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Full-reserve banking

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Full-reserve banking is a banking practice in which the full amount of each depositor's funds are available in reserve (as cash or other highly liquid assets) when each depositor had the legal right to withdraw them. Full-reserve banking was practiced historically by the Bank of Amsterdam and some other early banks but was displaced by fractional reserve banking after 1800. Proposals for the restoration of full-reserve banking have been made, but are generally ignored or dismissed by mainstream economists, who believe that the costs of such a change would outweigh any benefits.

History

Debate over full reserve

Proposals for full-reserve banking are rarely discussed in mainstream circles, although it has been supported by economists such as Milton Friedman and Laurence Kotlikoff. By contrast, within the Austrian school of economics, the relative merits of full-reserve and fractional-reserve banking are the subject of active debate.

Some argue that the strict enforcement of full-reserve banking would mean that there would be no entity to carry out true "banking" functions, because full-reserve banking would restrict potential intermediation activities between lenders with short-term deposits and borrowers with longer-term borrowing needs. However, 100% reserve banking would still allow for long term lending and borrowing between parties with similar time horizons.

The case for full reserve

This would eliminate (or at least greatly reduce) the financial risks associated with bank runs, as the bank would have all the money in reserve needed to pay depositors - regardless whether depositors actually claimed their money.

This form of banking would also eliminate the need for a lender of last resort (such as a central bank), which is normally needed to support the banking system in times of systemic risk or financial contagion, as these financial risks would not exist in a full-reserve banking environment. This simply requires that the resources available to the banks issuing credit money and demand deposits would be sufficient to convert all currency at once if so required. It was a central component in Social Credit proposals.

In a full-reserve system all currency is created by the federal government, and as a result all seigniorage revenue would also accrue to the federal government. This is in contrast to the current system, where a large proportion of the currency supply is in the form of demand deposits created by private banks. When the Federal Reserve creates currency and uses it to buy treasury bills, it collects seigniorage revenue in the form of interest payments which it then returns to the United States (for example, in 2002 the United States earned $24.495 billion in this manner). When a private bank creates currency, the government cannot collect any seigniorage from it. Since the Federal Reserve has a target for the size of the currency stock, any currency created by private banks is currency that is not created by the Fed and thus constitutes lost seigniorage. Some consider this an illegitimate "privatization" of what should be a public good, with these profits being retained by the government to finance essential social services and capial works.

Because fractional-reserve banking necessarily increases in the money supply and causes monetary inflation, some economists (most notably the Austrian School) consider this aspect of fractional-reserve banking to have deleterious and destabilizing effects on the economy over time.

It is argued by these economists that, in contrast to fractional-reserve banking, full-reserve banking guarantees a stable money supply, which ensures that the means of exchange is not debased over time. This improves the efficiency of the price mechanism, promotes saving and the deferral of consumption, provides much greater confidence in the financial system and in the integrity of all commercial transactions and therefore encourages sustainable, non-speculative, productive investment.

Reserve ratio

The reserve ratio of all banks operating in such a system would be 100%, making the deposit multiplier equal to one (1xM=M). The opposite of this system is fractional-reserve banking, in which the bank would hold only a fraction of all client deposits as reserves with the remainder used to supply loans and create credit.

Some advocates believe that full-reserve banking should only apply to demand not fixed loan deposits. The distinction that full reservists make is that demand deposits such as checking and some modern savings accounts are available for immediate use by the owner of the account, whereas a traditional savings account is restricted.

Criticism

The most common criticism of full-reserve banking, and by contrast, argument for fractional reserve banking, is the need for financial intermediation. Small savers often cannot lend or invest their meager savings, for want of knowledge and sufficient capital to make a loan. Likewise, without financial intermediaries, borrowers must seek out someone who can loan them the exact amount they need, instead of being able to draw on several loans from different small savers. Savers also face significant risk as individual investors, since if they lend to a single firm or individual, that entity can collapse, leaving the saver penniless. Furthermore, if they act as individual lenders, savers must wait for their loans to mature before recouping their money; a bank can make their deposits available at any time. There are also significant economies of scale in banks making investment and lending decisions, as they have access to knowledge and expertise which individual investors or lenders generally do not. Under full-reserve banking, a great deal of money would sit idle, as savers stored up their money, while entrepreneurs went without much-needed capital.

Among criticisms of a full-reserve banking system is the argument that full-reserve banking implicitly means that there is no government-controlled "monetary policy" at all. Critics also argue that a full-reserve system leaves us with an inelastic currency. Proponents argue that the lack of a government-manipulated currency (the lack of a "monetary policy") and the presence of a sound currency (as opposed to an "elastic" one) are advantages to a full-reserve system. More subtly, since full-reserve banking means that during periods of high demand for money, the prices of other goods must fall, the broader real economy may bear adjustment costs that are (in principle) no different from those it would bear during periods of moderate inflation (that is, if the cost of adjusting to absolute prices is low or negligible, moderate inflation should be no more problematic than moderate deflation). However, this subsequent deflationary effect is likely to have deleterious consequences if some prices are stickier than others; in particular, wages are often significantly stickier than other prices. Most economists believe that given wage stickiness, the adjustment costs of deflation are significantly higher than an equivalent inflation.

Pascal Salin, former professor at the Université Paris-Dauphine and former Mont Pelerin Society president, opposes such regulation of banking and disputes Murray Rothbard's characterization of fractional-reserve banking as a simple form of recursive embezzlement. He argues that a situation of perfect certainty doesn't exist even in a full-reserve banking system. He also argues that in a perfectly free banking system any customer must be free to choose the kind of notes and the system of payments for services he prefers since optimality cannot be defined independent of the wants of the individual.

Advocates of full-reserve banking do not necessarily advocate that the government lay down regulations stipulating a full-reserve system. In fact, some economists, such as Murray Rothbard (of the Austrian School) believe that government intervention sustains fractional-reserve banking, as governments have formalized the practice by making it legal and supporting it through the creation of central banks. Murray Rothbard argues that in doing this they have prevented periodic bank runs and other natural checks that would otherwise be placed on banks by astute customers, anti-fractional-reserve consumer groups, and other such organizations. Rothbard expresses this concern, and argues the case for 100% gold or silver-backed money, in his book What Has Government Done to Our Money? and other prominent published works. Austrian monetary theorist George Selgin disputes the Rothbardian account, arguing: "Those self-styled Austrian economists, mostly followers of Murray Rothbard, who insist on its fraudulent nature or inherent instability are, frankly, making poor arguments. I don't think the evidence supports their view, and that they overlook overwhelming proof of the benefits that fractional reserve banking has brought in the way of economic development by fostering investment."

Current examples

There are currently no examples of full reserve banking with an established history of operation. However, a variety of organisations aspire to provide full-reserve banking or claim to do so.

Islamic banking

In theory, Islamic banking is often synonymous with full-reserve banking, with banks achieving a 100% reserve ratio. In practice, however, this is not the case, and no examples of 100 per cent reserve banking are observed. According to Islami Bank Bangladesh:

The fractional reserve system versus 100% reserves would have different policy implications. Under the former system, banks would have the ability to draw profits on funds that they have exerted no productive effort. Such earning is against the original spirit of Islamic banking. One solution may lie in the nationalization of commercial banks, which has already occurred in most of these countries. As regards the latter, we have a fair amount of theoretical insight from the western literature but do not have any valuable empirical observations on the operations of 100% reserves even in countries that have adopted Islamic banking. These Islamic banks are still operating under fractional reserve system. Hence, the operation of monetary policy under 100% reserves system needs further research.

Digital gold or silver

Since 1996, a form of private currency called digital gold currency has been in circulation. Many of these currency providers claim to act like full-reserve "private banks" with a one-to-one ratio of the currency they issue and the hard asset, usually gold or silver, that they store as reserves. The most prominent examples are GoldMoney and e-gold, with the latter encountering various issues. Also available are physical gold exchangers and storage providers, such as BullionVault.

Some monetary reformers believe a new free market will emerge in money production and distribution, as the Internet allows renewed decentralisation and competition in this area, eroding the central government's and bankers' old monopoly control of the means of exchange. Some monetary reformers believe that in a genuine free market, where government did not impose a monopoly currency on the populace, a predominantly full-reserve banking system, backed by a gold standard or silver standard monetary system, would arise spontaneously out of the free market.

See also

External links

• The Mystery of Banking, Murray Rothbard
• Money, Bank Credit and Economic Cycles, Huerta de Soto, J. (2006), Ludwig von Mises Institute
• The Ethics of Money Production, Jörg Guido Hülsmann (2008), Ludwig von Mises Institute
• Free Banking and Fractional Reserves: a Comment (Pascal Salin)
• Alternatives to Conventional Banking Products By Maryam Ayaz
• In Defence of Fractional Reserve Banking (Pascal Salin)
• Money upside down
• Transforming Money
• Free Banking FAQ
• Greening the Dollar Reclaiming our democratic Values Through Monetary Reform

References