A Road to a Stable Banking System

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We have been hearing a lot in recent years about problems of large banks and the efforts of central banks and governments to keep them afloat. These actions are motivated, among other things, by an intention to prevent a large catastrophe of the whole financial system. Certainly, the threat of such a catastrophe would be much smaller if banks were not operating on the basis of the fractional reserve principle. However, the problem with the alternative one hundred percent reserve principle is that the banks that would apply it could become much less attractive in the eyes of customers. This text will explain why we can expect such a problem to occur and how it could be dealt with. We will also try to fathom whether it would be possible for the banking system to transform in the direction of greater stability without any reserve level requirements being imposed, and how this process could be aided.

Let us begin with presenting the differences between one hundred percent reserve banking and fractional reserve banking.

The principle of one hundred percent, or full, reserve means that a bank that adheres to it will always have enough money on hand to satisfy the claims of all depositors that are entitled to withdraw their deposits at a time. That entails that all demand deposits must be left untouched, and not loaned out, as those who made them are entitled to withdraw their money any time they wish. As the bank will not be able to take benefit of the deposited funds, it will be natural for it to charge the depositors with a storage payment. Things look different, though, with time deposits. If, for example, the bank’s customer makes a time deposit for two years, the bank will be allowed to use this deposit during the period of two years, but the depositor will not be able to withdraw his money until the deposit’s maturity date. In return he will receive interest. In other words, the customer will lend the money to the bank for two years. The bank will perform the function of an intermediary between depositors and borrowers, but that does not mean it has to find for each depositor a borrower wishing to borrow an exactly the same amount. Deposits can be pooled to form a bigger loan.

Let us now pass to a fractional reserve bank. Such a bank can use both demand and time deposits to make loans. In fact, the division between these two types of deposits is only formal, as both are, in practice, demand deposits. The customer can terminate the deposit before the maturity date, usually losing only part of the interest. A fractional reserve bank puts aside a fraction of the deposits as a reserve (hence the name) and lends out the rest.

The basic problem with using the fractional reserve principle is that banks are vulnerable to “runs”, that is panic driven rushes of customers to withdraw their deposits. No bank can withstand such a rush. And as all banks are fractional reserve banks the whole banking system can potentially collapse in a very short period of time. There is, however, an institutional infrastructure to prevent such an occurrence. First, there is the deposit insurance. It allows most depositors to retrieve their money in the event of a bank failure. The insurance fund is sufficient when a single bank becomes insolvent, but a systemic collapse would be beyond its capabilities. Second, the central bank can help banks that have problems with liquidity (it is sometimes called “the lender of last resort”). Its efficiency in this respect is largely due to the fact that it is the currency issuer, so it will always be able to provide sufficient funds. Nevertheless, a bankruptcy of any large banking institution is a big problem for the financial system and that allows large banks to threaten the government with a financial Armageddon if they are left unaided.

The above institutional support is not the only reason why the fractional reserve banking has triumphed. It has a great competitive advantage over the full reserve banking in that depositors can withdraw their funds, including time deposits, whenever they wish. People value this opportunity very much. However, this advantage can be reduced, if not totally removed, if depositors are provided with a convenient way to sell the rights to their deposits. This idea can be put in practice by means of different instruments. Let us illustrate its essence with an example. Let us suppose that a bank’s customer makes a deposit of $10,000 for five years at 4 percent of annual interest. After the period of five years he will be entitled to receive $12,166. Let us now imagine that due to some previously unpredicted circumstances he wishes to withdraw his money after two years. He cannot terminate the deposit, but he can sell the deposit to someone else. If the buyer pays the amount of the principal, that is $10,000, he will, in practice, become an owner of a three-year deposit at 6.75 percent. It should not be hard to find such a buyer, especially if new deposits will still offer 4 percent. The original depositor could also count on preserving some of the interest. If he kept 2 percentage points of interest, selling the deposit for $10.404, the buyer would receive 5.35 percent for the period until maturity. Finding such a buyer should not be very hard either. On a well-developed and very liquid market the rate of the salvaged interest should tend to approach the interest on new deposits, which is more than what banks usually offer to those who terminate their time deposits prematurely.

There exist some financial instruments that function according to the above principle. The example are Negotiable Certificates of Deposit. They cannot be terminated before maturity, but they can be sold on the secondary market. Unfortunately, they are offered only for deposits exceeding $100.000, but there is no fundamental reason why such an instrument could not be accessible to all depositors, even those who deposit small amounts. Also when banks issue bonds we can say that the idea of “tradable deposits” is realized.

Undoubtedly, a system of all such instruments would have the best field for development if the principle of one hundred reserve were legally enforced. Many economists, over the last century and more, have advocated such a solution, not only to make the banking system more stable, but also because they have seen the fractional reserve banking as one of the root causes of economic maladies that nations have suffered. However, if we put aside the question of banks’ vulnerability to runs, and the moral issue whether fractional reserve is fraud or not, the two banking systems – of fractional and full reserve – do not seem to be economically that different as it is often presented. For example, some economists have claimed that in the system of fractional reserve the amount of credit does not even remotely reflect the rate of saving, or, as it is sometimes called, “saving-investment”. This thesis is based on the following reasoning: We deal with saving (or saving-investment) when a person resigns from spending a certain amount of money in order to achieve a monetary return after some period of time. Making a loan is such an act, while entrusting money to a bank as a demand deposit is not, because the depositor does not temporarily renounce the use of his money. By making demand deposits people demonstrate the wish to simply keep money on hand and not to save and invest. Therefore, banks invest what hasn’t been saved with an intention to invest, which leads to distortions in market interest rates resulting in excessive and ill-directed credit, and, consequently, the phenomenon of the business cycle.[1] However, how can we know that a bank’s customer who makes a time deposit does not wish to make an act of saving-investing? The deposit may, for all intents and purposes, be a demand deposit, but how does this contradict an intention to save and invest, especially if the interest rate is attractive? Besides, why should we treat the wish to save and invest, and the wish to keep money on hand, as mutually exclusive? One’s primary intention may be to make an investment for a return, and the secondary intention may be to be able to retrieve the invested money in case of an emergency. Note that in a system of one hundred percent reserve depositors will be able to quickly retrieve their money by selling their deposits, so there is no reason to believe that the cluster of intentions must be different. The system of fractional reserve is also accused of causing inflation and high indebtedness of the population due to the mechanism of “creating money through credit”. This mechanism goes as follows: when someone makes a deposit the bank puts aside a fraction of this money as a reserve and lends out the rest; the borrower spends the money and it lands at someone else’s bank account (or accounts); part of it is put aside and the rest is lent out; and so on. The amount of money in bank accounts, and the cumulative amount of credit given by banks to borrowers, grows with each such step. But we will deal with a similar mechanism in the system of full reserve. When someone makes a time deposit the bank will lend the money and the borrower will spend it; whoever gets the money they will likely make a time deposit and thus provide the bank with the funds to make another loan; the lent money can become another time deposit, making another loan possible. Before the original deposit matures the amount of credit “created” by the banking system may exceed it by many times. If the time deposits that originate in this process are marketable, we will deal with a close equivalent of time deposits in the present banking system. The depositor will not have money in an account, but he will have a deposit that could be sold at practically any moment. That’s true that such deposits could fluctuate in value, and (probably) you wouldn’t be able to use them as payment in shops, so they could not be formally considered as part of the money supply (at least according to the predominant theories). Yet if a depositor is certain that he could quickly sell the deposit for at least a certain amount of money, this certainty will make him treat his deposit as if it was this amount of money in an account or stashed under the mattress, with all the consequences for his disposal of current income and other funds. In other words, the marginal utility of his money stock will be affected the same way as if he really was in the possession of a certain amount of money. The above analysis should not lead us to the conclusion that both systems allow for unlimited creation of money and credit. Only the central bank, or other institution that can create money at will, can be a source of such unlimited creation.

As a side note, let us notice that the influence of one’s ownership of marketable assets on the marginal utility of one’s money stock is a general phenomenon that can be taken into account when analyzing various economic facts or events such as, for example, quantitative easing. When quantitative easing consists in buying assets from banks, or other private entities, then, admittedly, the sellers have more cash in result, but they have less assets, so they will have the perception of having more money to lend, spend or invest only to the extent that they believe they become richer in general. In short, such a procedure is inflationary only to the extent that the central bank overpays. The situation is different when the central bank buys, directly or indirectly, newly issued government bonds , as new money is introduced into the economy without taking existing marketable assets in exchange.

Coming back to the main subject of this article, an important question is: could issuance of tradable instruments become the dominant form of acquiring funds by the banking system without any legal requirements concerning the level of reserves? It seems perfectly possible. First, such instruments are comfortable for banks as they do not need to worry that depositors come for their money prematurely. Second, the more developed the market for such instruments becomes the better terms should the sellers acquire so it should be increasingly easy to convince people to invest their money this way. Third, as banks can lend the whole amount of a deposit, without putting aside part of it at as a reserve, they can afford to offer more attractive interest yields to depositors. However, there are many conservative savers who are accustomed to making traditional deposits at banks and do not even consider buying instruments that are tradable on the secondary market, nor would they accept such an offer from their bank, as they would be afraid of not being able to sell their deposits on good terms. Such savers could be offered instruments that, on the one hand, would function like traditional time deposits, that is you could terminate them any time you wish receiving the principal and perhaps some interest from the bank, and, on the other hand, you could sell them on the secondary market. It’s an attractive solution from the point of view of customers as they could potentially achieve more on the market than what the bank guarantees. Such instruments may not, in themselves, make banks more stable, but they can help develop the market of tradable deposits, also those that do not have any features of demand deposits, and they could change the investment awareness and attitudes of traditional savers.

Could the government do something to contribute to the development of the market of tradable deposits? Certainly, but we should be cautious as compulsion might lead to some unintended consequences, so it would be better to incentivize banks to use such instruments on their own initiative. This could be done by, for example, reducing the rate of compulsory insurance premiums for banks that use tradable instruments to fund their lending operations in some proportion or by relieving the interest on such instruments from the capital gains tax. Certainly some other options could also be considered.

Acquiring funds by banks through issuance of instruments that cannot be redeemed on demand but can be sold on the secondary market is a road to a stable banking system, as such practice makes banks less vulnerable to failure resulting from panic driven massive withdrawals of deposits. Hopefully, owing to private initiatives by banks, and well-considered measures by the government, the growth of usage of such instruments will lead the banking system to a level of stability at which the threat of a systemic collapse will no longer be present.


[1] See, for example, Jesús Huerta de Soto, Money, Bank Credit and Economic Cycles, Second Edition, Ludwig von Mises Institute, Auburn, Alabama, 2009, p. 134-136, 188-189, 348-352, passim; available at: http://www.mises.org/books/desoto.pdf.

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About Rafał Rudowski

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