Monthly salary tides

Safety first

In the previous chapter I showed that full reserve banking is safer than fractional reserve banking, because full reserve banking prevents bank runs. That’s because in full reserve banking, all credits are funded by long-term deposits. So sudden, large withdrawals by many clients at once, of money that the bank lent out to others, cannot happen, so they cannot endanger the bank’s stability.

Possible run on the bank

Fractional reserve banking on the other hand, does cause an inherent instability: banks use not only long money for credit granting, but also short money.

Short money is cash and money in on demand deposits. If too many short money depositors suddenly want their money back, the bank runs into problems, because it simply doesn’t have all that money: most of it has been given to borrowers as loans.


That’s the theory. But what does this look like in practice, in a modern, highly electronicized society? I posed that question in the previous chapter, and I will now try to answer it.

Dutch wages and salaries


Let’s look at a realistic example of massive withdrawals from bank accounts, to see what happens.

I take this example from how things work in the Netherlands, which is where I live. To understand the description from the perspective of other countries, e.g. the United Stated of America, you may need to substitute giro transfer by checks, and debit card by credit card.

However, these are technicalities. The essential point is unaffected.

Monthly payments

Here in the Netherlands, people who have a job get their wages or salary on a monthly basis. They get it by the end of the month, usually around the 25th or 26th. The employer pays it by means of a giro transfer, meaning it orders its bank to transfer the money from the employer’s bank account to the employee’s bank account.

Employees can spend that money by obtaining cash using a debit card in an ATM. Or they can issue giro transfers from their bank account to the bank accounts of people and companies that they owe money. The debit cards can also be used for payments in shops, as a replacement of cash. It means the amount is charged to their bank account almost immediately.

(Credit cards are a known phenomenon here too, but they aren’t used very often. Primarily for holidays, and for remote internet purchases in the USA.)

Volume, overdrafts

The volume of such payments taking place every month is considerable: a company with, say, 500 employees isn’t unusually big. A monthly salary of something like 2000 euros isn’t unheard of. So that means several companies exist, that need to have about a million euros ready on their current account by the 24th each month, in order to be able to make those salary payments.

Some companies will succeed, but some will need to overdraw the account or bank credit. If they’re a healthy company, it is to be expected that during the month, there will be sufficient revenues, so by the end of it the company will be ready for the next round of salary payments.

So some companies will have a bank account position that goes from just above one million on the 24th, to just above zero on the 26th, and then slowly up again. Other companies will display a monthly pattern of 800,000 euros on the 24th, to a 200,000 euros overdraft on the 26th.

Likewise, at the receiving end, some employees can get by with their salary, and go from just over 2000 euros on the 26th to just over zero by the 24th of the next month.

Others, as the Dutch expression goes, will have days left at the end of the month (instead of having money left), so their figures may be 1600 euros and 400 overdraft respectively.

(Of course, if they’re smart, they also involve savings accounts and receive some interest. But most Dutch savings account are also on demand these days, so for my purpose (looking at the role of short money in credit granting), that makes no difference.)

What kind of money?

To the banks, all of this is short money: it is on demand, in checkable accounts.

In many cases, these giro transfer transactions stay within the same bank, because most banks are big and have many clients, among them both employers and employees.

Of course it will happen that the employer has its bank account with ABN AMRO, but that many of its employees are with ING or Rabobank. So quite a bit of money will flow to and from those banks every month. Because other companies have their bank account with Rabobank or ING, while many of their employees have theirs with ABN AMRO, and many other combinations, also involving smaller Dutch banks, most of this will even out. What remains can and will be handled via interbank clearing or interbank lending.

Tidal waves

So what we see every month is somewhat like a tidal wave: money abruptly flows from companies to individuals and then gradually back from individuals to companies, eventually including the companies those individuals work for.

On both sides, from the point of view of banks, this involves credit positions, but also debit positions. Debit positions mean the bank is granting credit.

By the 24th of each month, many of the debit positions tend to be with employees. By the 26th, suddenly a lot of those are with companies instead.

Withdrawals, but no bank run

So by the 25th of each month, we see massive money withdrawals by companies, who need to pay out salaries. However, that doesn’t represent a bank run and isn’t a threat to the banking system’s stability.

That’s because practically all of that money, the moment it is withdrawn, returns to those banks, except that it is in different account holders’ bank account. The money doesn’t disappear, it only moves.

Financial tides

Fractional reserve banking

As said, all of this involves short money, that is money under the definition of M1.

In a system with fractional reserve lending, banks may use long money, but also short money, to grant credits.

That means in the above example, the massive money withdrawals by employers do not change much to the position of banks. After pay-day, the amount of credits banks have granted is still roughly the same as before, only it is in different accounts.

The amount of money in accounts that are not in overdraft is also roughly still the same. That money, short money, can be used by the banks to fund the overdrafts at the other side of the bank’s balance sheet.

So the total of the money in accounts in a country is like the water in an ocean: it flows to and fro with the rhythm of the tides. But there’s still as much water in the ocean.

Full reserve banking

Now let’s look at companies paying monthly salaries the same way as above, but now suppose we have a full reserve banking system.

In full reserve banking, banks may only use long money for lending. Short money must stay in the bank because that is considered safer.

That means that in such a system:

In full reserve banking, all of those credits must instead be financed using long money, that is, money from time deposits, certificates of deposit, and savings accounts with a period of notice.

This in spite of the fact that plenty of short money is also readily available. But it cannot be used.

Does that make sense? I don’t think so.

Is it safer? In theory: yes. In practice: no, at least not where this example is concerned.

Think about it

So if you think fractional reserve banking is evil, and you’d rather have full reserve banking instead, just think of the consequences.

It means if you want to buy a house and you want a mortgage loan, banks might say to you: “sorry, you cannot have it, because the funds we need for that are already in use to enable some of our business clients to pay the monthly salaries”.

If you want to start your own business and you need a five-year investment loan to get things going: same answer.

Banks in such a system will have plenty of short money, only they’re not allowed to use it. So they must use other money, long money, that they could otherwise have borrowed to you.

It goes without saying!

Again, just like when describing bank functions, while writing this article I had this feeling like:

“This is all so trivial, everybody knows this already, do I really have to explain this? Isn’t this article a bit silly and childish?”

Well, apparently not. Because if I look at the internet, there are lots of people out there who think fractional banking is bad and dangerous, and want to return to full reserve banking. But it seems they never really thought about the consequences and disadvantages.

Addition 20 October 2012

Article 17 is in fact a note to articles 4, 6 and 7.

Copyright © 2012 R. Harmsen. All rights reserved.