By Nicholas Larsen, International Banker
What happens to the money you deposit in a bank account? Does all of it just sit there idle, accruing interest? Or is it used to fund other purposes? According to a September 2019 study conducted by bitcoin-mining company Genesis Mining of 1,000 US consumers, 26 percent of respondents thought banks were required to keep 100 percent of the money deposited by customers in reserve, while 52 percent of respondents believed that not to be the case. But of the latter 52 percent, just 9 percent believed banks were required to hold only 1-10 percent at all times.
The truth is that commercial banks are required to hold only a small fraction of customer deposits in reserve to meet withdrawal requests from their customers. Indeed, this requirement underpins the fractional-reserve system of modern banking commonly used around the world. And as such, banks are free to use the remainder of deposited funds to provide loans to other customers, meaning that instead of just sitting unused in customer accounts, the vast majority of money deposited into banks can be used for lending instead.
The system typically works because depositors do not need access to all of their money at all times. People invariably only withdraw a fraction of their savings at any given time, meaning that rather than having the remainder just sitting idle in their bank accounts, it can be used by the bank to advance loans to other borrowers. And should any single customer seek to withdraw their entire savings, the bank should still have enough accrued from all customers’ accounts to meet this withdrawal. Indeed, it is for this purpose that the bank cannot lend out all the money it receives in deposits; instead, a country’s central bank will normally set a cash reserve ratio (CRR), which determines the portion of reserves banks must retain rather than lend out. This ratio can be changed and is used by central banks as a vital monetary-policy tool to control how much banks can lend.
Indeed, the biggest advantage of fractional-reserve banking is its central role in spurring economic growth, specifically through the “money multiplier” effect. With the bulk of customer savings being loaned out to other borrowers, those borrowers can then use their borrowed funds to spend and invest in new projects. The recipients of this spending and investing can also spend or invest, or they can deposit the money they receive into their bank accounts. And once again, the process can be repeated, such that the initial customers’ savings have created a multiplier effect that has stimulated further economic growth. In March 2020, shortly after the coronavirus pandemic reached US shores and began severely curtailing economic activity, for instance, the Federal Reserve (the Fed) reduced the cash-reserve requirement to 0 percent in a bid to stimulate bank lending and rejuvenate economic growth.
For the bank itself, meanwhile, a distinct advantage of the fractional-reserve system is that it can earn interest on the money it lends out to borrowers over and above the rate it pays to depositors and savers. This is known as the net interest margin (NIM). It is rarely the case that banks charge customers for making deposits; rather, banks pay interest to customers and typically do not charge any fees for storing their funds. The interest paid, however, will be less than the interest earned by banks on what they lend out to help them cover any costs associated with the two activities.
But fractional-reserve banking does throw up several challenges, none greater than having to reconcile the fact that customers don’t have access to all their money simultaneously. If a specific event prompts all of a bank’s customers to pull their savings, the bank will not have enough in reserve to meet this demand. Indeed, this tends to happen when the public loses confidence in the banking system and fears the bank will fail. Unless banks immediately implement capital controls, a run on banks is the inevitable outcome.
Should customers’ fears be confined to just one specific bank, however, an unusually large volume of withdrawals should be manageable, provided the bank can continue to borrow reserves from other banks. But the effectiveness of this interbank market is not guaranteed, which can have significant implications for the solvency of the entire banking system.
As such, determining the cash ratio is the crucial issue at the heart of fractional-reserve banking—how much less than 100 percent can a bank hold and still meet a potentially heavy withdrawal load at any time? Clearly, the higher the reserve ratio, the lower the risk of triggering a bank run. Thus, it seems that this is as much a statistical calculation as anything. But should that calculation be in error, such that the bank ends up holding too little in reserve, what punitive measures are in place should the bank fail to meet all of its customer-withdrawal obligations? Such measures are equally important in acting as a deterrent against excessively liberal lending.
Similarly, the sheer fact that customers are not informed that banks will not hold 100 percent of their deposits raises legal and moral issues over the nature of fractional-reserve banking. While banks are mandated to produce customers’ money in full upon request, the fractional-reserve system ensures that this can’t be possible for all customers at once. Indeed, the system was instrumental in people losing their life savings during the Great Depression when a number of banks ended up failing and was thus instrumental in the US government-funded Federal Deposit Insurance Corporation (FDIC) being established in 1933. To this day, the FDIC protects customer funds up to $250,000 per depositor per insured bank, should that bank fail. Anything more than this limit is lost, however.
Nonetheless, questions remain over the effectiveness of this system, with some continuing to argue that banks should always hold 100 percent of customer deposits as a way of guaranteeing the stability of the banking system at all times, such that should every customer demand complete withdrawal of their money, the bank could satisfy all requests. Indeed, this was another proposed solution during the Great Depression and became known as the Chicago Plan. This scheme separated the banking system’s monetary and credit functions by requiring 100-percent reserve backing for deposits. According to economist Irving Fisher, such a plan had four distinct advantages over fractional-reserve systems:
- Much better control of a major source of business-cycle fluctuations, sudden increases and contractions of bank credit, and the supply of bank-created money.
- Complete elimination of bank runs.
- Dramatic reduction of the (net) public debt.
- Dramatic reduction of private debt, as money creation no longer requires simultaneous debt creation.
“We study these claims by embedding a comprehensive and carefully calibrated model of the banking system in a DSGE model of the U.S. economy,” a 2012 working paper by the International Monetary Fund (IMF) stated. “We find support for all four of Fisher’s claims. Furthermore, output gains approach 10 percent, and steady state inflation can drop to zero without posing problems for the conduct of monetary policy.”
But if a bank maintains a 100-percent ratio, surely that means it will have zero available to lend to borrowers and would simply operate as a storage deposit box for each of its customers? And therein lies the conundrum and why many economists believe that further allocation of customer deposits would be required to ensure money was still available for lending purposes. For instance, the deposits a bank receives could be divided into current accounts that serve customers’ daily requirements and longer-term savings and investment accounts, whereby customers agree to a time-deposit arrangement that prevents them from accessing their funds for a certain period. Such funds could then be lent out to other customers whilst maintaining a 100-percent cash reserve ratio concerning the current account.
The Financial Times’ chief economics commentator and celebrated financial journalist Martin Wolf voiced support for a similar system, whereby money creation is separated from financial intermediation, in a 2014 article for the publication titled “Strip private banks of their power to create money”. Rather than banks having the ability to create money through fractional-reserve lending, Wolf argued, the responsibility for money creation should instead be handed over to the state, which would thus prevent banks from being able to create investment accounts “out of thin air”. And the holdings maintained in investment accounts would be prohibited from being reassigned. According to Wolf, any new money injected into the economy would serve four specific needs: financing government spending in place of taxes or borrowing; making direct payments to citizens; redeeming outstanding private and public debts; and making new loans through banks or other intermediaries.
“Opponents will argue that the economy would die for lack of credit. I was once sympathetic to that argument. But only about 10 per cent of UK bank lending has financed business investment in sectors other than commercial property. We could find other ways of funding this,” argued Wolf. “Our financial system is so unstable because the state first allowed it to create almost all the money in the economy and was then forced to insure it when performing that function. This is a giant hole at the heart of our market economies. It could be closed by separating the provision of money, rightly a function of the state, from the provision of finance, a function of the private sector.”