Full Reserve Banking

by William F Hummel

updated July 4, 2016

A near melt-down of the financial system in 2008 has sparked a renewed interest in full reserve banking. Some believe that fractional reserve banking is a root cause of asset price bubbles that can end in debt deflation and deep recessions. In the following, we outline a full reserve system for the U.S. and compare it with the current fractional reserve system for individual banks and for the banking system as a whole. 

Individual Bank Operations

In full reserve banking, every bank would be required to hold reserves equal at all times to its transaction deposits. Those reserves are effectively bound to the deposits and therefore could not be used by the bank. We will call them bound reserves. For its own investments -- making loans or buying securities -- a bank would need additional reserves. We will call them free reserves. As in fractional reserve banking, reserves could be held in any combination of vault cash and deposits at the Fed. They would not be required against savings or term deposits, but all deposits would be insured by the FDIC up to specified dollar limits.

In fractional reserve banking, the distinction between free reserves and bound reserves is less relevant. As long as the bank can meet the reserve ratio requirement on average over a 14-day period, it can use all of its reserves to cover a new loan. This provides a degree of freedom not available in full reserve banking. 

Regardless of the required reserve ratio, a bank must have sufficient reserves to cover a loan on the day it is made. If the bank is in good standing and temporarily short of reserves, it may receive a daylight advance from the Fed. However the amount of the advance is limited to a fraction of the bank's capital, and is subject to an interest charge.

A bank acquires new reserves whenever it receives a new transaction deposit. However in full reserve banking, all those reserves would be bound rather than free. To increase its lending power, the bank would need to acquire additional free reserves. Its options are: (1) borrow from the Fed, (2) borrow from another bank, (3) borrow from a non-bank, (4) induce its transaction account holders to move funds into savings or term deposits, (5) sell assets in the open market, or (6) sell additional bank shares to investors. 

Option 1 is normally used to address liquidity issues rather than as a source of funds to lend because Fed loans are designed to cost more than other options. Option 2 simply transfers free reserves between the banks without increasing the total. All other options increase free reserves but at the expense of reducing aggregate transaction deposits. Then how could the transaction money supply grow in a full reserve system? The answer is:  through open market operations by the Fed.

Accounting Details

Each bank would need two accounts at the Fed, a Bound Reserves Account (BRA) and a Free Reserves Account (FRA). The BRA together with the bank's vault cash should equal its total transaction deposit liabilities. The FRA would hold the bank’s discretionary funds.

Each bank would report its total transaction deposits and its vault cash to the Fed at daily closing. The difference should equal what it holds in its BRA. If there is a discrepancy, the Fed would transfer funds between the bank’s BRA and FRA as needed to correct it.

When a bank makes a loan, it would transfer that amount from its FRA to its BRA. Conversely when the loan is paid off, it would transfer that amount from the bank's BRA to its FRA. When the bank makes payment for an investment or for goods and services, the Fed would debit the bank’s FRA and credit the BRA of the recipient’s bank.

When a bank depositor deposits a check in his account, the bank would credit his transaction account with that amount and report the payment to the Fed. The Fed would debit the payer bank’s BRA and credit he payee bank’s BRA. It would then instruct the payer’s bank to reduce the balance in the payer’s transaction account.

When a depositor moves funds from his transaction account to a term or savings account, it would free up that much of the bank’s bound reserves. This would be noted in the bank’s daily report to the Fed, who would transfer funds from the bank’s BRA to its FRA. Conversely if a depositor allowed a loan to the bank to mature or moved funds from his savings account to his transaction account, it would be reported to the Fed who would transfer funds from the bank’s FRA to its BRA.

If a bank depositor withdraws or deposits cash, the difference between total deposits and cash would remain unchanged, thus requiring no change in the bank's BRA or FRA.

Implementing Monetary Policy

The Fed would implement monetary policy by setting a target for the interest rate on interbank loans of free reserves. It would offer to lend free reserves to banks with adequate collateral at 40 basis points above the target rate and borrow at 40 basis points below the target rate. These margins could be adjusted by the Fed to control the total amount of such lending and borrowing. By observing the amount loaned versus the amount borrowed in a given period, the Fed could determine the amount of reserves it needs to add or drain to balance supply versus demand at the target rate.

The Fed would buy or sell securities in the open market thus adding or draining transaction deposits and their related reserves. However open market operations (OMO) with the non-bank sector can only create bound reserves equal to the increase in transaction deposits. The excess of funds in non-interest-earning transaction deposits would induce the sellers to move some of their funds into term deposits at the same bank. Any such purchases would convert that much in bound reserves to free reserves, and thereby influence the interest rate on interbank loans. 

In the fractional reserve system, the Fed controls the short-term interest rate by operating on a relatively small pool of reserves. That pool would be considerably larger in a full reserve system since it would comprise the discretionary funds (free reserves) of the entire banking system. Therefore in a full reserve system the Fed would have to deal in larger increments in open market operations to achieve the same level of control.

The Banking System

From the perspective of non-bank firms and households, the banking system in a full reserve regime would not seem much different from the current fractional reserve system. However banks would have to work harder to make the same kinds of profits, and that could affect the fees charged for their depository services. Since new transaction deposits would bring no free reserves to a bank, banks would have little incentive to seek them unless they believed the depositors would move some of the funds into savings or term deposits. 

To enhance the stability of the banking system, new operating rules and restrictions for banks should be established. For example a bank's capital (assets minus liabilities) should be at least 10% of its risk-weighted assets. A bank should be required to hold on its own balance sheet at least 10% of each loan it issues so as to share in the risk of a default by the borrower. Permissible investments should exclude those whose basic purpose is to leverage bets in the financial markets.

Money Supply Growth

Government spending has no net effect on aggregate bank reserves and transaction deposits in either a full reserve or fractional reserve system. The Treasury spends out of its account at the Fed which it must continually replenish to avoid depletion. It does so with transfers from its commercial bank accounts where it deposits receipts from taxes and the sale of securities. By targeting a fixed balance in its Fed account, the Treasury leaves total reserves in the banking system unchanged except for short-term transients. By balancing its inflows against outflows through the net sale or redemption of securities, the Treasury leaves the money supply unchanged on average. In effect, the Treasury pays for its deficit spending with securities rather than money.

Since the demand for loans varies with the interest rate, the total amount of transaction deposits would depend on the interest rate banks charge on loans, which they would normally set at a markup from the Fed’s target rate. Thus growth in the money supply would be endogenous, varying with demand as influenced by the Fed's target rate. 

Transition to a Full Reserve System

As of June 2016, reserves totaled about $2,250 billion and transaction deposits about $1,350 billion, the result of the Fed’s quantitative easing programs. If the Fed declared the full reserve system in effect at that time, bound reserves would total about $1,350 billion and free reserves about $900 billion. Banks would need some portion of those free reserves as working balances, probably less than $200 billion. The rest would have to be recaptured by the Fed. This could be done as follows:

The Fed would offer securities to banks from its own portfolio at a discount to induce them to spend their excess free reserves. It would also declare that bank savings accounts could no longer be used as checkable deposits. That should induce a movement of some savings deposits into transaction accounts, thereby converting that much of free reserves into bound reserves. The interest paid on reserves would be limited to free reserves only and gradually reduced to zero.

Transition to the full reserve system would be complete when total reserves equaled total bank transaction deposits plus what banks chose to hold in free reserves after the end of interest on reserves. The interest rate in the interbank lending market would then be controlled by the Fed through open market operations as it did before the financial crisis of 2008.