Context: Under ‘Full Reserve Banking System’, the banks are prohibited from creating loans without actual cash in their vaults to back these loans.

• Banks act as custodians and hold all demand deposits in their vaults at all times.

What is Full Reserve Banking?

• Full-reserve banking, also known as 100% reserve banking, is a banking system in which banks are required to hold 100% of their customers’ demand deposits in reserve.

• A demand deposit is money deposited into a bank account with funds that can be withdrawn on-demand at any time.

• Under this system, banks are not allowed to use customers’ deposits to make loans or investments.

• Instead, they act solely as custodians, holding the deposits securely in their vaults and charging a fee for this service.

Lending in a Full-Reserve System

• Banks can only lend money received as time deposits, allowing time to repay depositors with interest.

• This contrasts with fractional-reserve banking, where banks create electronic loans exceeding actual cash reserves.

Reduced Risk of Bank Runs

• Full-reserve banking prevents excessive loans and reduces the risk of bank runs.

• Demand for cash remains minimal due to non-cash transactions and central banks provide emergency cash if needed.

Economic Growth Debate

• Supporters of fractional-reserve banking believe it spurs investment and economic growth.

• Proponents of full-reserve banking argue it prevents crises and restricts banks’ influence on the money supply.

Advantages of Full-Reserve Banking

• Stability and Reduced Risk: With 100% reserve backing, there is no risk of a bank run since the bank will always have enough physical cash to meet all withdrawal demands. This enhances the stability of the banking system and reduces the fear of a financial crisis due to sudden deposit withdrawals.

• Prevents Fractional Reserve Risks: Full-reserve banking eliminates the risks associated with fractional reserve banking, where banks create money through lending without holding adequate reserves. This prevents the possibility of banks’ lending out more money than they actually possess, reducing the potential for economic bubbles and financial instability.

• Fractional-reserve banking is the system of banking that is commonly used in modern economies.

• Under this system, banks are required to hold only a fraction of their customers’ deposits as reserves and are allowed to lend out the remainder to borrowers.

• The fraction of deposits that banks must keep in reserve is determined by the reserve requirement set by the central bank.

• Clearer Money Supply Control: In a full-reserve system, banks cannot create money out of thin air, resulting in a more stable and predictable money supply. This can prevent inflationary pressures caused by excessive money creation.

Disadvantages of Full-Reserve Banking

• Reduced Lending: It could lead to a reduction in lending since banks can only lend money that they receive as time deposits. This may limit the availability of credit for businesses and individuals, potentially slowing down economic growth.

• Opportunity Cost: Banks earn profits by lending out customers’ deposits and charging higher interest rates than they pay on deposits. In a full-reserve system, banks would not be able to earn as much from interest income, which could impact their profitability.