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FULL-RESERVE BANKING V/S FRACTIONAL-RESERVE BANKING

FULL-RESERVE BANKING V/S FRACTIONAL-RESERVE BANKING

Why in News?

Economists are engaged in a debate regarding Full-Reserve Banking (100% reserve banking) versus Fractional-Reserve Banking.

What is Full-Reserve Banking V/s Fractional-Reserve Banking?

• Full-Reserve Banking: Safeguarding Deposits
• Under full-reserve banking, banks are strictly prohibited from lending out demand deposits received from customers reducing the risk of bank runs.
• Instead, they must always hold 100% of these deposits in their vaults, acting merely as custodians.
• Banks serve as safekeepers of depositors' money, charging fees for this service.
• Banks can only lend money received as time deposits.

Fractional-Reserve Banking: Expanding Credit and Risk

• Fractional-reserve banking system, currently in practice, allows banks to lend more money than the cash they hold in their vaults.
• This system relies heavily on electronic money for lending.
• Bank runs are a potential risk if many depositors simultaneously demand cash.
• However, central banks can provide emergency cash to avert immediate crises.

Differing Perspectives: Supporters of fractional-reserve banking argue that it spurs investment and economic growth by freeing the economy from relying solely on real savings from depositors. On the other hand, advocates of full-reserve banking argue that it prevents crises inherent in the fractional-reserve system and leads to a more stable economy.

Difference Between Demand Deposits and Time Deposits

Demand Deposits:

• Demand deposits refer to funds held in a bank account that can be withdrawn at any time without any notice or penalty.
• These are also known as "current accounts."
• It provides high liquidity and flexibility for everyday transactions and payments.
• Since customers can withdraw funds on demand, banks typically pay little to no interest on these accounts.

Time Deposits:

• Time deposits are funds held in a bank account for a fixed period, commonly known as a "term" or "tenure."
• The account holder agrees not to withdraw the funds until the term expires.
• In return for locking in their money, the bank rewards the account holder with a higher interest rate compared to demand deposits.
• However, withdrawing the funds before the maturity date typically incurs a penalty.

Bank Run

A bank run refers to a situation where a large number of depositors simultaneously withdraw their funds from a bank, often due to concerns about the bank's solvency or stability.

Impact:

• Liquidity Crisis: A sudden and massive withdrawal of funds can lead to a liquidity crisis for the bank.The bank may not have enough cash reserves to meet all the withdrawal requests, which can further fuel panic among depositors.
• Contagion Effect: A bank run on one bank can create a ripple effect, spreading fear and panic to other banks in the system. This contagion effect can lead to a broader financial crisis if it isn't contained promptly.
• Loss of Confidence: A bank run can erode public confidence in the entire banking system, leading to a loss of trust in financial institutions. This can result in a long-term decrease in deposits, making it harder for banks to lend and support economic growth. It can also lead to increased informalisation of economy.