the plan for the future

Full reserve banking and Chicago Plan

19 October 2019 (latest update: 18 February 2023)


Banks create money out of thin air and profit from it. We all pay for bank profits and bankers' bonuses via inflation, interest, financial crises and bailouts. Since the end of the gold standard in 1971, credit in the financial system has expanded at an unprecedented pace. According to the documentary 97% Owned, the money supply in Great Britain rose from £ 0.5 billion in 1870 at an annual rate of 2.7% to £ 3.2 billion in 1939 and then at an annual rate of 6.9% to £ 25 billion in 1970 and then at an annual rate of 12.5% to £ 857 billion in 2000 and then at an annual rate of 9.8% to £ 2,185 billion in 2010.

Most of this newly created credit had speculative purposes, like buying existing houses, rather than productive ones, like starting new businesses. Most notably, the United States and the United Kingdom have financialised their economies, which gave them more economic clout than their industrial bases justify. And that adds a political dimension to monetary reform. A fairer financial system could end the dominance of the United States. And things might not improve when more oppressive regimes like China and Russia take over. And so, monetary reform might require an open, democratic and unified world.

There are good reasons to reform the financial system, but existing reform proposals come with issues. Cheap business loans may not always be possible as there is less risk attached to mortgages than business loans. Governments could set goals for banks, for instance, a percentage of small-business loans. And financial institutions might participate in businesses as intermediaries for depositors who become investors, a scheme similar to Islamic banking. Many monetary reform proposals are problematic because they involve increasing reserve requirements or full-reserve banking. That is because of the view on savings many monetary reformers share.

Many monetary reformers think that if banks create money out of thin air, the money in bank accounts isn't savings. But savings are capital, not money. The reformers think in terms of money, but money itself is not capital. It represents capital. When I build a house using materials I barter, I never use any money. But in the end, I own a home. That is capital I have saved. So, if I sell that home to someone who takes out a mortgage to buy it, the money in my account is savings. It gets a bit more questionable if abstract forms of capital like goodwill are involved, but savings back the money in our financial system.

Full reserve banking

In the aftermath of the financial crisis of 2008 there was a renewed interest in monetary reform. One of the most well-known monetary reform proposals is full reserve banking, for instance the Chicago Plan. With full reserve banking banks are not permitted to lend out funds deposited in demand accounts or current accounts. Hence, money in these accounts isn't debt but backed by central bank currency or cash. In this way banks can't go bankrupt when depositors demand cash.

With full reserve banking loans must be made out of longer-term savings, which is money that can't be withdrawn on demand but is entrusted to the bank for a longer period of time. This plan is likely to reduce bank lending and the amount of outstanding bank debt. It could make the banking system less vulnerable to failure so that there might be less need for bank bail-outs by governments and central banks.

For these reasons full reserve banking may solve a few issues that have been ailing the banking system since the introduction of fractional reserve banking, most notably excess credit created by banks. It is therefore not surprising that full reserve banking gets attention whenever banks run into trouble. Full reserve banking would reduce the business for banks so it is also not suprising that banks and their lobbyists don't support it.

Many proponents of full reserve banking do not want money creation to be under private control as this might constitute a subsidy to the banking sector. Money created by banks can create inflation as banks can create money for profit and the inflation is paid for by the public. Fractional reserve banking may contribute to economic cycles and financial crises. And when a bust sets in and debts can't be repaid banks may need to be bailed out with public funds.

There are downsides to full reserve banking. Often it is argued that banking services will become more expensive as banks can't lend money that is in demand accounts and current accounts so that they have to make up for that with fees. That is a rather insignificant problem and there are more troubling issues. These are:

  • There could be less credit and interest rates could be higher.
  • Alternative schemes like shadow banks might be set up that look like fractional reserve banking.
  • The issue of matching the terms of loans and deposits doesn't disappear.

  • Less credit and higher interest rates

    With full reserve banking there could be less credit and interest rates could be higher. Full reserve banking would make lending money to a bank less attractive because money would be locked up for a considerable period of time. To make people save, interest rates on savings accounts may need to be significantly higher. Consequently, there could be fewer funds available for lending so with full reserve banking interest rates would probably be higher.

    Proponents of full reserve banking might see this as an upside. Higher interest rates allow for less debt to exist as debtors can service less debt. The only problem they may worry about is that it might take an economic depression to get there. If interest rates were to rise to a modest level like 4%, a massive wave of bankruptcies might follow. They may argue that the underlying problem is excess debt fuelled by low interest rates so that debt liquidation is necessary.

    If government and central bank backing for the financial system would disappear, this would add a risk premium to savings and other forms of credit. This can contribute to higher interest rates. Savers may feel they need a compensation for the risk of bank failure and systemic failure. The low interest rates we currently see express a belief in the market that central banks will do whatever it takes to keep the financial system afloat.

    Higher interest rates not only allow for less debt to exist, but also for less capital so that the amount of wealth could go down. In other words, we could all be poorer with full reserve banking. That is because credit is the cornerstone of the capitalist economy. With full reserve banking money remains idle and is not used for economic purposes. In other words, it is not used for investment or consumption, and this may harm the economy.

    Higher interest rates can affect the competitiveness of businesses. If one country is to introduce full reserve banking, there could be less credit and the cost of borrowing could go up. Businesses would have more difficulty competing with foreign corporations as their access to credit is constrained and interest costs are higher. Businesses in countries that allow for fractional reserve banking would therefore have a competitive advantage.

    Alternative schemes like shadow banks

    Imagine there is full reserve banking in Paradise and that Eve and Adam only do business with each other. Both have € 100 in their current account they use for their daily business transactions. This money can be used for payment because it is in the current account. For that reason they don't receive interest. Assume now that the bank offers savings accounts with an interest rate of 4% but money in savings accounts can't be used for payment.

    Then a snake comes along. It advises Eve and Adam to administrate their payments between themselves and to put their money in a savings account. In this way they both can receive interest on their € 100. They give each other credit so that Eve can borrow € 100 from Adam and Adam can borrow € 100 from Eve. In this way they don't need money in their current accounts so they can put their money in a savings account and receive interest.

    At first Eve and Adam had no savings, only money in their current account. The scheme of the snake allows them fabricate savings out of credit. This looks like creating money, only this is not money but credit. Credit can be used for payment like money. Similar schemes can be devised on a larger scale. These are called shadow banks. Shadow banks don't create money, only credit. The difference between fractional reserve money and this type of credit may not be so great.

    When banks create money they do the same. Banks can act as an intermediary between Eve and Adam so that they can lend each other money even when they do not business with each other or do not trust each other. This is also credit but it is called money because the law states that bank credit is legal tender and therefore money. The government backs this scheme. For that reason banks are subject to regulations as a stable financial system is a key public interest.

    The financial crisis of 2008 started in a shadow bank that creates credit and not in a regular bank that creates money. Shadow banks don't have to comply to the regulations that apply to regular banks. Regular banks ran into trouble because they had given credit to shadow banks. Money creation therefore wasn't the problem. Replacing regular banks with shadow banks could destabilise the financial system and leading to more financial crises.

    If a financial crisis is to occur, full reserve banking can ensure that money in current accounts is safe, but that doesn't apply to savings. If the debtors of a bank fail to meet their obligations, the bank may get into trouble and savings entrusted to the bank may be in jeopardy. To ensure financial stability, governments and central banks may end up supporting savings banks and even shadow banks so that the benefits of full reserve banking may end up being void.

    Matching the terms of loans and deposits

    Full reserve banking means that banks have enough cash at all times, even when all account holders come to the bank on the same day to empty their accounts. That hardly happens and it is becoming less likely as cash is used less and less for payment and saving. The security against bank runs that full reserve banking is to provide may therefore be rather limited and it doesn't protect us from financial crises and economic depressions.

    With full reserve banking savings are still not safe. The terms of deposits and loans hardly ever match. A thirty year mortgage might be backed by a five year deposit so a bank might run into trouble when the deposit is not renewed and no other deposit is made. So banks may end up holding a reserve on savings to meet such situations like they are now holding a reserve on current accounts and demand deposits to meet possible withdrawals.

    This means that the problem persists in the savings area and still has to be dealt with by holding reserves. Even more so, the distinction between money and savings is arbitrary. A one year deposit can probably be considered savings with full reserve banking but a one day deposit probably cannot. But where do you draw the line? The distinction between money and savings is therefore arbitrary. If one day deposits are savings too this is very close to fractional reserve banking.

    Financial instability, inflation and public losses

    Full reserve banking may not solve much because only money in current accounts and demand deposits would be safe. A financial crisis can still happen and may even be more likely because alternative forms of finance like shadow banks may fill up the void. The public may still end up paying for losses in the financial sector because the alternative could be an economic depression. And full reserve banking may reduce credit and push up interest rates so the economy may suffer.

    Financial instability, inflation and public losses are not caused by private banks creating money alone, but by all forms of lending together. The solution may not come from full reserve banking or reining in credit by raising interest rates. If financial instability is caused by interest, raising interest rates could make things worse. Interest is a major cause of financial instability for two reasons:
  • incomes fluctuate while interest payments are fixed
  • interest contributes to questionable lending because interest is a reward for risk

  • Financial stability is a key public interest because it reduces the risk of lending so interest rates can be lower. The economy benefits from this as more capital can be profitable and there can be more wealth. Therefore governments and central banks back the financial system. If interest causes financial instability, interest also causes public losses. The cost of financial instability is probably higher than these losses so it makes economic sense to back the financial system.

    If interest is a major cause of financial instability, inflation and public losses, introducing full reserve banking or raising interest rates can make matters worse. It also follows that allowing interest rates to go negative and phasing out lending at positive interest rates can solve these issues. How this might work out is explained in the financial stability hypothesis, which can be found via the following link: