Working Paper

On the welfare properties of fractional reserve banking

Abstract: Supersedes Working Paper 13-32/R. Monetary economists have long recognized a tension between the benefits of fractional reserve banking, such as the ability to undertake more profitable (long-term) investment opportunities, and the difficulties associated with it, such as the risk of in-solvency for each bank and the associated losses to bank liability holders. I show that a specific banking arrangement (a joint-liability scheme) provides an effective mechanism for ensuring the ex-post transfer of reserves from liquid banks to illiquid banks, so it is possible to select a socially efficient reserve ratio in the banking system that preserves the safety of bank liabilities as a store of value and maximizes the rate of return paid to bank liability holders.

Keywords: Fractional reserve banking; Reserve management; Risk sharing;

JEL Classification: E42; G21;

Bibliographic Information

Provider: Federal Reserve Bank of Philadelphia

Part of Series: Working Papers

Publication Date: 2015-04-14

Number: 15-20

Pages: 36 pages