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

Subject : Economy

Section: Monetary Policy

Concept :

Owing to the failures of three United States banks and one major European investment bank in March this year, it is important to understand the working type of the banks. (Full-Reserve Banking and Fractional reserve banking).

Full-Reserve Banking System

Full-reserve banking is also known as 100% reserve banking.
Full-reserve banking is a system where banks are prohibited from lending out the money they receive as demand deposits from customers.
Instead, they are required to keep all customer funds in their vaults at all times.
In this model, banks only act as custodians for depositors’ money and may charge a fee for this service.
This stands in contrast to the current banking system, where banks pay interest to customers on their demand deposits.
Under full-reserve banking, banks must maintain reserves equal to 100% of their demand deposits to ensure they can meet withdrawal requests and prevent a bank run, even if all depositors decide to withdraw their funds simultaneously.

How full-reserve banking system lend money?

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.
Under a full-reserve banking system, banks can only lend money that they receive as time deposits from their 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.

What is Fractional reserve banking?

The current banking system operates on fractional-reserve banking, where banks primarily hold cash deposits from customers in their vaults.
However, they can lend out more money than the physical cash they possess, as most lending occurs in the form of electronic money.
This practice creates electronic loans that can exceed the actual cash reserves.
If borrowers demand cash withdrawals exceeding the bank’s physical cash, it can lead to a bank run due to insufficient cash to meet the demand.

Why Bank runs are rare?

Bank runs are rare due to several reasons.
Non-cash instruments: Firstly, most transactions in modern economies occur through checks and non-cash instruments, reducing the demand for physical cash. This lessens the likelihood of a large number of customers seeking immediate cash withdrawals simultaneously.
Bail out: Secondly, central banks intervene by providing emergency cash to banks, ensuring they can meet sudden increases in customer cash demands.