Full-reserve banking

Full-reserve banking is the banking practice in which the full amount of each depositors' funds are available in reserve at the bank 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.

History

See Bank of Amsterdam

Debate over full reserve banking

Proposals for full reserve banking are regarded as unsound or meaningless by mainstream economists and bankers, and are rarely discussed in mainstream circles. By contrast, within the Austrian school of economics, the relative merits of full reserve and fractional reserve banking are the subject of active debate.

The case for full-reserve banking

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 greatly reduce 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.

A bank could engage in full reserve banking by making loans backed completely by a commodity or government created debt-free currency. Banks would not have the power to create "money" as they are able to do within a fractional reserve banking system. The monetary base would remain stable.

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.

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 out of thin air.

Some advocates believe that full-reserve banking should only apply to demand deposits 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.

A system in which all currency is backed by another asset and commercial banks are required to maintain a 100% cash reserve ratio has never been implemented in any actual economy.

In monetary policy, the closest analogy to a full reserve bank is that of a currency board, in which commercial banks are not required to maintain a 100% cash reserve, but all of the money in circulation is backed by another asset held by the central bank. This system is in use in Hong Kong where the Hong Kong dollar is backed by United States dollars deposited in the Exchange Fund of the currency board. Other independent states such as Lithuania, Estonia and Bosnia have implemented currency board-like systems (local currencies are anchored to the euro). Argentina had a currency board-like system (anchored to the U.S. dollar) up until 2002 (when it broke the link with the U.S. Dollar and devalued the Argentine peso), and many Caribbean states have used this kind of system up until recently.

Criticism of full-reserve banking advocates

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 might also argue that a full-reserve system leaves us with an inelastic currency. Proponents would likely 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 economy will bear 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).

Pascal Salin, former professor at the Université Paris-Dauphine and former Mont Pelerin Society president, opposes such regulation of banking. 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 such a system. In fact, some economists, such as Murray Rothbard (of the Austrian School) believe that government has everything to do with the pervasiveness of fractional-reserve banking, as governments have essentially formalized the process by making it legal and supporting through the creation of central banks; and, in doing this, they have prevented the natural checks that would likely 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?.

Current Examples

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 [1]

Digital gold

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 e-gold, e-Bullion and GoldMoney. Also available are physical gold exchangers and storage providers, such as BullionVault.

Monetary reform

Many monetary reform groups focus on the perceived inequities and dysfunctional effects of fractional-reserve banking as a target for reform. Monetary reformers such as Joseph Huber and James Robertson both support full-reseve banking as part of a comprehensive review of monetary policy in the information age. They argue for one major monetary reform: the reappropriation by governments of the right of seigniorage now possessed by private banks. Almost all new money currently issued takes the form of loans made by private banks to borrowers. Huber and Robertson want to make this method of privatised money creation illegal. The creation of new money, both cash and non-cash, should be the exclusive prerogative of the central bank, according to these writers. The government-owned central bank should determine how much money creates in the light of the objectives chosen for the country's monetary policy and long-term (sustainable) wellbeing, and credit the new money to the government, at no cost. This interest-free credit will then put it into circulation by the central government simply spending it..

Michael Rowbotham has also advocated a very similar policy of monetary reform.

Another full-reserve proposal is put forward by the "American Monetary Institute" AMI: "The Federal Reserve banks would be nationalized, but not the individual member banks. The power to create money was to be removed from private banks by abolishing fractional reserves – the mechanism through which the banking system creates money. So the plan called for 100% reserves on checking accounts which simply meant banks would be warehousing and transferring the money and charging fees for their services."

See also

• Gold standard
• Ludwig von Mises
• Money creation
• Murray Rothbard
• Reserve requirement
• Seignorage
• Silver standard
• Gala Évora

External links

• Money, Bank Credit and Economic Cycles, Huerta de Soto, J. (2006), Ludwig von Mises Institute
• Free Banking and Fractional Reserves: a Comment (Pascal Salin)
• 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
• Full Reserve Banking Explanation (A.B. Dada)