Bank balance sheet changes caused by the switch from fractional to full reserve.

Two attempts have been made to show the central bank and commercial bank balance sheet changes that would result from a switch from fractional to full reserve banking. They are both far too complicated. One is by Messers Benes and Kumhoff and set out in their IMF paper. (See page 64 onwards). The other is by the two Positive Money (PM) authors Ben Dyson and Andrew Jackson in Ch.8 of their book “Modernising Money”.

The IMF paper is about 36,000 words. I did a 2,000 word summary of it here.

Also, the IMF system for converting to full reserve involves a debt jubilee of truly astronomic proportions, the reasons for which are a puzzle. There may be merits in debt jubilees, but that’s an entirely separate issue from switching from fractional to full reserve banking.

I’ve set out a much simplified set of balance sheets below. But first, the arguments leading to the latter balance sheets.

First, you will see no reserves on the balance sheets prior to the switch. That is because in normal times (e.g. prior to the crunch) reserves form a very small proportion of commercial bank’s assets. Indeed in many countries, commercial banks can have that proportion as small as they like. For example in Canada  just prior to the crunch, bank reserves were around 0.3% of bank assets. So let’s just ignore reserves prior to the switch.

I’ve also ignored bondholders and shareholders. As to bonds, they are essentially just a form of long term deposit, ownership of which is frequently traded, so I’ve merged them with depositors. Thus the balance sheets below are applicable both to high street banks which obtain a lot of money from retail depositors and investment banks which obtain no money from the latter source, relying instead on bonds or quasi-bonds.

As to shareholders, they formed a very small proportion of banks’ liabilities (if indeed you can call shares a liability).

Of course that proportion will rise A BIT as a result of recent attempts to raise capital ratios. But the regulators are having a hard job raising those ratios by any significant amount.

The switch.

Come the switch, let’s say depositors want 60% their money to be completely safe, i.e. have 60% of their money lodged “full reserve fashion”. That would mean commercial banks just open safe accounts for those depositors, and shift £0.6X from depositors’ existing accounts to the newly created safe or “full reserve” accounts.  At the same time, the central bank credits the account of the commercial bank with £0.6X (created out of thin air).

At that stage, there has been a large gift (worth £0.6X) made by the central bank to commercial banks, which of course cannot be allowed. And “X” of course amounts to BILLIONS. And a further anomaly is that there are £X of loans (e.g. mortgages) supported by only £0.4X  of deposits, which is a nonsense.  In the case of PM’s system, the latter £0.4X would be made up of depositors willing to put their money in to investment accounts. Under Lawrence Kotlikoff’s system which in principle is the same as PM’s, PM’s “investment accounts” take the form of mutual funds (“unit trusts” in the UK).

So, £(X – 0.4X) i.e. £0.6X of loans needs to be given by commercial banks to the central bank. And the result is that the central bank has then not made any sort of net gift to commercial banks. The central bank would collect interest and repayment of capital on those loans and mortgages, or it could sell on the latter to any willing buyers.

In the balance sheets below, the initial assets and liabilities of the central bank are shown as zero, which is obviously unrealistic in a sense. However, given that it’s just the CHANGES to bank balance sheets that of relevance here, ignoring the EXISTING assets and liabilities of the central bank is a justifiable simplification.

Another simplification is that under Kotlikoff’s full reserve system, depositors who want their money investing or lending on put their money into mutual funds (“unit trusts” in the UK). And mutual funds are separate legal entities to the banks (or other entities) that run those funds, thus those mutual funds SHOULD HAVE their own balance sheet below. However, I’ve merged those mutual fund balance sheets with commercial banks’ consolidated balance sheet.

Initial balance sheets.

Commercial
banks.

Assets.	Liabilities
Loans.       £X	Deposits.   £X

Central bank

Assets.	Liabilities.
Zero	Zero.

Balance
sheets after conversion to full reserve.

Commercial banks.

Assets.	Liabilities.
Loans. £0.4X	Deposits in PM’s investment accounts or Kotlikoff’s mutual funds.             £0.4X
Reserves.£0.6X	Safe or full reserve deposits.     £0.6X

Central banks.

Assets.	Liabilities.
Loans (formerly owned by commercial  banks)    £0.6X	Commercial banks’ Reserves.     £0.6X

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