |
|
2. Here, the
bank lends both demand and term deposits. |
2. Banks
predominantly do not lend money in the form of physical cash. So the cash
deposits that they receive from their customers, whether as demand deposits
or as time deposits, mostly stay in their vaults. |
Arguments
in favour of Full Reserve Banking:
1.
Custodian Role:
● In
a full-reserve banking system, banks hold all money received as demand deposits
from customers in their vaults, acting as safekeepers of depositors' funds.
2.
Limited Lending:
● Banks
can only lend money from time deposits, which customers can withdraw after an
agreed-upon period.
3.
Preventing Bank Runs:
● The
full reserve ensures banks can meet depositor demands even if all customers
seek to withdraw their money simultaneously, reducing the risk of a bank run.
4.
Restricted Money Supply:
● Banks
cannot create money through loans, limiting their influence on the economy's
money supply and potentially preventing artificial bo and busts.
Concerns
in Fractional-Reserve Banking:
1.
Lending with Electronic Money:
● Banks
in a fractional-reserve system predominantly lend in the form of electronic
money, allowing them to lend more than the physical cash they have in vaults.
2.
Risk of Bank Runs:
● Although
electronic money minimizes cash withdrawals, excessive loans can lead to a bank
run if depositors demand cash that exceeds the actual cash reserves.
3.
Supporting Economic Growth:
● Proponents
argue that fractional-reserve banking fuels investment and economic growth by
allowing banks to create loans without relying solely on customer savings.
WAY
FORWARD:
● The
Fractional-Reserve banking frees the economy from the constraints of real
savings, stimulating investment and growth and the full-reserve banking is more
natural, prevents bank runs, and limits banks' ability to create money, which
could prevent economic instability.