A Plan for Monetary Reform

William F Hummel

A near melt-down of the financial system in 2008 has sparked a renewed interest in full reserve banking. Some believe that fractional reserve banking is a root cause of asset price bubbles that end in debt deflation and deep recessions. In the following, we outline a full reserve system for the U.S. and compare it with the current fractional reserve system for individual banks and for the banking system as a whole. We then describe and propose a simplification of the full reserve system which involves the creation of a single National Depository.

1. Full Reserve Banking

Individual Bank Operations

In full reserve banking, every bank would be required to hold reserves equal at all times to its transaction deposits. Those reserves are effectively bound to the deposits and therefore could not be used by the bank. We will call them bound reserves. For its own investments — making loans or buying securities — a bank would need additional reserves. We will call them free reserves. As in fractional reserve banking, reserves could be held in any combination of vault cash and deposits at the Fed. They would not be required against savings deposits and time deposits, but all deposits would be insured by the FDIC up to specified dollar limits.

In fractional reserve banking, the distinction between free reserves and bound reserves is less relevant. As long as the bank can meet the reserve ratio requirement on average over a 14-day period, it can use all of its reserves to cover a new loan. This provides a degree of freedom not available in full reserve banking.

Regardless of the required reserve ratio, a bank must have sufficient funds on deposit at the Fed to cover a new loan on the day it is issued. Its freedom to lend is always constrained by the amount of liquid assets it can quickly commit. In this respect there is no difference between full reserve and fractional reserve banking. A bank may have ample capital but that is not enough. If it is short of reserves, it might receive a daylight advance from the Fed to cover a loan, but the advance would have to be paid off before closing time the same day.

A bank acquires new reserves whenever it receives a new deposit. However in full reserve banking, those reserves would all be bound rather than free. To increase its lending power, the bank would need to acquire additional free reserves. Its options are: (1) borrow from the Fed, (2) borrow from another bank, (3) borrow from a non-bank, (4) induce its transaction account holders to move funds into savings deposits or time deposits, (5) sell assets in the open market, or (6) sell additional bank shares to investors.

Option (1) is normally used to address liquidity issues rather than as a source of funds to lend because Fed loans cost more than other options. Option (2) simply transfers free reserves between the banks without increasing the total. All other options increase free reserves but at the expense of reducing aggregate transaction deposits. Then how could the transaction money supply grow in a full reserve system? The answer is: through open market operations by the Fed.

The Banking System and the Money Supply

Since reserves are normally non-earning assets, banks would want to hold only enough free reserves to cover new loans and maturing liabilities. They would seek to lend any excess in the Fed funds market to earn a return. In a full reserve system, the Fed can only create bound reserves through open market operations (OMO). However over a period of several days, a sizable fraction of the new transaction deposits created by the Fed through OMO would migrate to time or savings deposits, and convert that much in bound reserve to free reserves.

In place of a brokered Fed funds market between banks, it is proposed that the Fed become a dealer in reserves directly with banks. The Fed would set a target interest rate for reserves and offer to borrow reserves at a rate 50 bp below the target rate and lend reserves at a rate 50 bp above the target rate. For example, if the target rate is set at 3.5%, banks could borrow reserves from the Fed (suitably collateralized) at 4.0% and lend reserves to the Fed at 3.0%. The difference between the weighted average interest rate on those loans and the target rate would indicate the amount of reserves to add or drain via OMO to hold the Fed funds rate on target. Note that reserves created through Fed loans are all free reserves.

Government spending has no net effect on aggregate bank reserves and transaction deposits in either a full reserve or fractional reserve system. The Treasury spends out of its account at the Fed which it must continually replenish to avoid depletion. It does so with transfers from its commercial bank accounts where it deposits its receipts from taxes and the sale of securities. By targeting a fixed balance in its Fed account, the Treasury leaves total reserves in the banking system unchanged except for short-term transients. By balancing its inflows against outflows through the net sale or redemption of securities, the Treasury leaves the money supply unchanged on average. In effect, the Treasury pays for its deficit spending with securities rather than money.

From the perspective of non-bank firms and households, the banking system in a full reserve regime would not seem much different from the current fractional reserve system. However banks would have to work harder to make the same kinds of profits, and that could affect the fees charged for their depository services. Since new transaction deposits would bring no free reserves to a bank, banks would have little incentive to seek them unless they believed the depositors would move some of the funds into savings or time deposits.

In the fractional reserve system, the Fed controls the short-term interest rate by operating on a relatively small pool of reserves. That pool would be considerably larger in a full reserve system since it would comprise the discretionary funds of the entire banking system. In a full reserve system, therefore, the Fed would have to be more active and deal in larger increments in open market operations to achieve the same level of control.

Transition to a Full Reserve System

The following scenario applies to monetary conditions that existed before the Quantitative Easing program initiated by the Fed in September 2008. Prior to that date, there were essentially no excess reserves in the banking system, and the reserve ratio was about 10 percent.. Suppose there were 10 units of reserves and 100 units of deposits. The Fed would have to inject 90 units of reserves into the banking system to equal the 100 units of transaction deposits. It would do so by purchasing 90 units of Treasury securities in the open market. However that would also increase transaction deposits by 90 units, and result in 190 units of deposits against 100 units of reserves.

Additional purchases by the Fed would increase the reserve ratio further but it would never reach the full 100 percent target that way. However those who sold the Treasury securities to the Fed would not leave the proceeds in their transaction deposits where they earn no interest. Instead they would seek investments to earn a return. Regardless of where they invested the proceeds, however, the excess 90 units of transaction deposits would remain in the banking system until used to buy savings and/or time deposits in banks. As that happened, transaction deposits would decrease and eventually reach 100 units, resulting in a reserve ratio of 100 percent. Note that the Fed provides all of the required reserves in the transition at no cost to banks.

As a result of the Fed’s quantitative easing programs, total reserves are currently about what is needed to fully back existing transaction deposits. The transition could therefore be simpler and shorter than in the scenario above. It could be implemented by simply declaring the full reserve regime to be in effect, but with a grace period to allow banks to redistribute reserves among themselves through interbank loans. At the same time, the Fed would continue its open market operations as needed to balance aggregate transaction deposits with bound reserves at the target interest rate.

2. A Single National Depository

In the following we describe a functional equivalent of the full reserve system outlined above, which is simpler and more efficient. It would consolidate the transaction deposits of the many thousands of banks into a single National Depository run by the Fed. The deposits would be actual base money rather than claims on base money. The term reserves would no longer be relevant and could be dropped from the financial lexicon.

The National Depository would offer accounts to all who need the payment services of a traditional bank. It would only hold transaction deposits and would pay no interest. The Depository would neither lend nor borrow. It would simply execute payment orders and handle the accounting. The accounts at the Depository together with the circulating currency would comprise the entire transaction money supply, denominated in U.S. dollars. The Fed would have control over the total amount of deposits but would normally use it to manage the short-term interest rate rather than the total amount of money. The money supply would therefore vary as a function of demand for bank loans, just as it is in the fractional reserve system.

Implementation of the system would start after the full reserve system was in operation. All the reserve accounts of banks at the Fed would be transferred to the National Depository. Bound reserves would become deposits in the accounts of the respective owners. Free reserves would become deposits in accounts of the respective banks. At their option, banks could exchange their vault cash for free reserves at the Fed to be included in the transfers. The balance sheets of banks would be downsized by the transfers, but the net worth of each would remain unchanged.

Banks could no longer create or accept transaction deposits. However they could continue to offer savings and time deposits, which would in effect be loans to banks. The deposits would be credited to the customers’ respective bank accounts, and the funds would be credited to the banks’ respective accounts in the Depository. Savings and time deposits would be insured by the FDIC up to specific limits, as in the current system. Banks would be required to offer payment services against their customers’ respective transaction accounts in the Depository. They would also be required to issue cash against, and accept cash as credit to, a depositor’s savings account.

In addition to serving the entire private sector, the National Depository would serve the U.S. government, and offer accounts to foreign banks and governments that need to transact in U.S. dollars. All of the Treasury’s funds would be held in its account at the Depository where it would deposit its receipts from Federal taxes and the sale of its securities. Likewise all of government spending would be paid out of the Treasury’s account at the Depository. To avoid impacting the money supply, the Treasury would sell or redeem securities as needed to balance on average its inflows and outflows, just as it does in the current system.

The computer used by the National Depository would be an extension of the Fed’s computer system. Payment orders would be accepted by electronic means via plastic cards, the Internet, Fed wire, or telephone. Paper checks would be phased out, after which verifying balances and making payments would all be done in real time. Payments would be executed by simply transferring funds between accounts. The only exception would be transactions with the Fed which would involve a transfer of funds in or out of the Depository.

One should not confuse the National Depository with Federal Reserve Banks. The latter would continue to implement monetary policy through open market operations and provide loans to banks. All such transactions would result in credits or debits in accounts at the Depository. The Fed would continue to purchase notes and coins from the Treasury and maintain a stock sufficient to meet the public’s demand for currency. Local offices of Reserve Banks or their ATMs would provide currency in exchange for deposits and vice versa. The Depository itself would hold no currency.

Source: http://wfhummel.cnchost.com/monetaryreform.html (November 21, 2012)

William Hummel is qualified in physics, electronics and electrical engineering. He has developed interests and expertise in the nature of money and credit, long-term investing, Post-Keyensian economics, and organising internet discussion groups.