Working Paper No. 13-32 on the Welfare Properties of Fractional Reserve Banking

Monetary economists have long recognized a tension between the bene…ts of fractional reserve banking, such as the ability to undertake more pro…table (long-term) investment opportunities, and the di¢ culties associated with fractional reserve banking, such as the risk of insolvency for each bank. The goal of this paper is to show that a speci…c form of private bank coalition (a joint-liability arrangement) allows the members of the banking system to engage in fractional reserve banking in such a way that the solvency of each member bank is completely guaranteed. Under this arrangement, I show that a lower reserve ratio usually translates into a higher exchange value of bank liabilities, bene…tting the consumers who use them as a means of payment. Keywords: bank coalition, fractional reserve banking, interbank credit, reserve management JEL classi…cations: E42, G21