Full-reserve banking, also known as 100% reserve banking, is a banking system where banks are not allowed to lend out money from customers' demand deposits.
Banks act as custodians to depositors' money under full-reserve banking, holding all money they receive as demand deposits in their vaults at all times.
Unlike the current banking system, under full-reserve banking, banks do not pay interest to customers on their demand deposits.
Banks are required to hold reserves backing 100% of their liabilities in the form of demand deposits to ensure they can meet redemption demands from depositors and prevent a run on the bank.
In a full-reserve banking system, banks can only lend money received as time deposits from customers.
Time deposits are funds that customers can withdraw from the bank only after a predetermined period, as agreed upon with the bank.
Banks use time deposits to lend to borrowers at a specified interest rate, collect repayments, and eventually return the deposited money to customers along with interest.
In the current banking system (fractional- reserve banking), banks mainly keep cash deposits from customers in their vaults and lend money electronically rather than in physical cash.
Banks can create electronic money by opening loan accounts for borrowers and crediting them with the loan amount, even if it exceeds the actual cash in their vaults.
Banks face the risk of a run if many borrowers decide to withdraw their electronically loaned money in cash, as the bank may not have enough physical cash to meet the demand.
Bank runs rarely happen because most transactions occur through non-cash instruments, reducing the need for cash withdrawals.
Additionally, central banks provide emergency cash to bail out banks in times of crisis.
Comparison
Under full-reserve banking, banks are prohibited from issuing loans without actual cash to back them.
Some economists argue that banks issuing loans without sufficient cash should be considered fraudulent, while supporters of fractional-reserve banking disagree, believing it can stimulate investment and economic growth.
Supporters argue that fractional-reserve banking frees the economy from relying solely on real savings from depositors to fuel growth.
Advocates of full-reserve banking claim it is the natural form of banking, preventing crises and minimizing the risk of bank runs.
Full-reserve banking restricts banks from creating money, which proponents argue prevents artificial economic booms and busts associated with changes in money supply.
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