Chapter 27: Problem 26

Should banks have to hold 100\% of their deposits? Why or why not?

Short Answer

Expert verified

In conclusion, banks holding 100% of their deposits has both advantages and disadvantages. While it promotes financial stability and avoids excessive credit creation, it also reduces lending capacity and may result in a less competitive banking system. The ideal reserve requirement depends on factors such as the economic environment, financial system stability, and policymakers' objectives in managing inflation and economic growth.

Step by step solution

Introduction to Fractional Reserve System

Currently, most banks operate under a fractional reserve banking system wherein they are only required to hold a fraction of their deposit liabilities in reserves. This allows banks to lend out the remaining portion to borrowers and earn interest. The objective of this exercise is to discuss the advantages and disadvantages of banks having a 100% reserve requirement.

Argument for 100% Reserve Requirement: Financial Stability

One reason banks should hold 100% of their deposits is that it promotes financial stability. In a system with 100% reserve requirement, banks can only lend out the funds that they have on hand. This reduces the likelihood of bank runs, where depositors withdraw their funds en masse, leading to the collapse of the banking system. This can prevent bank failures and the need for government bailouts, which can be costly for taxpayers.

Argument against 100% Reserve Requirement: Reduced Lending Capacity

On the flip side, having a 100% reserve requirement means that banks would have significantly less capital available for lending. This reduced lending capacity can negatively impact economic growth, as businesses and consumers will find it more challenging to secure loans for investment and consumption. Consequently, this could lead to slower economic growth and potentially higher unemployment.

Argument for 100% Reserve Requirement: Avoidance of Excessive Credit Creation

Under the current fractional reserve system, banks can create new money by extending loans. When banks lend more money than their actual deposits, it can lead to inflation and asset bubbles. By holding 100% of their deposits, banks would be prevented from engaging in excessive credit creation, thus reducing the risk of inflation and financial instability in the economy.

Argument against 100% Reserve Requirement: Less Competitive Banking System

A 100% reserve requirement could result in a less competitive banking system. With limited lending opportunities, smaller banks may struggle to compete against larger institutions that have more diverse income sources, such as investment banking and asset management. This lack of competition may lead to higher interest rates on loans and lower interest rates on deposits, which could be detrimental to consumers and the overall economy.

Conclusion

In conclusion, there are both pros and cons to banks holding 100% of their deposits. While it may promote financial stability and reduce excessive credit creation, it also limits lending capacity and could lead to a less competitive banking system. The ideal reserve requirement may be influenced by various factors such as the prevailing economic environment, the stability of the financial system, and policymakers' objectives in managing inflation and economic growth.

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