Competitive Banking with Fractional Reserves and Regulations

Institutions providing demand-deposit-like services have been singled out among financial intermediaries, because demand deposits, unlike an insurance contract, must be paid solely upon its owner’s demand. Therefore, when demand deposits are backed by fractional reserves, self-fulfilling panics may occur, so that banks become inherently unstable (Friedman (1959)). Rolnick and Webber (1985) present the conventional view that inherent instability in banking means that bank panics can occur without economy-wide real shocks that directly disturb aggregate economic activity. They, and Smith (1986), emphasize the usual explanation for how this can happen through a local real shock that propagates by the actions of incompletely informed depositors. In the face of this instability governments have found it necessary to intervene and regulate the banking industry. However, there is no agreement concerning the desirability, or even feasibility of the actual policies adopted by various governments.