Reserve banking

Is it time to explore an alternative to fractional-reserve banking?

By Nicholas Larseninternational banker

Owhat happens to the money you deposit in a bank account? Does all this sit idle, earning interest? Or is it used to fund other purposes? According to a September 2019 study by bitcoin mining firm Genesis Mining of 1,000 US consumers, 26% of respondents believed that banks were required to hold 100% of money deposited by customers in reserve, while 52 % of respondents thought this was not the case. the case. But of that 52%, only 9% thought banks were only required to hold 1-10% at any one time.

The truth is that commercial banks are required to hold only a small fraction of customer deposits in reserve to meet their customers’ withdrawal requests. Indeed, this requirement underlies the fractional reserve system of modern banks commonly used around the world. And as such, banks are free to use the rest of the funds on deposit to make loans to other customers, which means that instead of sitting idle in customer accounts, the vast majority of the money deposited in banks can be used for loans.

The system generally works because depositors do not need to have access to all of their money at all times. People invariably only withdraw a fraction of their savings at any given time, which means that rather than having the rest sitting idle in their bank accounts, it can be used by the bank to advance loans to other borrowers. . And if a single customer seeks to withdraw all of their savings, the bank must still have enough accumulated in all customers’ accounts to accommodate that withdrawal. Indeed, it is for this purpose that the bank cannot lend all the money it receives in deposits; instead, a country’s central bank will normally set a cash reserve ratio (CRR), which determines how much of the reserves banks must hold rather than lend out. This ratio can be changed and is used by central banks as an essential monetary policy tool to control how much banks can lend.

Indeed, the greatest advantage of fractional-reserve banking is its central role in stimulating economic growth, in particular through the “money multiplier” effect. Since most of the clients’ savings are lent to other borrowers, these borrowers can then use their borrowed funds to spend and invest in new projects. The recipients of these expenses and investments can also spend or invest, or they can deposit the money they receive in their bank accounts. And again, the process can be repeated, so the initial customer savings created a multiplier effect that spurred economic growth. In March 2020, shortly after the coronavirus pandemic reached US shores and began to significantly reduce economic activity, for example, the Federal Reserve (the Fed) reduced the cash reserve requirement to 0 % with the aim of boosting bank lending and rejuvenating economic growth.

For the bank itself, meanwhile, a distinct advantage of the fractional reserve system is that it can earn interest on the money it lends to borrowers above the rate it pays depositors and savers. This is called the net interest margin (NIM). Banks rarely charge customers for making deposits; instead, banks pay interest to customers and generally charge no fees for storing their funds. However, the interest paid will be less than the interest earned by banks on what they lend to help them cover the costs associated with both activities.

But fractional-reserve banking raises several challenges, the biggest of which is reconciling the fact that customers don’t have access to all of their money at once. If a specific event prompts all of a bank’s customers to withdraw their savings, the bank will not have enough in reserve to meet that demand. Indeed, it tends to happen when the public loses confidence in the banking system and fears that the bank will fail. Unless banks immediately implement capital controls, a run on banks is the inevitable result.

However, if customer concerns were to be confined to one particular bank, an unusually high volume of withdrawals should be manageable, provided the bank can continue to borrow reserves from other banks. But the efficiency of this interbank market is not guaranteed, which may have significant implications for the solvency of the entire banking system.

As such, determining the liquidity ratio is the crucial question at the heart of fractional-reserve banking – how much less than 100% can a bank hold while facing a potentially heavy withdrawal load at any time? Clearly, the higher the reserve ratio, the lower the risk of triggering a bank run. So, it seems to be as much a statistical calculation as anything else. But if this calculation is wrong, so that the bank ends up holding too few reserves, what punitive measures are in place if the bank does not meet all of its customer withdrawal obligations? Such measures are equally important in deterring excessively liberal lending.

Likewise, the mere fact that customers are not informed that banks will not hold 100% of their deposits raises legal and moral questions about the nature of fractional-reserve banking. While banks are mandated to produce all of customers’ money on demand, the fractional reserve system ensures that this cannot be possible for all customers at once. Indeed, the system was instrumental in the loss of their savings during the Great Depression when a number of banks eventually failed and was therefore instrumental in the creation of the Federal Deposit Insurance Corporation (FDIC ) funded by the US government in 1933. To date, the FDIC protects customer funds up to $250,000 per depositor per insured bank, in the event of that bank’s failure. However, anything above this limit is lost.

Nevertheless, questions remain about the effectiveness of this system, with some continuing to argue that banks should always hold 100% of customer deposits to ensure the stability of the banking system at all times, so that if every customer demands the complete withdrawal of his their money, the bank could satisfy all demands. Indeed, it was another solution proposed during the Great Depression and became known as the Chicago Plan. This scheme separated the monetary and credit functions of the banking system by requiring a 100% reserve for deposits. According to economist Irving Fisher, such a plan had four distinct advantages over fractional-reserve systems:

  1. Much better control of a major source of business cycle fluctuations, sudden increases and contractions in bank credit and the supply of money created by banks.
  2. Complete elimination of bank runs.
  3. Dramatic reduction in public debt (net).
  4. Dramatic reduction in private debt, as monetary creation no longer requires the simultaneous creation of debt.

“We investigate these claims by integrating a comprehensive and carefully calibrated model of the banking system into a DSGE model of the US economy,” said a 2012 International Monetary Fund (IMF) working paper. “We find support for all four of Fisher’s demands. Moreover, output gains approach 10% and steady-state inflation can fall to zero without posing problems for the conduct of monetary policy.

But if a bank maintains a 100% ratio, does that surely mean that it will have nothing to lend to borrowers and would simply function as a storage vault for each of its customers? And therein lies the conundrum and why many economists believe that further allocation of customer deposits would be necessary to ensure that money was always available for lending. For example, the deposits a bank receives could be divided into checking accounts that meet customers’ day-to-day needs and longer-term savings and investment accounts, with customers agreeing to a term deposit agreement that prevents them to access their funds for a certain period. These funds could then be loaned to other customers while maintaining a 100% cash reserve ratio for the current account.

The Financial Times’ Chief economic commentator and renowned financial journalist Martin Wolf expressed his support for a similar system, in which money creation is separated from financial intermediation, in a 2014 article for the publication entitled “Strip private banks of their power to create money”. Rather than banks having the ability to create money through fractional-reserve lending, Wolf argued, the responsibility for money creation should instead be given to the state, thereby preventing banks from being able to create money. investment accounts “from scratch”. . And assets held in investment accounts would be prohibited from being reallocated. According to Wolf, any new money injected into the economy would meet four specific needs: finance public spending instead of taxes or borrowing; making direct payments to citizens; repay unpaid private and public debts; and making new loans through banks or other intermediaries.

“The opponents will say that the economy will die for lack of credit. I was once sympathetic to this argument. But only around 10% of UK bank lending has funded commercial investment in sectors other than commercial property. We could find other ways to fund that,” Wolf explained. “Our financial system is so unstable because the state first allowed it to create almost all the money in the economy and then was forced to insure it when performing that function. “a giant hole in the heart of our market economies. It could be closed by separating the provision of money, rightly a function of the state, from the provision of finance, a function of the private sector.”