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.
• In this case, 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.
• This is in contrast to today’s banking system in which banks pay interest to customers on their demand deposits.
• Thus, 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.
• 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.

FRACTIONAL RESERVE BANKING

• In the banking system that exists today, also known as the fractional-reserve banking system, banks predominantly do not lend money in the form of physical cash.
• Banks lend more money than the cash they have in their vaults.
• This is made possible because most lending to various borrowers happens in the form of electronic money.

BENEFITS

• It is the only natural form of banking and that it can prevent the various crises that affect today’s fractional-reserve banking system.
• Since banks will be allowed to make loans to borrowers only out of their time deposits and since they will be legally forced to keep demand deposits in their vaults to meet depositor demands for cash, the chances of a bank run would be negligible under a full-reserve banking system.
• Since banks will not be able to create money out of thin air in a full-reserve banking system, their influence on the economy’s money supply will become severely restricted.
• This will prevent artificial economic booms and busts that are said to be the consequence of changes in money supply.

HOWEVER

• Full-reserve banking unnecessarily restricts bank lending.
• Supporters of fractional-reserve banking believe that such banking frees the economy from having to rely on real savings from depositors to finance the huge investments required to fuel growth.