September 24, 2018 Reading Time: 5 minutes

Banks these days are financial supermarkets. Along with facilitating payments, they offer a smorgasbord of other services including mortgages, lines of credit, bond and equity underwriting, financial advice, and mutual funds and other investment opportunities. They also provide insurance and safety deposit boxes, and trade on their own accounts.

In theory, each of these financial services could be provided separately by a stand-alone entity. Consider the payments function. What would a bank look like if it decided to focus solely on facilitating payments? Such a stripped-down bank would allow depositors to make debit-card payments at the point of sale, wire funds, and engage in peer-to-peer payments. But it wouldn’t provide loans or overdrafts, among other services. 

Would this payments bank be able to compete with a financial supermarket? I’d argue that historically the deck has been stacked against pure payments banks. But this may be changing. 

A payments bank would take the easiest possible route for managing its customers’ funds. It would invest everything in zero-maturity central bank–issued instruments. This investment strategy has the benefit of perfectly matching the maturity structure of the bank’s liabilities (demand deposits) with that of its assets. The demand deposits the bank issued to its customers would be of zero maturity: they could be redeemed by the customer at any moment at par (i.e., at face value). Likewise, the zero-maturity instruments the bank invested in — central bank notes and deposits — could be liquidated by the bank at par at a moment’s notice. By following this simple (and cheap) matching strategy, our payments bank could never fail to grant its customers’ requests to cash out. 

This payments bank is what is known as a full-reserve bank. Each deposit would be 100 percent backed by reserves. Contrast this with a fractional-reserve bank, which invests its depositors’ funds in riskier, non-zero-maturity assets, say loans, while only keeping a small amount of zero-maturity assets as a reserve. To engage in this activity, fractional-reserve banks have to hire a host of extra employees, including credit evaluators, liquidity managers, and investment analysts. 

The fact that you and I both bank at fractional-reserve banks, or financial supermarkets, rather than full-reserve banks is telling. Historically, fractional-reserve banks have always won out against their full-reserve cousins. For an analogy, consider that most people in need of a meal don’t typically go to one restaurant to buy food and another restaurant to get a drink. They prefer that a single establishment provide both. Likewise, many bank customers like the one-stop offering of a fractional-reserve bank. Not only does it provide all sorts of payments options, but it is a convenient place to get a loan. 

But full-reserve banks have also been crippled by the fact that they have always had to bear the cost of storing reserves.[1] In medieval times, when reserves comprised gold and silver coins, these costs involved vaulting, insurance, and handling and sorting. On top of that, coins don’t pay interest. So to stay afloat, full-reserve banks had to pass these costs on to depositors in the form of recurring fees. No one likes fees.

In contrast, a fractional-reserve bank needn’t hold much coin in reserve, so its storage costs were much lower. And unlike a coin, a loan isn’t barren: it yields interest. So whereas a full-reserve bank could only make ends meet by levying fees on its depositors, a fractional-reserve bank could reward its depositors with a recurring bonus: interest. And thus fractional-reserve banks succeeded in becoming the world’s dominant providers of payments services. 

But times have changed. Zero-maturity reserves, which originally comprised precious-metal coins, evolved to a far-less-cumbersome medium: paper. And now they are digitized, existing as mere bits on a central bank’s ledger. In digital form, reserves do not incur any storage costs. And unlike gold coins or cash held in a vault, they do not need to be insured. So one major impediment to full-reserve banking — the cost of holding physical zero-maturity instruments — has been dramatically reduced.

The rise of the internet has also helped. Banks traditionally had to set up a network of physical branches to gather funds. Setting up this network and operating it was expensive, so it made sense to provide a broad array of services to defray costs. By providing a means for a bank to set up virtually, the internet reduces the fixed costs of gathering funds. An example of this is PayPal, founded in 1998 during the internet tech boom. Although it is legally classified as a money-service business, PayPal can also be described as an online full-reserve bank that provides a range of transactional services to its customers.[2]

One more step has made full-reserve banking a more attractive proposition. Beginning in the 1990s, central banks like the Bank of Canada and the Reserve Bank of Australia began to pay interest on central bank deposits. The Federal Reserve did so a decade later, in 2008. The result is that a full-reserve banker would not only be free of the old burdens of storage, insurance, and sorting costs, but would earn interest: in the United States’ case, 1.95 percent per year; in Canada, 1.25 percent. 

It seems to me that the old curse of a full-reserve bank, the necessity that it charge customers a recurring fee to recoup its high costs, has finally been reversed. In addition to providing a full range of transactional services, a full-reserve bank should finally (in theory, at least) be able to provide depositors with interest. 

I am aware of several examples of full-reserve banks having been established in nations where central banks pay interest. Norway’s central bank allowed the Safe Bank of Norway to open an account in 2013, and TNB (or The Narrow Bank) is going through the process in the United States. I wrote about both of these institutions here. These full-reserve banks will only service a narrow range of clientele and will provide minimal payments options. Nevertheless, watch them carefully. It will be interesting to see whether full-reserve banks finally have the firepower to pull customers away from their old nemeses, fractional-reserve banks.


[1] See Selgin and White (1996, p. 97): “Fractional reserve banking has never been compulsory. Depositors have always been free to insist on 100 percent reserves. They can do so even now, by hiring safety deposit boxes and stuffing them with cash. (Some do, but mainly to hide their wealth rather than to secure it against bank failure.) Few people have taken the 100 percent reserve options because — as Rothbard (1990, p. 47) forthrightly acknowledges — it means foregoing interest and paying warehousing fees instead. Most depositors would rather receive interest on their deposits, and consider it more than adequate compensation for the risk involved in fractional-reserve banking.”

[2] Strictly speaking, PayPal doesn’t meet my definition of a full-reserve bank. Instead of holding central bank–issued zero-maturity instruments as reserves (i.e., Federal Reserve notes or deposits), PayPal holds private-bank-issued zero-maturity reserves (i.e., demand deposits). If it were allowed to bank directly at the Federal Reserve, rather than having to obtain Federal Reserve services via an intermediary, PayPal would be a true full-reserve bank.

J.P. Koning


J.P. Koning is a financial writer and blogger with interests in monetary economics, economic history, finance, and fintech. He has worked as an equity researcher at a Canadian brokerage firm and a financial writer and publisher at a large Canadian bank. More recently, he has written several papers for R3, a distributed ledger company, on the topics of central bank cryptocurrency and cross border payments. He founded the popular blog Moneyness in 2012. He designs economics and financial wallcharts at Financial Graph & Art.

Koning earned his B.A. in Economics from McGill University.

Get notified of new articles from J.P. Koning and AIER.