Banking Sector Reforms

Full-Reserve Banking vs. Fractional-Reserve Banking


From UPSC perspective, the following things are important :

Prelims level: Full-Reserve Banking

Mains level: Not Much


Central Idea

  • Full-reserve banking, also known as 100% reserve banking, and fractional-reserve banking are two different systems of banking that determine how banks handle customer deposits and lending practices.
  • This article discusses the key differences between these two banking systems and the arguments put forth by proponents of each approach.

What is Full-Reserve Banking?

  • Custodian Role: In a full-reserve banking system, banks hold all money received as demand deposits from customers in their vaults, acting as safekeepers of depositors’ funds.
  • Limited Lending: Banks can only lend money from time deposits, which customers can withdraw after an agreed-upon period.
  • Preventing Bank Runs: The full reserve ensures banks can meet depositor demands even if all customers seek to withdraw their money simultaneously, reducing the risk of a bank run.
  • Restricted Money Supply: Banks cannot create money through loans, limiting their influence on the economy’s money supply and potentially preventing artificial booms and busts.

Contrary Idea: Fractional-Reserve Banking

  • Lending with Electronic Money: Banks in a fractional-reserve system predominantly lend in the form of electronic money, allowing them to lend more than the physical cash they have in vaults.
  • Risk of Bank Runs: Although electronic money minimizes cash withdrawals, excessive loans can lead to a bank run if depositors demand cash that exceeds the actual cash reserves.
  • Supporting Economic Growth: Proponents argue that fractional-reserve banking fuels investment and economic growth by allowing banks to create loans without relying solely on customer savings.

Arguments for both systems

  • Fractional-Reserve Banking: Supporters believe fractional-reserve banking frees the economy from the constraints of real savings, stimulating investment and growth.
  • Full-Reserve Banking: Supporters argue that full-reserve banking is more natural, prevents bank runs, and limits banks’ ability to create money, which could prevent economic instability.

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