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Full reserve banking?

19 and 23 July 2012

Khan Academy

The opposite of fractional reserve banking is full reserve banking. In a video available on Youtube, the Khan Academy explains how that works.

Note that this video is impartial, it does not promote full reserve banking, it just explains it. In the words of the presenter (Is it founder Salman Khan himself? His voice certainly sounds similar.):

I do wanna clarify that the whole point that I’m showing these weaknesses in fractional reserve banking, isn’t to argue that it necessarily has to go away, or that it is somehow unviable, [...]

Either on demand, or certificate of deposit

The video uses an example similar to mine. Where I assumed that 100 dollars were deposited in the bank, the video assumes just 3 dollars.

The essential difference is that I assumed that all the cash is put in a checking account (so it is an on demand deposit), whereas the video assumes that only one third (so that’s one dollar, in their example) is in a checking account. The other 2 dollars are in a CD (2m55s in the video).

Not being American, I had to look that up: a CD is a certificate of deposit. Here in Europe, or in the Netherlands, with which I am most familiar, we certainly have comparable banking products: in Dutch, we might call it a spaardeposito or savings deposit.

The important point is that the money in such an account is not available to the saver on demand, but will expire only after a pre-agreed period.

In slightly different banking products, the money is available on demand, but only after a period of notice: the saver can ask his money back at any time, but only really gets it after a pre-agreed period, which starts when he enters the request, will have expired.

Balance sheet

I’ll set up a balance sheet, showing the bank’s financial position just after it granted the credit. I’ll use the figures and situation of the aforementioned video by the Khan Academy. The details start at 1m50s in that video.

My purpose is to compare this balance sheet with what I arrived at in my first article just after step 2. I hope by comparing the two, we can find out what is the essential difference between fractional reserve lending and full reserve lending.

That balance sheet looks like this:

Description Debit (assets) Credit (liabilities)
Cash 1
Checking account (demand deposit) of Villager A 1
Certificate of deposit (savings deposit) of Villager A 2
Loan facility of Villager B 2

Below I repeat the balance sheet I had arrived at for fractional reserve banking, but with changed amounts so they correspond to Khan Academy’s example, for easier comparison.

Description Debit (assets) Credit (liabilities)
Cash 1
Checking account (demand deposit) of Villager A 3
Loan facility of Villager B 2

What are the differences?

What do we see?

The amount of cash the bank has in its till or vault, is the same in both cases: 1 dollar.

The loan amount that the bank granted to villager B, is also equal: 2 dollars.

What is also the same, is that Villager A, in return for depositing his 3 dollars of cash, now has a claim on the bank amounting to a total of 3 dollars.

The difference however is in the time frame: in my example, with fractional reserve banking, this claim is on demand: Villager A may claim the full amount back at any time. In Khan Academy’s example for full reserve banking, only 1 dollar is on demand. And that’s the dollar that the bank didn’t give to Villager B as a loan.

The 2 dollars that the bank did use to grant a loan from, has a time restraint towards Villager A: he can only get it back after several months or even years, but not right now.

That certainly makes full reserve banking safer: a bank run cannot happen. The bank still has all the money that anyone can demand back at short notice.

With fractional reserve banking, if more people want their money back than the cash reserve is sufficient for, the bank has a big problem. The question is however, how likely that is to occur in practice, especially in a modern society, where all individuals and all companies have bank accounts, and not very much cash.

What is the essence?

From the above comparison we can see, that the essential difference between fractional reserve banking and full reserve banking, is not so much in the fractional nature of the former. In a full reserve banking system too, part of the deposits will be on demand, because otherwise bank payments (writing a check, or transferring money to another account by wire) would be impossible.

This on demand part in full reserve banking plays a similar role (see the 1 dollar amount in the example) as the required cash reserve in fractional reserve banking.

The essential difference between fractional reserve banking and full reserve banking is this:

Full reserve to avoid money creation?

What is long and what is short, is a matter of definition. The details vary per central bank.

For example, M1 money consists of cash in the hands of the public (households and companies), plus their deposits in on demand bank accounts.

M2 comprises M1, and in addition (as the European Central Bank defines it) savings deposits with a period of notice up to three months, or a maturity period of at most two years.

The US Fed however does not have a period restraint, but does set an amount limit: ‘time deposits’ of less than 100,000 dollars count as M2. Larger deposits are not M2, but are M3.

In the video by Khan Academy about full fractional lending, at 3m10s the presenter says:

They [i.e. the bank; RH] are saying: this a is time deposit, that this money, you are giving it to us now, and you can get it back in six months or a year or two years or whatever [...].

Under the European definition of M2, such short-term savings accounts, or certificates of deposit, or whatever you want to call them, do count as money, provided the notice period is at most 3 months or the maturity is less than 2 years. The claim on the bank is M2 money. So in this example, other than Khan Academy suggests, the money supply is in fact extended and money creation does take place.

It is not money creation in terms of M1, but it is in terms of M2.

(Note that I do not say this to criticize that video. I think the video is very good and I recommend it. Just like me, the people at Khan Academy cannot and should not cover every detail in all of the videos/articles, or it would be too confusing. One thing at a time. They do treat the various definitions of ‘money’ in a separate video called “Money Supply – M0 M1 and M2”. See also 3m43s and 4m05s in the video on full reserve banking.)

Under the American monetary definition of ‘money’ (M2 or M3), money creation by credit granting takes place even in a full reserve banking system, regardless of the maturity or notice period of the deposits!

In essence, it is not fractional reserve banking that causes money creation by commercial banks. Money creation follows from the nature of credit itself: the owner doesn’s need the money but instead has a claim; the borrower has the money and can spend it. The claim is also a kind of money, so after credit granting, part or all of the money exists twice.

So for people who think money creation by non-central banks (i.e., commercial banks) is a bad thing (but I don't think so!), full reserve banking is not the solution. That’s because with full reserve lending, money creation (in terms of M2 or M3 money) happens as well.

Next

The next article describes a consequence of full reserve banking.


Addition 20 October 2012

Article 17 is in fact a note to articles 4, 6 and 7.


Copyright © 2012 R. Harmsen. All rights reserved.

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