Article originally published in GoldMoney Research (15th May 2012)
Improving the banking system
Governments grant central banks a monopoly on the creation of hard currency. At the same time, we ordinarily make transactions with other means of payment supplied by commercial banks. This is possible because in our monetary system commercial banks are able to create so-called bank money. These means of payment consist of different banks’ deposits that can be used with cheques, bank transfers, credit or debit cards and direct billings, which make our lives much easier as we do not have to hold or carry bank notes or coins to make ordinary transactions.
However, commercial banks are not free to issue their own currency. Bank money has to be denominated in the currency issued by the national central bank and the banks are legally required to redeem their sight deposits in the currency of the central bank at any time. However, the need to back any single deposit of their clients does not necessarily mean that the bank is keeping all our money in their vaults at all times. According to current regulations, they just have to keep a tiny fraction of it. This is the legal reserve ratio. In the eurozone this is 2% of banks’ total deposits; and for this reason we call it a fractional reserve monetary system. This system allows for easy expansion of the money supply, but it also involves a significant risk: that of bank runs caused when depositors all try to take their money out of banks at once.
Banks started to operate under a fractional reserve system in the early modern era, when it started dawning on them that in ordinary times, few clients actually asked for the money kept on deposit. So they started to lend part of it out. By doing so, new deposits were created and hence new means of payments. Consequently, banks increased their balance sheets as well as their profits quite substantially, as the costs of backing their new deposits were much lower than the earnings coming form the new loans. Since the mid to late 19th century, with the expansion and development of modern banking, banks were able to offer these new means of payment more efficiently – which did not require the use of paper notes or coins. As a result, banks realised that their clients needed less and less physical currency, which resulted again in a reduction in reserve ratios.
But during the 19th century the gold standard regime – championed by the British Empire – was an effective means to limit monetary expansion, both from central banks and commercial banks, as they still had to keep gold in reserve to back their issuance of money and credit. However, with the abandonment of the classical gold standard during the First World War, banks no longer needed to keep valuable assets in their vaults as the new reserve money of the economy was the notes of the central bank; which, in theory, could be expanded overnight with no tangible costs. This new system, in combination with the running of purely discretional monetary rules, resulted in excessive money creation and, finally, in more inflation and output instability in the late 1960s and 1970s.
Consequently, fractional reserve systems based on fiat currency tend to over-issue money unless strictly controlled by the central bank, or by the emergence of free competition in money. With the former, the central bank commits to a sound monetary rule focused on maintaining the purchasing power of money. Under this rule, both the central bank and the commercial banks are able to create means of payments but are subject to restrictions.
As sight deposits are redeemable at very short notice, banks could be required to fully back all their sight deposits with an equivalent amount of notes. Hence, the reserve ratio would amount to 100% of all sight deposits. Under this regulation, banks could only create new means of payment by lending the money kept in their time or savings deposits. It would result in a more stable monetary system but at the cost of having a less developed banking system, and thus a much smaller money supply.
In my view we do not have to go all the way towards a 100% reserve ratio to preserve the stability of the monetary system, while allowing for the development of the banking system. The gold standard seen in Britain and other countries during the 19th century is a good example of a self-correcting monetary system that nonetheless operated on a fractional reserve basis.
However it is achieved though, greater recourse to preserving the purchasing power of money would go a long way to improving our current monetary system.