A Plan for Monetary Reform

by William F Hummel

updated April 17, 2015

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. We then describe a simplification of the full reserve system which involves the creation and use of a single National Depository.

Full Reserve Banking

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 deposit. However in full reserve banking, 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 Deposit Liability Account (DLA) and a Free Reserves Account (FRA). The DLA together with its vault cash should equal its transaction deposit liabilities. The FRA would hold the bank’s discretionary funds.

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

When a bank makes a loan, it would report an increase in transaction deposits that day. The Fed would move that much from the bank’s FRA to its DLA. Conversely when the loan is paid off, the Fed would move that much from the bank's DLA 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 DLA of the recipient’s bank.

When a depositor spends out of his transaction account, the Fed would transfer that much of his bank’s DLA to the DLA of the recipient’s bank. His transaction account would be debited accordingly. When a depositor receives a payment to his transaction account from another bank, the Fed would transfer that much to his bank’s DLA and debit the DLA of the payee’s bank.

When a depositor withdraws cash from his transaction account, the reduction in the transaction account would be matched by the reduction in vault cash. Conversely if the depositor deposits cash in his transaction account, the increase in the transaction account would be matched by the increase in the bank’s vault cash. In either case there would be no change in his DLA.

When a depositor moves funds from his transaction account to a savings or term 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 DLA to its FRA. Conversely if a depositor allowed a term account to mature or transferred savings deposits to transaction deposits, the increase in the latter would cause the Fed to transfer funds from the bank’s FRA to its DLA.

The Banking System

The Fed would implement monetary policy by setting a target for the interest rate in the interbank lending market. It would offer to lend short term 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 can 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 can determine the amount of reserves it needs to add or drain to balance supply versus demand at the target rate.

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 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.

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 book value plus retained earnings 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 making the loan. Permissible investments should exclude those whose basic purpose is to leverage bets in the financial markets.

Money Supply Growth

The Fed’s purchase of securities from the non-bank sector  would increase transaction deposits as well as bound reserves in the banking system. However the sellers of the securities would seek to reinvest the proceeds in order to earn a return rather than leaving them idle. Regardless of how invested, the funds would remain in transaction accounts until invested in term or saving deposits of banks, whereupon free reserves in the banking system would increase accordingly. 

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
Currently (April 2015), reserves total about $2,670 billion and transaction deposits about $1,720 billion, the result of the Fed’s quantitative easing programs. If the Fed declared the full reserve system in effect now, bound reserves would total about $1,720 billion and free reserves about $950 billion. Banks would need some portion of those free reserves as working balances in a full reserve regime, probably less than $100 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 in free reserves into bound reserves. 

Transition to the full reserve system would be complete when total reserves equal total bank transaction deposits plus what banks chose to hold in free reserves after the Fed ended the payment 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. Until then the Fed would continue to pay interest on reserves as needed to control the short term interest rate.

A Single National Depository

In the following we describe a functional equivalent of the full reserve system outlined above which is simpler and more efficient. It consolidates the transaction deposits of the many thousands of banks and thrifts into a single institution called the National Depository, run as a public service by the Fed.  A key difference from the full reserve system is that deposits in the National Depository would be actual base money rather than claims on base money. In effect the deposits would be legal tender in digital form. The term reserves would no longer be relevant and could be dropped from the financial lexicon. 

One should not confuse the National Depository with Federal Reserve Banks. The latter would continue to implement monetary policy through open market operations and provide loans to banks. All such transactions result in credits or debits to accounts in the Depository and thus affect the total money supply.

Implementation of the National Depository System

Transition to the National Depository system would begin after the full reserve system had been in operation long enough to settle into steady state. The required infrastructure must be built and ready for use. It would consist of a secure computer network of the 12 district Fed banks and their 24 branches, and an ATM system to acquire and deposit currency. The ATMs could be located in banks that offer to provide the service as well as in post officies. The Depository itself does not handle currency.  

All reserve accounts at the Fed would be transferred to the Depository. Bound reserves (those backing transaction deposits) would become deposits in the accounts of the respective owners. Free reserves would become deposits in accounts of the respective banks. At their option, banks could exchange their vault cash for deposits at the Depository. The balance sheets of banks would be downsized by the transfers, but the net worth of each would remain unchanged. 

For economic analysis, each account would have a label to indicate the type of owner, for example:  bank, credit union, non-bank financial institution, non-financial firm, non-profit organization, eurodollar bank, foreign central bank, or household. Labels to further subdivide accounts by owner type within the top levels could also be helpful. Without disclosing the owners of individual accounts or their holdings, the data could be aggregated on a minute by minute basis and made available for analysis. This would be particularly useful in times of economic or financial stress. 

Depository Services

The National Depository would offer accounts to all who need the payment services of a traditional bank. It would only hold transaction deposits and would pay no interest. The Depository would neither lend nor borrow. It would simply execute payment orders and handle the accounting. Banks would be required to provide payment services against their customers' respective accounts in the Depository if requested.

The computer used by the National Depository would be an extension of the Fed's computer system. Payment orders would be accepted by electronic means via plastic cards, the Internet, Fed wire, smart phones, or by telephone. Paper checks would be phased out, after which verifying balances and making payments would all be done in real time. The time delays and nuisance of check float would vanish. Payments would be executed by simply transferring funds between accounts. The only exception would be transactions with the Fed which would involve a transfer of funds by wire in or out of the Depository.

Banking after the Transition

Banks could neither create nor accept transaction deposits. However they could accept term loans of various maturities and pay interest on them. Term loans would be insured by the FDIC, which would be renamed the Federal Loan Insurance Corporation (FLIC). The funds paid by an investor in a term loan to a bank would be credited to the bank's account in the Depository, and immediately useable by the bank for its own investments. Banks would hold no short-term liabilities except to the Fed or to other banks. Thus there is no possibility of a bank run in the National Depository System.

Banks could provide most of the same services they do in a fractional reserve system, including making payments out of a customer's account in the Depository. The customer  would have to authorize each payment, and fees might be charged. However a bank would likely provide such services without charge if the customer held a term loan to the bank.

Money in the Depository earns no interest so banks would normally hold only what is needed in the near-term for redeeming maturing liabilities and for operating expenses. Money acquired in excess of that would be used to buy securities such as Treasury bills or loaned short-term.   

A bank makes a loan by simply transferring funds from its own account in the Depository to the borrower's account, and recording a new loan asset on its books. If the bank had to acquire additional funds in order to make the loan, it has many options -- repo its securities, sell securities outright, borrow in the interbank lending market, borrow from a non-bank, or borrow from the Fed. Borrowing from the Fed would increase the total money supply, but the others simply move funds between accounts within the Depository. 

In general, the Fed should charge banks more than the other options in order to encourage them to first look elsewhere for funds. However a growing economy needs an increasing money supply and the Fed must stand ready to lend to banks or to monetize securities for that purpose. Indeed the Fed is the only institution capable of increasing the money supply in the Natonal Depository System.

To enhance the stability of the banking system, new operating rules and restrictions for banks should be established. For example a bank's book value plus retained earnings should be at least 10% of its risk-weighted assets. A bank should be required to carry on its own balance sheet at least 10% of each loan it issues so as to share in the risk of making the loan. Permissible investments should exclude those whose basic purpose is to leverage bets in the financial markets.

Monetary Policy Implementation

The Fed would implement monetary policy by setting a target for the interest rate on interbank loans. It would buy or sell securities in the open market as needed to balance supply against demand at that rate. The Fed’s purchase of securities from the non-bank sector would not directly increase bank-owned funds. However the sellers would seek to reinvest the proceeds in order to earn a return rather than leaving them idle. Regardless of where invested, the excess funds would remain in non-bank accounts at the Depository until invested in term loans to banks. It is likely a sizable fraction of the excess would end up at banks and thereby enable the Fed to control the interbank lending rate. 

To enhance bank liquidity, the Fed would offer to lend to banks against adequate collateral at 40 basis points above the target rate, and borrow from banks at 40 basis points below the target rate. By observing the amount loaned versus the amount borrowed in a given period, the Fed can determine the amount of money it needs to add or drain to keep the average interbank lending rate close to the target rate. The ability to borrow directly from the Fed in order to lend greatly enhances the flexibility of a bank in a full reserve system.   

Treasury Operations

In addition to serving the private sector, the National Depository would serve the U.S. government, and offer accounts to foreign banks and governments that need to transact in U.S. dollars. With the exception of U.S. currency in circulation, the entire U.S. dollar supply would exist in accounts at the National Depository. 

The general fund of the Treasury would be held in the Depository where it would deposit receipts from Federal taxes and the sale of its securities. All government spending would be paid out of the Treasury's account. To avoid interfering with the Fed’s monetary policy operations, the Treasury would target a fixed balance in its account, sufficient to meet its near-term payment obligations. It would do so by selling or redeeming securities to cover the imbalance between government spending and tax revenues, in effect paying for government deficit spending with securities rather than money.