Full reserve banking

What Is Full Reserve Banking?

Full reserve banking is a monetary system in which commercial banks are required to hold 100% of their demand deposits as reserves. This means that for every unit of currency deposited by a customer, the bank must keep an equivalent amount in its vaults or at the central bank, rather than lending out a portion of it. This system falls under the broader field of monetary economics, aiming to fundamentally alter how money is created and managed within an economy. In a full reserve banking system, the power of credit creation from new deposits would be removed from commercial banks and instead centralized, typically with the central bank.

History and Origin

The concept of full reserve banking gained significant attention during the Great Depression of the 1930s, particularly through the work of American economist Irving Fisher. Fisher, concerned by the instability of the money supply under the prevailing system, proposed what he called "100% Money" in 1935. This proposal, sometimes referred to as the Chicago Plan due to its promotion by economists from the University of Chicago, advocated for commercial banks to hold full reserves against checking deposits to prevent issues like inflation and deflation and to mitigate the severity of economic downturns¹⁵, ¹⁶.

Fisher believed that the ability of banks to create and destroy "check-book money" (demand deposits) through lending and loan recall was a primary cause of economic instability and the collapse of the money supply observed between 1929 and 1933¹⁴. His solution aimed to separate the money creation function from the lending function of banking, ensuring that all checkable deposits were fully backed by actual money¹², ¹³. The idea was to eliminate bank runs and prevent sudden contractions in the money supply, which he saw as a key driver of financial crises¹¹. The International Monetary Fund (IMF) revisited these concepts in a 2012 working paper, analyzing the potential benefits of such a system using modern economic modeling¹⁰.

Key Takeaways

• Full reserve banking requires banks to hold reserves equal to 100% of their demand deposits.
• The primary goal is to enhance financial stability by eliminating bank runs and controlling the money supply more directly.
• Under this system, the power of money creation shifts from commercial banks to the central monetary authority.
• Lending activities would be funded by time deposits or other forms of genuinely saved funds, not newly created money.
• Proponents argue it could reduce systemic risk and public debt, while critics cite potential impacts on credit availability and the growth of shadow banking.

How Full Reserve Banking Operates

In a full reserve banking system, the fundamental operation of commercial banks would be bifurcated. One part of the bank would handle deposits for transaction services, holding those funds as 100% reserves. These accounts would be fully secure and immediately available for withdrawal or payment, effectively acting as safe custody for money. The second part of the banking institution would operate as a true financial intermediary, facilitating lending by taking funds from savers (e.g., through time deposits or bonds) and lending them to borrowers. This separation ensures that the money used for transactions is distinct from the money used for investment and lending, making the system inherently more stable regarding deposit liquidity.

The central bank would be the sole entity responsible for expanding the money supply by injecting new money into the economy, for instance, through government spending or direct distribution. This contrasts sharply with the current system where commercial banks create new money when they issue loans.

Hypothetical Example

Imagine a simplified economy under a full reserve banking system. Sarah deposits $1,000 into her checking account at First National Bank. Under full reserve banking, First National Bank must hold the entire $1,000 in its reserves, either as vault cash or at the central bank. It cannot lend out any portion of Sarah's $1,000 demand deposit.

If John wants to borrow money to buy a car, First National Bank cannot create new money for his loan. Instead, it must source funds from actual savings deposited by others, for example, from individuals who have placed money in time deposits or from investors who have purchased bonds issued by the bank. If Mary has a $5,000 certificate of deposit (a time deposit) with First National Bank, the bank could potentially lend a portion of that $5,000 to John, as long as it adheres to the terms of Mary's deposit and any associated capital requirements. The key distinction is that the bank is lending pre-existing funds, not creating new money as a byproduct of the loan.

Practical Applications

While a full reserve banking system is a theoretical construct not fully implemented in any major economy, its principles are often discussed in the context of financial stability and monetary policy reform. The Federal Reserve, for instance, historically used reserve requirements as a tool to influence the money supply and credit conditions, though these requirements were reduced to zero percent effective March 26, 2020⁹.

Proposals for full reserve banking suggest that it could lead to:

• Enhanced Financial Stability: By preventing commercial banks from creating money, the system aims to eliminate bank runs and mitigate boom-bust cycles fueled by excessive credit creation⁸.
• Improved Monetary Control: The central bank would have direct and precise control over the money supply, potentially making monetary policy more effective in managing inflation and deflation⁷.
• Reduced Public and Private Debt: Some proponents argue that by centralizing money creation, the need for government borrowing could be reduced, and private debt might also decrease as money creation would no longer necessitate simultaneous debt creation⁶.

Limitations and Criticisms

Despite its proposed benefits, full reserve banking faces several significant criticisms. A primary concern is its potential impact on the availability of credit and economic growth. Critics argue that by removing the ability of commercial banks to create new money through lending, the overall volume of credit in the economy might shrink, potentially stifling investment and economic activity⁴, ⁵.

Another criticism centers on the potential for the growth of unregulated financial activities, often referred to as shadow banking. If traditional banks are restricted in their lending, other entities might emerge to fill the demand for credit, operating outside the central bank's direct control and potentially introducing new forms of systemic risk³. Furthermore, implementing such a drastic shift could be complex, requiring a complete overhaul of existing financial structures and regulations. There are also debates about whether a central bank can truly identify and enforce an "optimal" quantity of money supply, and if removing profit-making opportunities from banks might destabilize the financial sector¹, ².

Full Reserve Banking vs. Fractional-Reserve Banking

The fundamental difference between full reserve banking and fractional-reserve banking lies in the percentage of deposits that banks are required to hold as reserves.

The confusion between the two systems often arises because both involve banks holding reserves. However, the purpose and implications of these reserves are vastly different. In fractional-reserve banking, reserves primarily serve as a liquidity buffer and a basis for money creation. In full reserve banking, reserves are purely for safeguarding customer deposits, completely separating the function of holding money from the function of lending it.

FAQs

What problem does full reserve banking aim to solve?

Full reserve banking primarily aims to solve the problem of financial instability, bank runs, and the cyclical nature of credit-fueled booms and busts often associated with fractional-reserve banking. It seeks to provide a more stable and transparent money supply by centralizing its creation.

How would a full reserve system affect everyday banking?

For consumers, transaction accounts (like checking accounts) would become completely safe, as banks would hold 100% of these demand deposits as reserves. However, banks might charge fees for these safe-keeping services, as they would no longer earn profits from lending out these deposits. Lending activities would still occur, but they would be funded differently, potentially impacting interest rates on loans and savings.

Would full reserve banking eliminate all economic crises?

While proponents argue that full reserve banking would significantly reduce certain types of financial crises related to banking and credit creation, it would not eliminate all economic fluctuations. Other factors, such as productivity shocks, geopolitical events, or shifts in consumer behavior, could still lead to economic downturns.