Currently, around 97% of the world’s money is not given by the central banks or by a government institution but is created by private banks or commercial banks in the process of granting loans.
In a fractional reserve economic environment, one of the multiple faculties of the central banks is to demand from the credit institutions established under their supervision the requirement of minimum reserves that can not be used for the granting of loans.
As part of its monetary policy, it may be decided to increase or reduce the reserve ratio and this has a direct and immediate impact on the money supply (M2). The reason is simple, if the reserve ratio is reduced, banks have a greater capacity to lend, while if the coefficient increases, this capacity is reduced.
How does the reserve ratio affect the creation of money?
Imagine an assumption of a reserve ratio of 10% on a deposit volume of 100 euros. In the balance sheet of entity A, we would have total deposits in the liabilities and 10 euros in reserves and 90 euros in credits in the assets side.
Those 90 euros in credits translate into credit expansion. So they would come to entity B in the form of new deposits and, again, that entity should maintain 10%, that is, 9 euros, and with the ability to lend the remaining 81 euros.
As you can see, the money that can be lent is money that can be filtered through the economy and multiplied through a process of deposit expansion as companies and consumers request it to invest.
This process is described by economists as the multiplier effect. That means that changes in the reserve ratio will alter the multiplier effect, and alter the rates of expansion of the money supply.
The formula for the money multiplier is multiplier = 1 / reserve ratio. The monetary multiplier is the reciprocal of the reserve ratio. As you can see, changing the reserve ratio, which is inside the multiplier, quickly changes the multiplier in the opposite direction.
When the reserve coefficient is 10%, the multiplier would be 10. However, when the reserve coefficient increases to 20%, the multiplier decreases to 5, and so on in an inverse relationship.
The consequences of the fractional reserve banking system
The banking business does not focus its activity on storing money but captures the money of the depositors who are looking for a return on their savings and who do not need to have access to their savings immediately, to lend it to those who have financing needs.
With this activity, and as we have explained above, there is a credit expansion through the monetary multiplier, forming new deposits that lack any support.
Therefore, the first consequence we have is that the fractional reserve system is fraudulent because it promises to pay depositors amounts that do not really exist. In the structure of a bank, the deposits are not guaranteed since they are invested without the authorization of the depositors.
Fractional reserve banking continually causes inflation through the artificial reduction of interest rates compared to what would be in a stable monetary environment. This can happen indefinitely with the help and assistance of the central bank. Central banks can offer low interest rates to encourage the creation of new loans.
However, the expansion of credit leads to an artificial increase in money and credit in an economy inevitably leads to misallocation of capital resources because it allows pursuing investment opportunities increasingly lower than would have pursued if the money supply had been maintained stable.
A fractional reserve of 100%
It does not seem logical that a bank is authorized to take deposits at sight, whose availability must be immediate and then finance investments, through its loans, at five, ten, twenty or more years.
Therefore, one of the proposals is to alter this fractional reserve system and establish a 100% cash ratio that would mean that banks could not lend their deposits and accounts in view of their balance sheets.
The Spanish economist of the Austrian school, Jesus Huerta de Soto, exposes us in his book “Money, bank credit and economic cycles” a banking reform to establish a 100% cash ratio for private banking and leaving for the central bank, the responsibility to guarantee a growth of the money supply equal or slightly to the productivity growth experienced in the economic system (proposal by Maurice Allais ).
In this case, we find that in the transition from one model to another, depositors should choose if they prefer to be holders of their money or prefer shares over the bank’s investments that would be proportional to the volume of deposits , as well as the institutions of collective investment (IIC).
In turn, the problem of deposit support should be resolved, so the monetary authority should print notes of legal tender for an amount equal to the sum of total demand deposits and equivalents. With this, it would be possible to solve the problem of the backing caused by the fractional reserve system.
Under this reform, the entities would not focus their activity on obtaining the yield differential between deposits and credits, but, like the IICs, their income would come from the commissions for asset management and also, for the current services of payment they offer.
The current regulation on the ECB’s reserve ratio
Among the monetary policy control instruments held by the ECB are open market operations, permanent facilities and requires credit institutions to maintain minimum reserves in accounts with the Eurosystem.
The ECB explains that its objectives for its Eurosystem minimum reserve system are to help stabilize money market interest rates by providing entities with an incentive to smooth out the effects of temporary liquidity fluctuations, and to create or expand a structural liquidity deficit.
In the event of default, the ECB imposes sanctions on entities that fail to comply with the obligations arising from the regulations and decisions of the ECB relating to the application of minimum reserves.
The ECB has modified its monetary policy linked to the reserve ratio. Until January 2012, banks had to maintain in their national central banks a minimum coefficient of 2% of certain liabilities, mainly customer deposits. Since then, this coefficient has been reduced to 1%.