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Full reserve banking

Overview of full reserve banking in comparison to fractional reserve banking. Created by Sal Khan.

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Video transcript

Narrator: I do want to clarify that the whole point that I'm showing these weaknesses in Fractional Reserve lending isn't to argue that it necessarily has to go away or that it is somehow unviable. It's clearly viable, it's the system that most market economies, actually all that I know of, use today. The reason why I am doing it is to show that it's not the only type of system that we really should scrutinize any systems that we have in place to realize that they aren't a law of physics, that we have to have Fractional Reserve lending. That in order to have this system function there has to be engineering in place and there still are some drawbacks, the un-stability in order to combat that you need to have central bank insurance and you also have to have the central bank as a lender of last resort of reserves. The bad incentives ... and these are well documented, these aren't just coming from me. Bad incentives, if you were looking to invest in any other type of investment company, someone who is taking your money and investing it on your behalf, they would typically be talking about how good they are at investing money. Most, when you're looking at Commerical banks that's not what they're talking about because they know that that's not what consumers care about because of the insurance there. They will talk about things like how easy it is to access your money with their ATM's and their online banking, how low their fees are. They won't even bring up the idea that hey, we're lending your money and we're lending it in really, really, responsible ways. It is also well documented by having a Fractional Reserve lending system, it is putting a significant amount of the money creation system, essentially the checkable deposits, it's putting it in the hands of private banks as opposed to the central banking authority. With that out of the way you're probably saying are there any other alternatives. I'm not advocating one or the other, but I'm just showing you that this is not necessarily the only way that we would have to set up our banking system. In fact, the original way is the alternative. The original way would be Full Reserve banking. (writing) full, full reserve, reserve banking. It is exactly what it sounds like, which is that a bank would have to ... if someone puts reserve or cash dollar or federal reserve notes in their demand deposit account then the bank would just have to keep it there. If I have a bank, right over here, (drawing) If I have a bank and if I were to put $3. (drawing) $3, 3 federal reserve notes here 3 federal reserve notes here. If I were to say that this is in my ... I want to have this on demand. I want to be able to go to the bank at any moment in time and be able to take these things out then the bank would have to keep all of these reserves there. You might say, well then how will lending happen and all the rest? In order for lending to happen the bank would have to say hey, look, you're not going to need them to have all of this on demand, why don't you keep some fraction of this on demand, maybe it's this dollar bill right over here and the rest of these, we, the bank, will literally borrow that from you. This isn't an actual foreign concept. When you go buy a certificate of deposit at a bank, when you put your money in a CD at the bank that's essentially what the bank is doing. They are borrowing that money from you, they're making it explicit. They're not saying that that money will be on demand. They're saying this is a timed deposit that this money, you are giving it to us now and then you can get it back in 6 months, or a year, or 2 years or whatever. Usually the longer the duration, the longer you keep your money ... you lock your money in with them the higher the interest they would pay. They'll say, look, this is on demand (writing) This is on demand, that's in a demand deposit. Then this right over here, you will loan it to us, this is a time deposit. (writing) This is a time deposit. Then the bank could loan this money out. It could loan these reserves out. This loan process would not increase the money supply, so that money could be loaned out maybe to someone else and maybe that gets deposited in another bank and maybe in a demand deposit, it gets deposited right over here in a demand deposit. You might say, well isn't this just like Fractional Reserve lending? Now you have $5 in the system. The difference is, is that no one can now use this perceived money right over here as money. You wouldn't be able to write checks against this money right over here. You could write it against this over here and that's okay. You could write a $1 check and it's backed by this $1 of reserves so you're not creating any new money. The only reserves here that really can act as money or be used to back checks are now the original $3. (writing) The original $3 here. The value of this type of a system, and there are drawbacks to it, the main drawback is, that the bank is not going to be able to make any money on its demand deposits so it will probably have to charge higher fees to customers to keep their money. They'll say, hey I'm safeguarding your money, I'm putting it in a vault for you, I'm making it accessible to you through checks, through ATM's so I'm going to charge you more money for me to essentially safeguard your money. Right now what banks are doing and Fractional Reserves system is like, hey, we'll do all of these services for you for a lot less, sometimes even free if you keep a large enough deposit with them. We're going to hold your money for you, we're going to keep it accessible on ATM, we're going to give you a bank ATM card and all of these things. The reason why the bank is able to do that is because they're essentially doing ... they're lending out a significant fraction of your money and getting interest on it and that's how they're making money. Here it just becomes much more explicit. The bank is saying, look, on this right over here we are doing a service for you, we are holding your money, we are keeping it on demand from wherever you want to access it and over here you are doing a service for us, you are lending us your money and then we are going to lend it out probably for higher interest so that way we can make money off of it. Obviously if we were to convert to some type of a system like this, there wouldn't be as much money being created or actually no money would be created by this lending process. So, the central bank or whoever the monetary authority is in the country would have to essentially print more money to have the money available to essentially be the grease in the economy. Just to make it clear that this isn't a fringe idea, that this is essentially what banking was until the mid 14th Century. It was the Venetian bankers who first brought up the idea of Fractional Reserve lending and there were some very mainstream banks that did full reserve lending into the 1800s. As The Great Depression got longer and longer, in 1939 some very serious economists proposed a reversion back to Full Reserve banking. They even articulated exactly how it would do and how it would not introduce too many interruptions to the economy. Although, anything like this would be dangerous because you introducing a whole new way of doing things and you don't know exactly what the repercussions will be on the economy. If you want to read their proposal it's actually quite fascinating. In just reading their proposal you'll get more depth on how the monetary system works. It's written by mainstream economists. Do a Google search for A Program for Monetary Reform. (writing) ... for Monetary, monetary Reform. It was written in 1939, so you can also do a Google for that. On Wikipedia there is actually the full text of A Program for Monetary Reform. When it was published it was supported actually by a majority by mainstream economists to go to a Full Reserve banking system.