Full-Reserve Banking V/s Fractional-Reserve Banking

• 28 Jul 2023

For Prelims: Full-Reserve Banking, Fractional-Reserve Banking, Bank run, Deposit Insurance and Credit Guarantee Corporation

For Mains: Issues Related to Banking Sector in India

Source: TH

Why in News?

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

• While both systems have their proponents and critics, understanding the key differences between them is crucial in assessing their potential impact on economic growth and financial stability.

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.

What is the 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  • Demand deposits refer to funds held in a bank account that can be withdrawn at any time without any notice or penalty.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.

What is Bank Run?

• About:
  • 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.

Note:

In India, the Deposit Insurance and Credit Guarantee Corporation (DICGC) provides deposit insurance for bank deposits up to a certain limit (currently ₹5 lakh per depositor per bank). However, in the event of a bank failure, depositors with funds exceeding this limit may face losses.