Full-reserve banking (also known as 100% reserve banking, narrow banking, or sovereign money system) is a system of banking where banks do not lend

demand deposits Demand deposits or checkbook money are funds held in demand accounts in commercial banks. These account balances are usually considered money and form the greater part of the narrowly defined money supply of a country. Simply put, these are depo ...

and instead, only lend from time deposits. It differs from

fractional-reserve banking Fractional-reserve banking is the system of banking operating in almost all countries worldwide, under which banks that take deposits from the public are required to hold a proportion of their deposit liabilities in liquid assets as a reserve, ...

, in which banks may lend funds on deposit, while fully reserved banks would be required to keep the full amount of each customer's

cash In economics, cash is money in the physical form of currency, such as banknotes and coins. In bookkeeping and financial accounting, cash is current assets comprising currency or currency equivalents that can be accessed immediately or near-imm ...

, available for immediate withdrawal. Monetary reforms that included full-reserve banking have been proposed in the past, notably in 1935 by a group of economists, including

Irving Fisher Irving Fisher (February 27, 1867 – April 29, 1947) was an American economist, statistician, inventor, eugenicist and progressive social campaigner. He was one of the earliest American neoclassical economists, though his later work on debt def ...

, under the so-called "

Chicago plan The Chicago plan was a monetary and banking reform program suggested in the wake of the Great Depression by a group of University of Chicago The University of Chicago (UChicago, Chicago, U of C, or UChi) is a private research university i ...

" as a response to the

Great Depression The Great Depression (19291939) was an economic shock that impacted most countries across the world. It was a period of economic depression that became evident after a major fall in stock prices in the United States. The economic contagio ...

. Currently, no country in the world requires full-reserve banking across primary credit institutions, although Iceland has considered it. In a 2018 ballot referendum, Switzerland voted overwhelmingly to reject the Sovereign Money Initiative which has full reserve banking as a prominent component of its proposed reform of the Swiss monetary system.

Views

In favor

Economist

Milton Friedman Milton Friedman (; July 31, 1912 – November 16, 2006) was an American economist and statistician who received the 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, monetary history and theory and the ...

at one time advocated a 100%

reserve requirement Reserve requirements are central bank regulations that set the minimum amount that a commercial bank must hold in liquid assets. This minimum amount, commonly referred to as the commercial bank's reserve, is generally determined by the centra ...

for checking accounts, and economist

Laurence Kotlikoff Laurence Jacob Kotlikoff (born January 30, 1951) is a Professor of Economics at Boston University, a William Warren Fairfield Professor at Boston University, a Fellow of the American Academy of Arts and Sciences, a Research Associate of the Natio ...

has also called for an end to fractional-reserve banking.

Austrian School The Austrian School is a heterodox school of economic thought that advocates strict adherence to methodological individualism, the concept that social phenomena result exclusively from the motivations and actions of individuals. Austrian school ...

economist

Murray Rothbard Murray Newton Rothbard (; March 2, 1926 – January 7, 1995) was an American economist of the Austrian School, economic historian, political theorist, and activist. Rothbard was a central figure in the 20th-century American libertarian m ...

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 run A bank run or run on the bank occurs when many clients withdraw their money from a bank, because they believe the bank may cease to function in the near future. In other words, it is when, in a fractional-reserve banking system (where banks no ...

s.The Case for a 100% Gold Dollar
Murray Rothbard

Jesús Huerta de Soto Jesús Huerta de Soto Ballester (born December 23, 1956) is a Spanish economist of the Austrian School. He is a professor in the Department of Applied Economics at King Juan Carlos University of Madrid, Spain and a Senior Fellow at the Mises Inst ...

, another economist of the Austrian school, has also strongly argued in favor of full-reserve banking and the outlawing of

fractional reserve banking Fractional-reserve banking is the system of banking operating in almost all countries worldwide, under which banks that take deposits from the public are required to hold a proportion of their deposit liabilities in liquid assets as a reserve, ...

. The

financial crisis of 2007–2008 Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fi ...

led to renewed interest in full reserve banking and

sovereign money Monetary sovereignty is the power of the state to exercise exclusive legal control over its currency, broadly defined, by exercise of the following powers: * Legal tender – the exclusive authority to designate the legal tender forms of payment. ...

issued by a

central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a central ba ...

Monetary reform Monetary reform is any movement or theory that proposes a system of supplying money and financing the economy that is different from the current system. Monetary reformers may advocate any of the following, among other proposals: * A return t ...

ers point out that fractional reserve banking leads to unpayable debt, growing

economic inequality There are wide varieties of economic inequality, most notably income inequality measured using the distribution of income (the amount of money people are paid) and wealth inequality measured using the distribution of wealth (the amount of we ...

, inevitable

bankruptcy Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the debtor ...

, and an imperative for perpetual and

unsustainable Specific definitions of sustainability are difficult to agree on and have varied in the literature and over time. The concept of sustainability can be used to guide decisions at the global, national, and individual levels (e.g. sustainable livin ...

economic growth Economic growth can be defined as the increase or improvement in the inflation-adjusted market value of the goods and services produced by an economy in a financial year. Statisticians conventionally measure such growth as the percent rate of ...

Martin Wolf Martin Harry Wolf (born 16 August 1946 in London) is a British journalist of Austrian-Dutch descent who focuses on economics. He is the associate editor and chief economics commentator at the ''Financial Times''. Early life Wolf was born in ...

, chief economist at the ''

Financial Times The ''Financial Times'' (''FT'') is a British daily newspaper printed in broadsheet and published digitally that focuses on business and economic current affairs. Based in London, England, the paper is owned by a Japanese holding company, Nik ...

'', endorsed full reserve banking, saying "it would bring huge advantages".

, Chief Economics Commentator at the ''

'', argues that many people have a fundamentally flawed and oversimplified conception of what it is that banks do.

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. 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. 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. The credits and debt banks create play a role in determining how delicate the economy is in the face of crisis. 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.

Money supply problems

In ''

The Mystery of Banking ''The Mystery of Banking'' is Murray Rothbard's 1983 book explaining the modern fractional-reserve banking system and its origins. In his June 2008 preface to the 298-page second edition, Douglas E. French suggests the work also lays out the “. ...

'',

argues that legalized fractional-reserve banking gave banks "carte blanche" to create money out of thin air. 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.

Fractional-reserve banking fraud issues

Deposit bankers become loan bankers when they issue fake warehouse receipts that are not backed by the assets actually held, thus constituting fraud. Rothbard likens this practice to counterfeiting, with the loan banker extracting resources from the public. However,

Bryan Caplan Bryan Douglas Caplan (born April 8, 1971) is an American economist and author. Caplan is a professor of economics at George Mason University, research fellow at the Mercatus Center, adjunct scholar at the Cato Institute, and former contributor ...

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.

Balance sheet fundamentals

Furthermore, Rothbard argues that fractional reserve banking is fundamentally unsound because of the timescale of a bank's balance sheet. 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.

Against

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. However, 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.

Shadow banking and unregulated institutions

In their influential paper on financial crises, economists

Douglas W. Diamond Douglas Warren Diamond (born October 25, 1953) is an American economist. He is currently the Merton H. Miller Distinguished Service Professor of Finance at the University of Chicago Booth School of Business, where he has taught since 1979. Diamond ...

and

Philip H. Dybvig Philip Hallen Dybvig (born May 22, 1955) is an American economist. He is the Boatmen's Bancshares Professor of Banking and Finance at the Olin Business School of Washington University in St. Louis. Career Dybvig specializes in asset pricing, b ...

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 In finance, a high-yield bond (non-investment-grade bond, speculative-grade bond, or junk bond) is a bond that is rated below investment grade by credit rating agencies. These bonds have a higher risk of default or other adverse credit events, ...

issuers) would take over the economically necessary role of

financial intermediation A financial intermediary is an institution or individual that serves as a middleman among diverse parties in order to facilitate financial transactions. Common types include commercial banks, investment banks, stockbrokers, pooled investment funds ...

and

maturity transformation Maturity transformation is the practice by financial institutions of borrowing money on shorter timeframes than they lend money out. Financial markets also have the effect of maturity transformation whereby investors such as shareholders and bondhol ...

, therefore destabilizing the financial system and leading to more frequent financial crises. Writing in response to various writers' support for full reserve banking,

Paul Krugman Paul Robin Krugman ( ; born February 28, 1953) is an American economist, who is Distinguished Professor of Economics at the Graduate Center of the City University of New York, and a columnist for ''The New York Times''. In 2008, Krugman was th ...

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 The shadow banking system is a term for the collection of non-bank financial intermediaries (NBFIs) that provide services similar to traditional commercial banks but outside normal banking regulations. Examples of NBFIs include hedge funds, ins ...

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. 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. Neither of these issues would be addressed by a full-reserve regulation on commercial banks, he claims.

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. 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. 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. The authors contend that LPB can accommodate any conceivable risk product, including

credit default swap A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default (by the debtor) or other credit event. That is, the seller of the CDS insures the buyer against som ...

s. Under LPB, liquidity would increase as such funds become publicly available to the market, which would determine how much bank employees would be paid. Most importantly, what limited purpose banking won't do is leave any bank exposed to

CDS The compact disc (CD) is a digital optical disc data storage format that was co-developed by Philips and Sony to store and play digital audio recordings. In August 1982, the first compact disc was manufactured. It was then released in Octo ...

risk since people, not banks, would own the CDS mutual funds.

References

External links

The Chicago Plan Revisited
IMF Working Paper, Jaromir Benes and Michael Kumhof, August 2012
In Defence of Fractional Monetary Reserves
(Pascal Salin) {{Portal bar, Business and economics, Money, Banks Banking Banking terms Monetary policy Monetary reform