Excessive leverage by the banks was one of the main causes of the Great Depression and of the 2008 financial crisis.
As such, lower levels of “fractional reserve banking” – i.e. how many dollars a bank lends out compared to the amount of deposits it has on hand – the more stable the economy will be.
But economist Steve Keen notes (citing Table 10 in Yueh-Yun C. OBrien, 2007. “Reserve Requirement Systems in OECD Countries”, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board):
The US Federal Reserve sets a Required Reserve Ratio of 10%, but applies this only to deposits by individuals; banks have no reserve requirement at all for deposits by companies.
So huge swaths of loans are not subject to any reserve requirements.
Indeed, Ben Bernanke proposed the elimination of all reserve requirements for banks:
The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.
Economist Keen informs Washington’s Blog that about 6 OECD countries have already done away with reserve requirements altogether (Australia, Mexico, Canada, New Zealand, Sweden and the UK).
But there is a growing recognition that this is going in the wrong direction, because fractional reserve banking can destabilize the economy (and credit can easily be created by the government itself.)
It was big news this week when one of the world’s most prominent economics writers – liberal economist Martin Wolf – advocated doing away with fractional reserve banking altogether… i.e. requiring that banks only loan out as much money as they actually have on hand in the form of customer deposits:
Printing counterfeit banknotes is illegal, but creating private money is not. The interdependence between the state and the businesses that can do this is the source of much of the instability of our economies. It could – and should – be terminated….