All students of economics learn about the money multiplier early in their studies. They are taught that banks multiply their initial deposit into assets (loans) after setting aside a small fraction of it as cash reserve. So, the amount of money created is the initial deposit multiplied by the inverse of the reserve fraction.

In reality, banks do the opposite. They do not create assets out of deposits. They create deposits out of assets. They make loans and then credit the account of the borrower with a deposit. In this, banks create assets first and liabilities consequently. They have not been financial intermediaries at all. The Bank of England admitted as much in a discussion paper in 2014. Currently, banks’ ability to create assets is constrained only by their risk appetite and leverage (debt) ratios imposed on them by the regulator and not by the amount of deposits. This allows banks to grow, becoming “too big to fail" (TBTF) and too big to be rescued too.

When bank assets lose value or are impaired, they threaten the entire economy, especially small ones. It happened in the case of Iceland. The two big Swiss banks almost brought the Swiss economy too to its knees. Hence, Switzerland has a referendum coming up on 10 June on the issue of banks issuing and creating money. It is called the “Vollgeld" (full money, literally) initiative. It is similar to 100% reserve banking or “full reserve" banking. That is, banks hold 100% cash reserve against the deposits they hold. Banks will be free to create assets out of explicit borrowing (liabilities) that they take on their balance sheet. This will significantly restrain credit creation or money creation by banks.

What are the implications of this? By the way, the Chicago Plan that Irving Fisher propounded in 1936 is different from what is discussed in this column. For a non-technical introduction to that, read the blog post by Michael Kumhof.

First, banks will charge more for loans than before given the amount of cash they set aside for 100% reserve banking. That can slow down frivolous lending and borrowing.

Second, in this system, banks are unlikely to court deposits and may even discourage them. Or, they may charge fees for accepting deposits and not pay interest at all. They may accept deposits only from those who borrow from it since they make up the costs for accepting their deposits through the interest they charge on the loans made to such depositors. Retail depositors will be affected.

But how real is the risk that banks will shoo away depositors and that they will find refuge only in non-banking options to keep their savings and cash for expenses? Most retail depositors will be keeping a credit card issued by the bank and will also be tapping the bank for mortgage loans. If banks shoo depositors away because of the need to keep unremunerated reserves, they will lose out on these businesses.

Further, they cannot rely exclusively on commercial loans funded by their own borrowings. In the absence of their deposits that give them relatively low-cost funding, what will the true cost of market funds be for banks? They may be deemed a higher risk. Hence, their cost of funds will likely be higher than what it is now.

Additionally, under “100% reserve" banking, TBTF banks will cease to exist. That is actually a state subsidy or insurance against their failure. If that is removed, their cost of funds will have to reflect the premium for such free insurance from the sovereign that the bank no longer enjoys. In the absence of TBTF protection and the recourse to low-cost deposits, banks’ cost of funds, and hence their lending rates, will make them an unviable funding source for better-rated borrowers, especially in countries with advanced and evolved capital markets. Consequently, banks may end up lending to less credit-worthy borrowers and those who cannot tap the capital market at higher interest rates. In that case, 100% reserve banking may have adverse distributional consequences.

As most of the above scenarios envisage higher cost of capital, the overall cost of capital in the economy may rise. It may not be a bad thing in advanced economies where they have been kept too low for too long. Economic growth engineered by debt is unsustainable and dives when paper assets conjured purely out of debt lose all value. Of course, if cost of funds goes up in advanced nations, then borrowers from developing nations will hesitate to borrow in foreign currency. In other words, full reserve banking may help herald the re-fragmentation of capital markets. That is a good thing for it would restore national policy autonomy, improve financial stability and greatly minimize spillover costs.

The Swiss National Bank and commercial banks are opposing the referendum proposal. That is a good reason to take the proposal seriously.

In the last two decades, commercial banks, facilitated in no small measure by central banks, have generated more wealth for the rich through credit creation. Thus, they have to shoulder a significant share of the blame for the rise of income and wealth inequality globally and for the consequent rise of “beggar-thy-neighbour" policies. A referendum that spotlights these issues should be welcomed and the proposal could be no worse than the status quo, if it succeeds.

V. Anantha Nageswaran is an independent consultant based in Singapore. He blogs regularly at Read Anantha’s Mint columns at

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