Fractional-reserve banking makes it possible for banks to simultaneously act as financial intermediaries, matching up borrowers and lenders, and maintain the safety and liquidity of financial wealth, especially the checkable deposits portion of the money supply.

Two Goals

• Profitability: Banks pursue profit as a financial intermediary with revenue generated from interest on loans. Because banks are profit-seeking businesses, they must receive revenue to generate profit and to remain in business. They do this primary through interest charged for lending.


• Safekeeping: Banks pursue safety of deposits and money supply stability by keeping a portion of deposit in reserve. As depository institutions, banks acquire the funds used for lending through deposits. Banks must keep customer deposits safe or they have no funds that can be used for interest-generating loans.

One of the most important consequence of this balancing act is business-cycle instability. Banks that fall short of the either profitability or safekeeping are prone to bankruptcy. If banks go out of business, then a part of the economy's money supply could, quite literally, vanish into thin air, triggering a business-cycle contraction.

Reserves

• Legal Reserves: Legal reserves are the TOTAL of vault cash and Federal Reserve deposits. These two assets are the only two assets that satisfy the legal reserve requirements handed down by government regulators. And the reason these assets are used to satisfy legal reserve requirements is that these are the two assets banks that are used for daily operations--such as cashing or processing checks or generally satisfying deposit withdrawals. Legal reserves can also be thought of as total reserves.


• Required Reserves: Required reserves are the amount of reserves--vault cash and Federal Reserve deposits--that regulators require banks to keep for daily transactions. Required reserves are specified as a fraction of outstanding deposits--usually about 1 to 3 percent depending on the size of the bank or the type of deposits.


• Excess Reserves: Any legal (or total) reserves over and above those required are excess reserves. These excess reserves are exceedingly important to the banking industry. Because reserves do not generate interest, add to revenue, or enhance profit, banks are prone to hold as few reserves as possible. Banks hold enough reserves to satisfy reserve requirements, because they have to. But they try NOT to hold excess reserves. Holding excess reserves means lost interest revenue. Excess reserves are then used to make profit-generating loans.

Full or No

• Full-Reserve Banking: With this alternative, banks keep 100 percent of all deposits in reserve. In effect, bank vaults are filled with the cash deposited by customers. In effect, banks function as storage businesses. With full-reserve banking, the safekeeping goal is well served. Customers are able to retrieve their deposits. However, banks cannot function as financial intermediaries. They do not make loans. And with no loans that generate interest, they need to obtain revenue in other ways, presumably by charging for the storage of deposits.

  With full-reserve banking, the temptation to use the stockpiles of cash locked away in bank vaults is enormous. Businesses, consumers, government agencies, and even the bank itself undoubtedly are motivated to use this cash, to borrow this wealth for capital investment, home construction, car purchases, or government spending. But if banks give in to this temptation, then they are back into the financial intermediary business, and fractional-reserve banking.



• No-Reserve Banking: With this alternative, banks keep 0 percent of deposits in reserve. Every dollar of deposits received by banks is used for loans. In effect, banks are nothing more than a broker or agent that matches up borrowers and lenders. In fact, they probably have no need for a vault. With no-reserve banking, the profit goal is well served as a financial intermediary, as long as customers continue to make deposits. However, the deposit safekeeping goal is NOT well served. Banks are NOT able to satisfy withdrawal requests from customers, at least not in a timely fashion. With NO reserves, banks cannot "cash" checks. And if customers cannot withdraw funds they are not as likely to deposit funds. If banks have NO deposits then they can make NO loans or function as financial intermediaries.