Full-Reserve Banking: Where Banks Act Solely As Custodians Of Customers’ Money

Relevance: GS3 - Indian Economy and issues relating to planning, mobilization, of resources, growth, development 

(Source: The Hindu, 07/26/2023)

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Why in the news?

• This article has discussed about the Full-Reserve Banking which is also known as 100% Reserve Banking.
• It is a banking system where banks are required to hold all the money they receive from customers as demand deposits in their vaults at all times. 
• Only time deposits can be used for lending purposes.

What is the aim of Full Reserve Banking?

• It states that banks must keep all the money they receive from customers and cannot use that money to lend to others. 
• It acts as keepers or guardians of the customers' money and may charge a fee for this service. 
  • In the Fractional-Reserve Banking System (current banking system), banks can use a portion of customers' money to make loans and pay interest to customers for using their money.
• The main idea behind full-reserve banking is to ensure that the bank always has enough money on hand to give back to customers if they want to withdraw their money. 
• This way, even if all customers come to take out their money at the same time, the bank will have enough cash to pay everyone and prevent a situation where the bank runs out of money.

How can money be lent in Full Reserve Banking?

• In Full-Reserve Banking, banks can only lend money received as time deposits, which customers can withdraw after an agreed-upon period. 
• This provides banks with time to lend these deposits to borrowers at interest rates, collect repayments, and return depositors' money with interest.

Significance and Criticism of Full-Reserve Banking

Significance

• It is the most natural and safe way to operate banks, which can prevent the crises that occur in the current fractional-reserve banking system. 
• In full-reserve banking, banks would only be allowed to lend money that customers have deposited for a specific period (time deposits), and they must keep all the money that customers can withdraw at any time (demand deposits) in their vaults. This reduces the risk of bank runs significantly.
• With limited ability to influence the money supply, it is believed that the economy will be more stable, avoiding artificial booms and busts caused by changes in money availability.

Criticism

• In a full-reserve banking system, banks are not allowed to give out loans unless they have enough actual cash in their possession to cover those loans. 
• If banks are required to keep all the money in reserves, it can limit their ability to lend money. 
• If banks will not be able to create money in a full-reserve banking system, their influence on the economy’s money supply will become severely restricted.

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FAQs

MCQ

Question: What is the primary characteristic of Full-Reserve Banking?

(a) Banks can lend out all customer deposits.

(b) Banks must keep all customer deposits in their vaults at all times.

(c) Banks can lend money only to borrowers with good credit.

(d) None of the above given