Definition of Full Reserve Banking

The definition of a full reserve bank, or a full reserve banking system, is fairly simple and short: a full reserve bank is a bank that backs up all its loans and deposits with 100% of the funds promised to others, also called bank reserves. On the face of the definition, this would appear to be the same thing as today’s banking system, but it isn’t.

Today’s banking system is called a fractional reserve banking system. The difference between a fractional reserve and a full reserve is huge. In the simplest terms, a fractional reserve bank is allowed to promise the same money to two people at the same time. Here is an example of a modern fractional reserve bank:

Mike has $100,000 to save. He takes it to a fractional reserve bank and deposits it into a savings account. The bank gives him a receipt for $100,000, which is his current available balance. Mike can take out any or all of that money on demand. The bank is allowed to keep only a 10% reserve on deposits. This means that the bank can now loan out $90,000 of Mike’s money to Tom, who wants to buy a house. The bank gives Tom a check for $90,000, which Tom gives to the home owner of the home he’s buying, Peter. Peter deposits that check, and gets $90,000 in his account to spend as he wishes. In this system, Mike still has $100,000 available to him, but Peter has $90,000 also, all from the same $100,000. To make matters worse, Peter’s bank has a 10% reserve requirement, so they can give Peter a $90,000 receipt, and loan out $81,000 of those funds to someone else. This is called a money multiplier, which we will discuss in another article.

Here’s how it would work in a full reserve bank:

Mike has $100,000 to save. He takes it to a full reserve bank. The bank gives Mike a few options: (1) He can deposit the $100,000 to secure it against theft, fire or loss, but this will cost him money as the bank can not loan out those funds since they are always withdrawable on demand. This means that Mike will have a negative interest rate so the bank makes some money; (2) Mike can deposit all of the money into a time deposit account, and earn interest. In this case, the bank finds someone to loan the $100,000 to for a set period of time, but Mike can not withdraw the money. This is similar to a CD, where Mike loses use of the money, but earns interest (as does the bank); (3) Mike can deposit part of the money into the on-demand negative interest rate account, and part of the money into a time deposit account (CD-like).

Because all of the $100,000 is only available as the total, there is no creation of new money or credit.

Most people would agree that on the basics, the full reserve bank seems proper, and the fractional reserve bank is immoral and fraudulent. This site will discuss all the various thoughts and complications of either banking system.

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