Full-reserve banking: where banks act solely as custodians of customers’ money

Source: The post is based on the article “Full-reserve banking: where banks act solely as custodians of customers’ money”  published in The Hindu on 26th July 2023.

What is the News?

This article talks about the Full-reserve banking system.

What is 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. 

The banks can only lend money that they receive as time deposits from their customers.

Hence, 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. 

This is done 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.

Note: Demand deposits are deposits that customers can withdraw from the bank at any point in time without any prior notice. 

– 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.

What is the type of banking system that exists in most of the countries currently?

The banking system that exists today is known as the fractional-reserve banking system.

Fractional-reserve banking is the banking system 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, and are at liberty to lend the remainder to borrowers.

Bank reserves are held as cash in the bank or as balances in the bank’s account at the central bank. 

The country’s central bank determines the minimum amount that banks must hold in liquid assets, called the “reserve requirement” or “reserve ratio”.

What are the experts’ views on the Full reserve and Friction reserve banking system?

Supporters of fractional-reserve banking believe that full-reserve banking unnecessarily restricts bank lending. They believe that allowing banks to create loans without the necessary savings to back these loans can help spur investment and economic growth.

However, proponents of full-reserve banking argue that it is the only natural form of banking and that it can prevent the various crises that affect today’s fractional-reserve banking system.

The full-reserve banking supporters also argue that 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.