Safety First? The Deceptive Allure of Full Reserve Banking

Abstract

In “Safe Banking,” Adam Levitin joins a venerable tradition in the money and banking literature. That tradition, called full reserve banking, has claimed a number of illustrious supporters over the years, including Irving Fisher, Henry Simons, and Milton Friedman. The basic idea of full reserve banking is seductive in its simplicity: “banks” should own nothing but physical cash. Because a full reserve bank has no investments, it can suffer no investment losses. A run on such a bank would be harmless, since the bank would never fail to meet redemptions (barring any loss or theft of cash). The process of bank money creation, familiar to any student of Economics 101, would go away. Money creation would be exclusively a government affair; “banks” would be pass-through vehicles, true depositories of currency. Our elaborate system of prudential bank regulation and supervision would be needless.

If it seems too good to be true, that’s because it is. Proponents of full reserve banking have long run up against two principal objections — one of them surmountable, the other fatal. The surmountable objection has to do with “regulatory arbitrage” or avoidance. Once we say that “deposits” must be backed by physical currency, the argument goes, nonbank financial institutions will create close substitutes for deposits and thereby evade the full-reserve requirement. Levitin treats this issue in some detail, and he offers a rather optimistic answer: he thinks that deposit substitutes can emerge on a large scale only with various forms of government “facilitation.” Remove such facilitation, he says, and the problem is basically solved. For reasons described below, I do not find this answer wholly convincing. The good news is that regulatory arbitrage can be dealt with through well-designed entry restriction laws, which have been a staple of banking law (not to mention public utility law) for centuries. Levitin’s full-reserve banking plan therefore can’t be rejected on this score.

It is the second objection — what I will call fiscal-monetary entanglement — that poses the real problem for full reserve banking proposals, including Levitin’s. As I show below, full reserve banking would present daunting challenges for both fiscal management and the administration of monetary policy. Unfortunately, Levitin’s article has little to say about this topic. Others before him have addressed the issue, but their answers are unsatisfying. While noble in intent — and despite their continuing allure — full reserve banking proposals do not offer a workable blueprint for financial reform.