The definition of full reserve banking can be a source of much confusion and consternation. The confusion revolves around the definition of “reserve ratio”. Normally, the reserve ratio is defined approximately as follows:

Reserve ratio  =

The money held by the bank

The money deposited in the bank by its customers

It is easy to see that the higher the reserve ratio, the smaller the risk of a bank run. With a ratio of 100% this means that even if every single customer demanded to take out their money, the bank will have it all available. This is clearly a very safe form of banking, but as described so far, the bank would simply be acting like a safe deposit box. It would not be able to make any loans. It appears that banks can not act as financial intermediaries between savers and borrowers. Indeed there are some economists that have pronounced that full reserve banking is useless for precisely this reason… but they are mistaken and here’s why:In the context of a full reserve banking system, we need to be slightly more precise about the meaning of the reserve ratio.

Reserve ratio  =

The money held by the bank

The money that the customers currently 

have the legal right to withdraw

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