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
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.
- Fractional-reserve banking system, currently in practice, allows banks to lend more money than the cash they hold in their vaults.
- 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.
- 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.
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- Demand deposits refer to funds held in a bank account that can be withdrawn at any time without any notice or penalty.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.
- Demand deposits refer to funds held in a bank account that can be withdrawn at any time without any notice or penalty.
- 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.
- Time deposits are funds held in a bank account for a fixed period, commonly known as a "term" or "tenure."
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.
- Liquidity Crisis: A sudden and massive withdrawal of funds can lead to a liquidity crisis for the bank.
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.