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Financial Stability and Fractional Reserve Banking

Author

Listed:
  • Shengxing Zhang

    (London School of Economics)

  • Cyril Monet
  • Stephan Imhof

    (Swiss National Bank)

Abstract

We analyze the optimal risk-return trade-off when banks can issue inside money. Optimally the quantity of inside money is restricted by some reserve requirements. Increasing the reserve requirements or decreasing the rate of return on central bank money makes loans to the private sector more expensive. This induces borrowers to take more risk. However, leverage also decline, which induces borrowers to take safer decision. The optimal combination of reserve requirement and inflation trades-off both effects. The Friedman rule or zero reserve requirement is not necessarily optimal, as it would induce too much leverage. In spite of being the safest system, fully backed inside money is not optimal as it reduces leverage too much.

Suggested Citation

  • Shengxing Zhang & Cyril Monet & Stephan Imhof, 2017. "Financial Stability and Fractional Reserve Banking," 2017 Meeting Papers 1407, Society for Economic Dynamics.
    • Handle: RePEc:red:sed017:1407
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