The financial system of any country plays a pivotal role in its economic growth and stability. Often, discussions regarding this essential infrastructure revolve around the banking sector. Recently, economists have drawn attention to debates involving Full-Reserve Banking and Fractional-Reserve Banking. These two monetary systems, each with its proponents and critics, greatly impact the economy and financial stability.
Understanding Full-Reserve Versus Fractional-Reserve Banking
Full-Reserve Banking is a system where banks hold 100% reserves against their demand deposits. It prohibits banks from lending out any money received as demand deposits, thereby reducing the risk of bank runs. The banks serve as custodians, safekeeping the depositor’s money and charging fees for the service.
Contrastingly, Fractional-Reserve Banking allows banks to lend out more money than they physically hold. This is the current system in practice which heavily relies on electronic money for lending. It bears a risk of bank runs if multiple depositors simultaneously demand cash withdrawal, but central banks can provide emergency cash to avert immediate crises.
Supporters of fractional-reserve banking argue that it enables investment and economic growth by freeing the economy from relying solely on depositors’ real savings. However, full-reserve banking advocates maintain that it prevents crises inherent in the fractional-reserve system, leading to a more stable economy.
Defining Demand Deposits and Time Deposits
Demand deposits refer to funds held in a bank account that users can withdraw at any time without notice or penalty, often known as “current accounts.” Despite providing high liquidity and flexibility for transactions and payments, banks pay little to no interest on these accounts due to the ability of customers to withdraw funds on demand.
Time deposits, conversely, are funds locked in a bank account for a fixed period known as a “term” or “tenure”. Customers agree not to withdraw funds until the term expires, and in return, banks reward them with a higher interest rate. However, early withdrawal typically incurs a penalty.
Concept and Implications of Bank Run
A bank run refers to the situation when a large number of depositors simultaneously withdraw their funds. This usually occurs due to worries about a bank’s solvency or stability. Bank runs can create a liquidity crisis for the bank, as it may not have enough cash reserves to meet all withdrawal requests.
The ripple effect of a bank run on one bank can spread fear and panic to other banks. Consequently, if not contained promptly, it might lead to a broader financial crisis. Public confidence in the banking system can also erode, leading to a long-term decrease in deposits. This makes it more challenging for banks to lend and support economic growth, contributing to the economy’s informalisation.
Notably, in India, the Deposit Insurance and Credit Guarantee Corporation (DICGC) provides insurance for bank deposits up to ₹5 lakh per depositor per bank. Despite this coverage, depositors with funds exceeding this limit might face losses in case of bank failure.
