U.S. Banks Are Now Operating With 100% Reserves - Is Full-Reserve Banking The Next Step?

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Includes: FAS, FAZ, FINU, FINZ, FNCL, FXO, IYF, IYG, RWW, RYF, SEF-OLD, UYG, VFH, XLF
by: Atle Willems

Summary

U.S. banks are now operating with 100% reserves, according to latest Fed data.

Banks operating with 100% reserves is probably a first in the history of U.S. fractional reserve banking.

A plausible explanation for banks' current stratospheric excess reserves is that full-reserve banking will be implemented in the U.S.

If implemented, bank stock prices could take a hit, bondholders gain.

Following the more than $3.5 trillion (391%) expansion of the Fed balance sheet since the end of Q2 2008, it seems to have gone largely unnoticed that U.S. depository institutions ("banks") are now effectively operating with a 100% reserve ratio, according to the latest Fed data.

The reserve ratio discussed here is one whereby immediately withdrawable deposits (does not include savings and time deposits) and currency in circulation (notes and coins) are backed 100% by bank reserves.* Under such a system, banks would only be able to lend what others have saved (in savings accounts and time deposits), effectively ending bank deposit (money) creation.

As the M1 money supply measures include both immediately withdrawable deposits and currency in circulation, the reserve ratio can be calculated by dividing bank reserves by the M1 money supply.** As of the end of August, bank reserves amount to $2.7863 trillion, while the M1 money supply is $2.7847 trillion, equating to a reserve ratio of just north of 100%. For the first time in the history of fractional reserve banking in the U.S. to my knowledge, banks are hence now in effect operating with a 100% reserve ratio, in line with those advocated by full-reserve banking.

As the chart shows, from January 1984 to August 2008, the reserve ratio averaged only 2.14%. It also shows the ratio more or less steadily declined during the 1984 to 2008 period. Looking at just the January 2000 to August 2008 period, the ratio drops to just 0.76%. At the end of August 2008, just prior to the culmination of the U.S. banking crisis, the ratio was 0.75%. Since then, the reserve ratio has shot up as a result of QE1, 2 and 3, and as the Fed started paying interest (0.25% p.a.) on bank reserves in October 2008.

It is interesting to observe that the reserve ratio has now reached 100%, just as the Fed nears the end of QE3. At the same time, unemployment remains elevated (the current U6 unemployment rate of 12.0% is 12.1% higher than average), and economic growth (any apparent growth is largely driven by money supply increases) remains less than stellar.

Now, why would the Fed end "stimulating the economy" just as the very factors it is meant to stimulate remain lacklustre? There are arguably many reasons for this. One reason for the Fed taper could be that it actually celebrates the unemployment numbers, and is actually pleased with a growth rate in nominal GDP substantially lower than that of the money supply. *** But, couldn't there be a reason for the Fed ending its purchase programs which actually makes economic sense? Creating more money in no shape or form makes a society better off (if anything, it makes it worse off).

There is one reason the Fed is now apparently ending its "monetary stimuli" which is becoming increasingly plausible, and that seems to have eluded the radar of economic commentators. Namely, is the Fed about to end fractional reserve banking as we know it, and in due course, replace it with full-reserve banking? The one thing the Fed fears perhaps more than anything else, as it would most certainly lead to an end of demand for US dollars and hence a collapse of the U.S. monetary system itself, is hyperinflation. Currently, U.S. banks hold about $2.69 trillion in excess reserves. This means that excess reserves currently make up almost all of banks' total reserves (excess + required), which is currently about $2.79 trillion, as mentioned above. With the current fractional reserve banking system requiring banks to hold less than 10% reserve ratio, this means there is virtually no regulatory limit to how much money banks can generate. To be specific, U.S. banks are currently in a position to create new money amounting to $26.9 trillion, dwarfing not only the M1 money supply (currently $2.8 trillion), but also the M2 money supply (currently is $11.4 trillion). As long as the Fed acts as a lender of last resort, banks will become ever more tempted to put those excess reserves to work and expand their loan portfolios and potential profits. Also, it could prove difficult, if not impossible, to remove this temptation by continuing to pay 0.25% p.a. on bank reserves, as it's a poor return. The Fed could naturally increase what it pays on reserves, but this would only lead to yet larger excess reserves.

The one reasonable way, and perhaps the only way, for the Fed to deal with these excess bank reserves, and as a result, effectively remove banks' ability to create hyperinflation, is to increase reserve requirements for banks substantially. Having completed the initial "emergency rescue" of the banks in 2008 and 2009, it is arguably plausible that the Fed undertook QE3 (and maybe even QE2) to bring the U.S. banking system up to a 100% reserve ratio for them to end fractional reserve banking in the U.S. as we know it, and replace it with a full-reserve banking system; i.e. the excess reserves becomes required reserves. Only then would these current stratospheric excess reserves make any sense at all. And only then would the Fed money printing make economic sense in retrospect, as it would have led to a new banking system, which would be inherently more stable, as opposed to inherently very unstable. Of course, bank stockholders could experience a significant drop in stock prices, as banks would no longer be able to make a profit on money created out of withdrawable deposits. Conversely, bank bondholders would likely gain due to a substantially reduced risk of bank-runs.

It should therefore, at this stage, surprise no one, whatever shape or form it comes in (if it comes at all), if a significant change is implemented in the U.S. soon or sometime in the future to bring the banking system at least a step closer to full-reserve banking. The banks are there already.

* See Money, Bank Credit, and Economy Cycles, 3rd ed. by Jesús Huerta de Soto, p. 716-735, where the author lays out the views of both Ludwig von Mises and Friedrich Hayek. Both Mises and Hayek argued in addition in favour of a gold standard.

** In addition, the M1 also includes Travelers Checks, but this is a negligible amount, as it only currently makes up about 0.12% of M1.

*** Year-on-year growth rate in nominal GDP was 4.2% in Q2 2014, while the M2 money supply increased 6.5% during the same period.

Disclosure: The author is short MYY.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.