A Plan to Arrive at 100% Reserves on Bank Demand Deposits

Introduction

This paper deals with the steps that are required to cover bank demand deposits 100% by reserves.  We will deal with ending the ability of the banking system to pyramid reserves into new money, created out of thin air, and will show the steps necessary for the banking system to transition from a fractional reserve system to 100% reserves without creating new reserves and without shrinking the money supply.  The paper will discuss the feasibility and the method to successfully transition to this new banking structure. Monetary expansion via the banking side would end, as would inflation and the boom/bust business cycle. (See note #1)

Summary of expected outcomes

Banking services would be divided into two separate businesses as described in chapters six and seven of Murray N. Rothbard’s The Mystery of Banking.  Bank demand deposits (checking accounts) would be backed 100% by reserves, housed in new Deposit Banks that provide payment services only.  Bank savings and time deposits would be backed by loans and securities, housed in new Loan Banks.  A Deposit Bank customer who wishes to earn an interest return on his excess demand funds opens an account at the Loan Bank.  He transfers ownership of his excess demand funds to the loan banker, who further transfers ownership of the demand money to his borrowing customer.  In other words, the original demand account holder “lends” his money to the loan banker, who further lends it to his (the loan banker’s) customer.  The loan banker acts as a financial intermediary, finding good credits and managing them in order to pay interest to his depositors (who actually are lenders to the Loan Bank).  He must earn enough from the loans he finds to pay interest to his depositors, fund his lending operation, and set aside a reserve for bad debt.  Notice that no new money is created anywhere in  this process.  The Loan Bank’s borrower takes temporary possession of the money originally in the Deposit Bank.  The possessor of the same money has changed temporarily, but no new money was created.  This paper will discuss the feasibility and method to successfully transition to this new banking structure.

Enough cash to cover demand accounts but not savings and time accounts

Here is the aggregate balance sheet (trillions of dollars) for all US banks as of November 2013 per Federal Reserve Data:

Notice that bank total cash assets exceed bank demand accounts by $1.151 trillion ($2.630 minus $1.479).  However, bank total cash assets are well short of covering total bank deposits by $7.116 trillion ($2.630 minus $9.746).  Therefore, it is technically possible at the present time for banks to maintain 100% reserves against demand (checking) deposits but not against total deposits.  In other words, if all bank depositors, including savings and time depositors, chose to exchange their deposits for cash and accept any contracted penalties, the banks would be $7.116 trillion short.  Total bank deposits are $9.746 trillion, of which $1.479 trillion are demand deposits, leaving $8.267 trillion in non-demand deposits; i.e., savings accounts and time deposits.

Morphing the current banking system into a Rothbardian banking system

But is this really a problem?  The banks do have loans and securities of $10.076 trillion, well in excess of the amount needed to secure their savings and time deposits in the Loan Bank.  Would not these depositors prefer to keep their funds invested rather than decide to “cash out” their savings and time deposits, accept the penalties, and place all or most of their money in the Deposit Bank where they not only would not receive interest but would pay fees to boot?  Let’s take a look at how the new Deposit and Loan Banks might be constructed after the split and what might entice savings and time depositors to keep their money in a new Loan Bank.  Here is what the new aggregated Deposit Bank and Loan Bank would look like:

Here’s how I divided the assets, liabilities, and capital:

1.  I moved all of the demand deposits into the Deposit Bank and all of the non-demand deposits into the Loan Bank.
2.  I gave the Deposit Bank enough of the cash assets to cover the demand deposits 100%.  I gave the rest to the Loan Bank.

3.  I gave the Deposit Bank the loans, securities, and the other half of the Other Assets.
4.  I divided the Other Assets equally between the two banks, assume these to be mostly fixed assets and office equipment.
5.  I gave the Deposit Bank enough Capital to balance its Liability side with its Asset side.  I gave the rest to the Loan Bank.
5.  I gave the Loan Bank all the Borrowings and all the Other Liabilities.

Here are the results:

1.  The capital ratio of the Deposit Bank is 30.1%; the capital ratio of the Loan Bank is 7.5%.
2.  The Loan Bank’s liabilities of $10.974 are secured by cash, loans, and securities of $11.227.
3   The Loan Bank has cash equal to 11.7% of its loans and borrowings, meaning that almost 12% of the non-demand depositors would have to ask for their money before the Loan Bank would be forced to sell some of its securities.

4.   The Loan bank has securities equal to another 24.6% of its non-demand deposits, so, in total the Loan Bank has cash and securities equal to 35.1% of its non-demand deposits to pay for deposit withdrawals.

5.  For individual Loan Banks that nonetheless find themselves short of cash and securities, the only answer is to sell their loans in the market at whatever discount is required to raise the funds necessary to honor their current deposit contracts.  Now the issue becomes one of simple market forces.  How much of a discount will these banks be forced to accept?

If customers wish to hold more demand accounts, secured by 100% fiat money, they will pay for the privilege in the form of fees at the new Deposit Bank, because the Deposit Bank will not be allowed to invest the cash, as is currently allowed by fractional reserve banking laws.  Banks who run out of excess reserves to back their redeemed savings and time deposits will be forced to sell some of their loans to banks with excess reserves.  They may be forced to offer discounted prices to these investors, which means the purchasers, presumably the new Loan Banks, will receive a higher return.  This will give a great incentive for current savings and time deposit customers to keep their deposits in a new Loan Bank rather than hold all their money in the form of demand deposits in a new Deposit Bank and pay fees for the privilege.

Individual banks that  cannot raise enough cash to honor all of its demand deposits must declare bankruptcy.  Their depositors will be paid out of the FDIC insurance fund.  This is a one-time occurrence, for after the banking system has been split into Deposit Banks and Loan Banks, the FDIC will be dissolved.

Regardless of whether banks make a profit or loss on securing their demand accounts 100% by cash, the accounting equation is fairly straightforward:  the Deposit Banks credit their loan accounts on the asset side and debit their savings and time deposits accounts on the liability side to the extent required so that the Deposit Bank holds only demand accounts, all of which are backed 100% by cash.  The loans will be debited to the asset side of the Loan Bank, securing the savings and time deposit liabilities that were credited to the liability side.

The look of the new Loan Banks

We can assume that some investors will want packages of highly rated loans and will be willing to accept a lower return for a more secure investment.  At the other end of the market will be packages of riskier loans offering higher rates of return as compensation for the increased risk.  We can expect great market diversity in the quality of loans within the same Loan Bank and among the many new Loan Banks.  For example, a new Loan Bank may offer several loan funds of differing risks and returns, or there may be many Loan Banks that specialize in only one or a few loan funds of the same kind of risk, ranging from silk stocking funds that pay low returns to high flyer funds that pay higher returns.  The market will determine the true value of the funds.  We should expect a great deal of market volatility at first, as the banking market reshapes itself.

Conclusion

The banking system has more than enough reserves to back its demand deposits 100%.  Even assuming that some current savings and time depositors would decide to accept deposit contract penalties and move their funds to one of the new Deposit Banks, there seem to be enough excess reserves to cover anticipated redemptions of this kind.  If not, those banks with insufficient reserves would be forced to sell loans at whatever rate the market requires to those banks with excess reserves.  In the end, all demand deposits held in the new Deposit Banks would be backed 100% by cash.  Savings and time deposits held in the new Loan Banks would be backed by some cash, some securities, but mostly loans.  These savings and time deposits would not be insured; the only insurance available to depositors would be the bankers’ capital accounts and their reputations for finding good loans.  The marketplace of Loan Banks would be very diverse, composed at one end by long standing, very safe banks with lots of capital, silk stocking loans, and offering low savings rates.  At the other end of the market would be start up banks with higher risk loans, less capital, and offering higher deposit rates.  The age of vanilla banking would be over as well as the age of moral hazard created by government deposit guarantees.

Assuming that the Fed is not allowed to increase reserves ex nihilo, this process of establishing the new Deposit Banks and new Loan Banks will result in a fixed money supply of notes, coins, and reserve balances at the Fed that can be converted into cash at any time.  Today we call this the “monetary base”.  The banks always must maintain reserves in an amount not less than their demand account balances.  Their reserves must be some mix of cash in their vaults plus balances at the Fed that can be converted to cash.

At this point the banking system will no longer be able to create money out of thin air via the lending process, which it was able to do under the fractional reserve banking system.  The banking side of the US monetary system will be placed on a sound, non-inflationary basis and this source of periodic boom/bust business cycles will be eliminated.

Patrick Barron

Note #1:

At this point we are discussing fiat money reserves and, as such, it is still possible for the Fed to manufacture reserves out of thin air by several means.  Although preventing the further expansion of fiat reserves is vitally important and many may consider it to be the logical first step to monetary reform, limiting the Fed’s power to do this is the subject of another paper.

Note #2:

According to Fed statistics for commercial banks as of November 27, 2013

Cash assets in commercial banks (cash and reserves held at the Fed): $2.630 Trillion

Bank loans:                            $7.337 Trillion

Bank securities:                     $2.698 Trillion

Bank loans and securities: $10.076 Trillion

Demand accounts in banks:          $1.479 Trillion

Non-demand accounts in banks: $8.317 Trillion

Total deposits in banks:                 $9.796 Trillion