How much to keep in the vault
Date posted: December 11, 2013
The Federal Reserve recently released a proposal to require a large banks to keep more of their deposits in the vault. Many argue that the proposal will help avoid the kind of financial problems that rocked the economy in 2008 and 2009. But will the proposal be adopted quickly? N.C. State University economist Mike Walden answers.
“It really gets to the heart of an old, old issue in the banking sector. When modern banks developed, they quickly realized they didn’t need to keep all the deposits they had back in the vault, because it was very rare for everyone to come in at the same time and wanted their cash. So banks quickly develop something we call the fractional-reserve system. They only keep a fraction of their deposits in the bank. They lend out the rest, and actually that benefits the economy because it creates more loans, creates more opportunity to borrow money, creates businesses that buy things, et cetera.
“We do have a problem, though, when we have those widespread panics. We had lots them in the 19th and early 20th century, where people did want all their money out of the bank. And that’s really what led in part to the creation of the Federal Reserve.
“The Federal Reserve stood behind the banks and said, ‘Hey, if you got a run on the bank, we are going to be there to give you cash.’ You still, though, have the issue of, hey, if we have banks having a very low percentage of the deposit in the vault, will that mean more of them could run into trouble?
“So the Federal Reserve and the federal government have always had this debate about what percentage should require banks to have. … Recently, the Federal Reserve decided, hey, that percentage is now too low. We need to raise it again. That makes sense, but the downside is that will mean more costly loans and less loans available.”
Category: Economic Perspective