Essay Sample: Fractional vs. Full Reserve Banking System

Problems with the Fractional Reserve Banking System

The fractional reserve banking is a modern model that the financial institutions throughout the country tend to utilize, according to the model; the banks tend to recognize that the deposers are often incapable of withdrawing all their depositors at a go. The model further establishes that banks have a minimum bench line that they have to maintain, for example, 25% of their total savings. However, banks often bypass their primary lending policies and offer loans that are worth more than two times their reserve value, which would then pose the risk of its collapse in case depositors make massive withdrawals or when the bad debts increase exponentially. The consequence of such action is the central bank or Fed being forced to print money to meet the maximum loan value that they would need.

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The significant issue of the fractional reserve is the capability of the company to get into a liquidity crisis. Such crisis could majorly result when the total value of the assets is more than the total value of the liabilities that the bank owes. The central bank often has to intervene by offering loans to the banks or to printing more money as a means of ensuring that there is adequate support to the bank.

The legislation in countries that relate to the banking sector tends to pose the risks to the existence of the bans. For example, in the United Kingdom, the reserve ratio that the banks have to maintain is 3%. As such, when the depositor loses confidence in the bank and makes the decision to withdraw their saving, the bank is likely to collapse.

The other effects of the monetary policy are laying of the monetary policy within the private sector; the private sector has the primary. The fractional reserve banking grants the business with the significant role of offering loans to their clients. However, such can be realized through the establishment of additional new bank deposits other than that which is provided by the bank customers. Furthermore, the banks tend to dictate the monetary supply in the society (Krugman, 2014). The total money that is kept by the banks tends to dictate the total money supply within the economy. Such could then affect the demand for the basic commodities within the marketplace.

The fractional reserve banking systems strategize its operation on the basis that accepts deposits in the banking system and only save on a fraction of deposit. However, in the United States, depositors believe in withdrawing the full amount of cash deposited at the same time upon their will while the banking system set nearly all of the deposits that are loaned out. Furthermore, the bank deposits the loaned funds and further issue loan to the customers upon the set limits of the bank reserves. The fractional bank reserves tend to create cash from thin air primarily by printing warehouse receipt as money hence creating fraudulent resources within the United States.

Advantages of full reserve banking

The full reserve banking is the ideal mechanism that is utilized by the banks, especially during the times of recession. The system seeks to ensure that there is stabilization in the interest rates that are offered by the financial institutions. Some of the additional benefits include the moderation of the interest rates, stability in the prices of the basic goods within the economy and the maximization of the employment opportunities that are offered within the economy (Mcleay, Radia & Thomas, 2014). The system establishes the Federal Reserve which acts as the lender of the last choice, from which the banks could borrow to finance their liabilities. Such could serve to minimize or eliminate the financial panics that could be existent within the economy. The Federal Reserve is instrumental in offering the basic liquidity that the banks would need to run their operations (Diamond & Dybvig, 1983).

The other advantage of the full reserve banking is the elimination of the likelihood of occurrence of the financial crisis. For example, the money the depositor's issue to the bank, with the expectations of withdrawing them at any time, is not lent out to other people. The other advantage of the model is the guarantee that the money available for lending is guaranteed through term deposits (Diamond & Dybvig, 1983). The banks would then have to reduce the risks that are often associated with their routine operations within the sector.

Full reserve banking proposes the social credit model of lending. The model affirms the capability of the banks to convert all currency to match the demand deposits within the bank. The model would also ensure that there the monetary control is under the control of the federal government and not the demand deposits that are dictated by the private banks as is the case in the current banking regime (Diamond & Dybvig, 1983). The model could also enable the government to earn the seigniorage revenue, through the issuance of the federal bonds. Furthermore, the money supply is enhanced through the process through the improvement of the price mechanism and the means of exchange in the financial system. However, the major criticism of the model is the idling of money that is deposited as demand deposits with the expectations that the bank customers could claim their money.

References

Diamond, D. W., & Dybvig, P. H. (1983). Bank runs, deposit insurance, and liquidity. Journal of political economy, 91(3), 401-419.

Krugman, P. (2014). "The Conscience of a Liberal." The New York Times. Retrieved from https://krugman.blogs.nytimes.com/2014/04/26/is-a-banking-ban-the-answer/?mtrref=undefined&gwh=1DE02E6C42F9F36C2A54C133EEBFA4AF&gwt=pay&assetType=opinion

Mcleay, M., Radia, A and Thomas, R. (2014). "Money creation in the modern economy." Bank of England Quarterly Bulletin. Retrieved from: https //www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy.