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. In other words, 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.
(Un)conditional lending
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.
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. So the cash deposits that they receive from their customers, whether as demand deposits or as time deposits, mostly stay in their vaults. Still, banks face the risk of a depositor run for a different reason — 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. A bank that wants to lend money can simply open a loan account in its books under the name of a certain borrower and credit the account with electronic money equivalent to the loan amount. In fact, the value of such electronic loans created by banks out of thin air can turn out to be many times the actual amount of cash in the banks’ vaults. So, if borrowers decided to withdraw in the form of cash all the money that was loaned to them electronically by the bank, the bank may be forced to use all the cash deposits that it received from depositors to meet the demand for cash and still be unable to meet the demand for cash. This can cause a run on the bank as the bank has created loans far exceeding the amount of actual cash in its vaults.
However, bank runs rarely happen for a number of reasons. For one, most transactions in today’s economies happen through checks and other non-cash instruments which ensure that the demand for cash remains minimal. So, banks rarely face the imminent risk of a large number of their customers suddenly showing up at their door demanding cash from their accounts immediately. Secondly, central banks bail out banks by providing them with any emergency cash that they may need to meet a sudden rise in the cash demands of customers.
The need to fuel growth
Under a full-reserve banking system, however, banks are prohibited from creating loans without actual cash in their vaults to back these loans.
In fact, some economists have argued that it should be considered as fraudulent practice if a bank issues loans without the necessary cash in its vaults to back their loans. Supporters of fractional-reserve banking, however, 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.
In other words, proponents 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.
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. 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. Supporters of full-reserve banking 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, they argue, will prevent artificial economic booms and busts that are said to be the consequence of changes in money supply.
