The Role of Cash Reserves in Fractional Reserve Banking.
Cash reserves serves the purpose of maintaining liquidity in the banking system and thereby ensuring system rigidity. Banks are compelled by legislation [Basel II and III] to have sufficient cash reserves at any given time, this is so as to avoid banking instability as attested to during the banking crisis of 2008.
Commercial banks keep a tiny portion of their demand deposits as reserves, and this is informed by the assertion that depositors seldom withdraw all their demand deposits at a given time, unless there is a bank run of course. This system of fractional reserve aid banks in the creation of demand deposits, and this demand deposits are above what the bank has as reserves.
How cash has evolved from commodity money to the current fiat money system.
Under the commodity money system standard money had abstract value. The measurement of money was defined as the aggregate quantity of precious metals coins of a specific quality i.e. weight and design ,circulating within the borders of a country.
Sources of money creation.
1).Minting of new coins can be facilitated by:
-Recently extracted gold.
-Melting existing from jewellery or ornaments.
2).The balance of payment surplus resulting from foreigners demand for local goods bring s in foreign gold.
Countries are relatively not equally endowed in gold deposits, and thus countries with no gold deposits would rely on the melting of jewellery brought to the smelters by the rich of the country this proved inefficient during economic growth era. Countries had to stimulate demand of their exports and thus a surplus balance of payments account. This brought much needed gold coins or bullion in to the country.
The very same way that coins could be created, they can also be destroyed and this resulted in the reduction of total coins available with in the country.
Sources of money destruction.
1).Wear and tear.
2).Negative balance of payments[deficit]due to the high costs of local goods vis-a-vis foreign goods. Coins of varying quality were used in the facilitation of commercial transactions. Silver ,bronze, copper were all used side by side in the market as abstract money. Commodity money was abstract i.e. not backed by anything, and as such can be regarded as cash. The varying degrees of coins quality impacted on the IV value of coins. Intrinsic value relates to the quality and quantity of metal used in the minting of coins. FV[face value]is the quantity of goods that the coin can fetch or buy in the market. When the FV of the coin was more than the IV value more coins would be minted or jewellery will be smelted into minting coins. The opposite would appear if the IV value was more than the FV, people would keep their jewellery and less coins would be minted.
David Hume concept of specie flow mechanism ensures that the level of equilibrium between local prices and foreign prices is realised. For instance, when the price of local goods expressed through the exchange rate is less than that of foreign goods, foreign courts will flow into the country and as such the quantity of cash in the country will increase and thus increasing local prices for goods until they equate to foreign prices. The same process will happen in the opposite way when local prices are more than foreign prices, locals will opt for cheaper foreign goods to costly expensive local goods. The outflow of cash from the local economy to foreign economy will raise prices in the foreign country due to an increase in the quantity of money from increases in their exports.
The notion of a pure barter system is a theory with little practicality during medieval times. Overwhelming evidence supports commodities as a facilitator of bridging the gap between desired good/services and ability to produce or make by self. In other words commodities were a lubricant to ensure that trade takes place between people, so long there exists a need in the secondary market for the bridging commodity/s. Commodity had to be liquid enough for it to be accepted as a facilitator of trade.
The gold standard straddled the 1870s till the start of WW I. Total cash was measured by total number of abstract money units contained in the gold coins, deposits and notes circulating with in the country in the hands of the non bank public. When the bank of England experienced a shortage of notes this posed an uncomfortable scenario for commercial banks, they had reserves with the central bank. The BoE had to legalize the tendering of its notes even though not backed by gold i.e. intrinsic money, the notes were to no longer be convertible to bullion. The non convertibility of BoE notes presented the issue of flooding the economy with notes, this would increase the reserve holding of banks and as such their demand deposit creation abilities, and as we know some portion of this demand deposits will be withdrawn as cash and this will impact on the inflationary pressures. This forced the bank of England to revert back to convertibility of their notes to gold, but with a fixed gold price. The Brits thus became vanguards of currency convertibility into gold.
Under the gold standard system trading nations had no limitations on the flow of gold across national borders, currencies were convertible into gold at a fixed price and international payments settled in gold. The exchange rate was determined by the quantity of currency payable towards a fixed ounce of gold, the system came to be known as mint parity. The first world war put an end to the system of converting currency into gold as nations had to finance the war. After the war the Brenton Woods system came into being. Currencies were convertible to the dollar for the public whilst the central bank currency was convertible to gold at a fixed price.
The banking sector would acquire cash reserves via:
1).A balance of payments surplus.
2).Buying gold from local producers.
3).Selling bonds to the central bank in the money market.
Central banks of the gold standard had a dual mandate of ensuring fiscal stability and also operated as commercial banks by discounting bills and giving loans.
Stabilizing the fiscus.
Central banks had an unofficial mandate of fiscal stability and this was achieved by limiting its deposits and putting a limit on its notes when excess notes held by commercial banks flooded the economy and compromised macro economic stability. The central bank would also raise the discount rate which they charged commercial banks for providing them with cash.
Control the variability of the demand for cash.
Just like commercial banks had control over cash variability via their demand deposit creation mechanism, the central banks provided commercial banks with cash reserves and thus control on the money supply. The abstract nature of money translated into the central bank’s reserves being cash, hence their ability to control the quantity of cash available to commercial banks. The ideology behind the central bank [BoE] control over the variability of cash conformed to the Real Bills Doctrine Mark II.
The pursuance of cash variability and fiscal stability presented a problem to authorities. This will be discussed under the constraints on the supply of credit by commercial banks
The fiat money system is a system where money is purely abstract, it’s not backed by anything or convertible to bullion like in the gold standard. Cash reserves includes cash only, not even an ounce of gold is regarded as cash reserve. Central bank engages in international transactions on behalf of local commercial banks and thus has a need for foreign currency from time to time. Occasionally central banks would pay each other in gold, hence the hogging of gold reserves by central bank, and this also hedge against currency fluctuations. Foreign currency, more so the U.S. dollar is a necessity as cash reserves in the modern central bank, most international transactions at non bank level are denominated and conducted in dollars, hence the importance of the dollar as a foreign currency reserve. China has the largest U.S. dollar reserve at more than a trillion.
The fact that under the gold standard central bank would engage in transactions like a commercial bank and make profit by discounting bonds issued by the private sector as a way of making cash available to commercial banks, this fact is not present in the modern central bank under the fiat money system. Central banks no longer buy bonds or bills for cash, they facilitate this process by offering repurchase agreements. Securities function as collateral for short term revisable loans to banks. The modern central bank is a single source of cash in the fiat money system. Commercial banks no longer raise cash from the public like it happened under the gold system. The important task of money supply in the economy rests solely with the central bank and the non banking public credit demand. There are positive corellations between economic growth and money supply.

Under the gold system the exchange rate was linked to the value of bullion. In the fiat money space the exchange rate needs to be flexible, although some currencies float with in a predetermined range i.e. the yuan and the euro against the dollar. It’s simply not advisable to literally fix a currency as this will create an artificial over heating of the economy and the accompanying consequences are well documented in Latin America where numerous currencies were once fixed or tagged to the U.S. dollar. Like alluded to before, the non convertibility of the currency to bullion and the legalized tender of central bank notes placed the central bank at center of cash supply in the economy with commercial banks involved also in the provision of demand deposits whilst cash remain solely the responsibility of the central bank. The conversion of demand deposits into cash have a bearing on the supply of money and the availability of cash in the market. Commercial banks affect the availability of money and by extension cash through their demand deposit creation operations. The central bank can only influence the supply of money and availability of cash by manipulating the repo rate at which commercial banks borrow cash from the central bank.
Derivative money applicable in the gold standard rendered the cash supply dependent on the availability of bullion and the central bank could do little about this as foreign bullion would flow into the country due to balance of payments surplus. The value of bullion had an effect on the demand for money from the non bank public. The higher the value of bullion the more the intrinsic value of coins became and the less circulation in the market coins will become, especially when the face value of the coin was less than the intrinsic value as determined by the value of the backing commodity, in this instance gold. The legalized tendering of notes with out backing by bullion[abstract money] facilitates the proliferation of notes in the public space and as such the central bank hands were tied in influencing the quantity of money.
Little difference exists between the gold money system and the fiat money system. In the gold money system notes issued are backed by gold bullion and convertible. Under the fiat money system money is abstract and backed by nothing, convertible to nothing. The central bank engineer the shortage of cash amongst commercial banks through its open market operations in the modern money system. Banks are forced to loan cash from the central banks via the repo[repurchase agreement] system.
Although central banks still keep gold reserves in the modern money system, this reserves are not for the purposes as in the gold money system. At times international transactions are settled in cash and this is a rare occasion by the way. The gold reserves are held as a hedging mechanism against the volatile currency markets.

As alluded to earlier, the diminished quantity of cash constraint on the supply of credit by commercial banks of the central bank is discussed here.
Under the gold standard money transformed from being backed by bullion to abstract money. Commercial banks lost their monopoly over the supply of money in the economy, although they still had monopoly over the supply of cash to commercial banks. Commercial banks had the liberty of controlling their demand deposit operations, they could also have reserves comprising of the central bank notes. The central bank’s buying of bills and bonds became a tool for the banking sector to obtain reserves and also for the central banks to exercise control over the availability of cash in the economy. This they achieved by manipulating interest rates on lending and discounting of notes.
In the fiat money system the central bank had to abandon some of its commercial bank practices i.e. they no longer have credit facilities for the non bank public. The central bank also no longer buys money market instruments for cash, they use the repo’s.
There are two important differences between the gold standard system and fiat system and this has a bearing on the way they affect the money supply in the economy.
1).Gold no longer function as cash in the fiat money system and the only source of cash for commercial banks in the central bank.
2).The variability of cash policy pursued by the central bank and discussed above made commercial banks short term money borrowing from the central bank via the repo an after thought, commercial banks would create demand deposits and grant loans first.
This entrenched commercial banks dependency on the central bank for cash even more, and also enhanced the central bank’s ability to influencing supply of cash via interest rates they charge. To get this, the central bank has no direct control over the demand deposit creation operations of commercial banks, banks have the liberty to engage in their operations so long they keep minimum reserve requirements[fractional reserves].
By application of open market operations the reserve bank ensures liquidity shortages in the economy and forces commercial banks to borrow from it via the repo agreements. That’s where the central bank has control over the price of cash over commercial banks as opposed to having the quantity of money constraints on the supply of credit by commercial banks.
The source/s of cash for the commercial banking sector.
Under the commodity money system commercial banks had to source cash via:
1).Positive balance of payments account.
2).Minting of coins from recently mined gold.
3).The melting of jewellery by smelters to mint coins.
In the gold standard system commercial banks could hussle for cash through:
1).Foreign banks. International trade transactions results in a negative or positive balance of payments, surplus or deficit balance. For the sake of staying relevant I will confine to a surplus balance as it creates money for the banking sector. The duties of the central bank as an intermediary for local commercial banks in trade settlements translates into an increase in account balances of commercial banks held with the central bank.
2).Local central bank.
By selling assets to the central bank in the discount window commercial banks cash balance increases.

Money and cash are not synonymous.
To the non economists or little apprehension of monetary economics, money and cash will be the same and of which it’s fallacious.
Money can be characterized to be definitive money or derivative money. But before I can dwell into this let me pontificate as to the definition of money in monetary economics terms.
To have a grasp as to what money entails one has to go back to the commodity money system or the so called barter era. Anything that could be used as a medium of exchange to facilitate trade functioned as money with pre-conditions that the particular commodity should be liquid enough for further use by the receiving party and that the commodity must exhibit some value. The more scarce the commodity was the easier was it to transact using it as a medium of exchange.
Demand deposit created by commercial banks are also money, they can be used a medium of exchange i.e. pay debts or buy goods and services. This kind of money is called derivative money due to its value being determined by debt. All of modern money is debt as its created by demand deposits. The quantity of this debt money decreases when debts are settled and increases when demand deposits or credit is extended.
Cash can be regarded as abstract money, money that has no backing or convertible to anything. Its value is the face value written on it. Demand deposits are backed by cash, convertible to cash when withdrawn, but cash is not convertible to anything, it buys or settle payments only. Although some people still uses it as a storer of value. The theoretical construct of a barter system can be said to exhibit characteristics of cash i.e. when cows or sea shells were used to settle payment their value was not tied to anything, what you see you got.
The developments in the banking sector result in money being debt in such it has become only a bookkepping entry, a debt created to increase the money the supply. Cash still remains a component in the whole banking sector due to:
1).Inter bank settlements occurs in cash only.
2). Foreign transactions are mostly settled in currency hence the importance of cash reserve for central banks.
Money has resulted in an overwhelming increase in trade and specialization. During the mercantilists times bills of exchange and promissory notes were used to facilitate trade in the absence of gold. Like the current fiat money, a bill or note had to have reputation for it to be used as a trading toll, or it could be guaranteed by a reputable person or institute, a process that still happens today i.e. government just guaranteed ESKOM raising of debt. The increase is economic activity is positively related to the quantity of money in circulation, because without money its difficult to engage in trading activities.
The availability of cash is associated with inflation, more cash is needed to perform transactions due to the high costs of goods and services. This explains the use of demand deposits[money] in mature economies as opposed to cash in under developed and some developing economies. Trading can take place without cash exchanging hands, parties can credit each other demand deposit with the relevant amount and this is the most convenient way to trade by the way. It’s a known fact that in under hand or corrupt practices cash is the preferred mode of payments, for obvious reasons i.e. to leave no paper trail. Cash is vulnerable to theft and wear and tear. It does not earn interest unless held as a demand deposit at commercial banks.
Money and cash exist side by side in the banking and financial market system, this is so like alluded to prior some portion of demand deposit will be converted into cash. Cash evolved out of the commercial paper market hence the Americans refer to their currency as dollar bills[bill of exchange] and the Brits refer to their currency as notes[promissory note].
The distinction between money and cash is essential for one to have a comprehensive understanding of the operations of the commercial banking sector and the central banks.

Nature of fractional reserve banking.
Fractional reserves banking is of importance in the commercial banking sector. Only fractional reserve banks can create money. Tracing the history of the evolution of money one gets the sense that since the gold standard reserves have been important, although not fractional.
Then there is warehousing bank. Warehousing banks create demand deposits equivalent to their holding of reserves i.e. if a bank has deposits of 1000 it will create demand deposits equivalent to 1000. Warehousing banks have limited ability to create money, so is their little impact in influencing economic growth.
A bank holds a fraction of its deposits as reserves for purposes of maintaining liquidity in the banking sector. The aftermath of the recent financial crisis compelled authorities to tighten regulations pertaining to reserve holding. Popular opinion is that banks create money out of nothing, and that’s a bit shallow argument coming from a student of monetary economics. It seems like that on the surface but after coming to understand the cash reserve requirements and stress test to determine bank stability that banks have to go through one gets the picture.
During the gold standard commercial banks had no authority of keeping their reserves own reserves, it was the mandate of the central bank to keep reserves on behalf of commercial banks. The cash crunch crisis experienced by the BoE forced it to let commercial banks to create their own demand deposits and keep their own reserves in the notes of the central bank. The convertibility of notes into gold meant that gold was also regarded as part of reserves.
The modern commercial bank is compelled to borrow cash requirements from the central bank of which the central bank charges them interest in order to influence the quantity of their demand deposits. All reserves held by commercial banks are in cash and as a fraction of the total demand deposits that commercial banks created. Fractional reserves banks don’t use previously held cash balance to create demand deposits, they issue new demand deposits, they issue IOUs to finance their operations. Commercial banks are handicapped in their spending and lending operations by the amount of cash they have[reserves]rather than the demand deposits they create. Cash money is thus very important to the existence of commercial banks.
Commercial banks have assets in their books and these assets can be sold to raise cash when needed. This translates into these assets being liquid in that they can be sold without struggles in times of need. In essence commercial banks reserves consists of:
1).Cash(primary reserves).
2).Liquid assets reserves(secondary reserves).
To recap:
Under commodity money system the public held the largest portion of available precious metal coins. Banks had gold more than cash held as reserves.
With the gold standard system:
-Gold function as primary reserves[cash].
-Definitive gold money sustained humongous quantities of derivative money[demand deposits].
-Only coins and gold were definitive.
-Money consisted of derivative and definitive money. Let me elaborate on this further. Notes, coins and deposits issued by the central bank are definitive money in a sense of being declared legal tenders and deposits issued by commercial banks being convertible to them.
Their derivative nature comes from their bookkepping entry or notes and bills paper issued by banks which in essence had no purchasing power except for they were backed and convertible to gold.
Under the fiat money system:
-gold is no longer a feature as reserves.
-The legalized tender of cash serves as the sole reserve. Meaning that demand deposits issued by commercial banks are no longer backed by gold.
-Definitive money consists of central bank money only.
The non convertibility of central bank money[definitive]impacted on the type of financial assets issued in the open market operations by the central bank. Money held by the central bank has no obligations to back it with gold, and this lessens the element of risk in the system and increases the creation of money.
Cash drains faced by commercial banks.
Commercial banks experience cash drains due to:
1).Foreign banks. Globalization and liberalization of international trade created a market for imports for international exporters. The increase in local money supply via demand deposits and if the marginal propensity to import is high amongst local then import will increase. A country should grow its increases in demand deposits in line with international median value, by offering more than the international norm. The main reason being the unpredictability of international payments.
2).Other local banks. An increase in demand deposits and credit extensions by local bank will result in the increase of the money supply and some of these money will be used to pay or settle payments with customers of other banks. Local commercial banks should increase their demand deposits and credit extension facilities in tandem with their local peers so that chances of inter bank settlement cancelling each other are maximised.
3).The local non bank sector. The proportion of cash the public wants to hold has impacts on the cash drain of local commercial banks. A bank run happens when depositors with demand deposits at a specific bank rush to withdraw their demand deposits[converting them into cash]due to perceived structural problems at that specific bank, as it happens locally with Saambou bank and the recent international banking crisis in Cyprus. By increasing their demand deposits commercial banks increases cash withdrawal from their banks, as said before some portion of demand deposits will be converted into cash. Fractional reserves banking increased the demand for demand deposits and thus lessened the public’s desire to hold cash, this is related to the advancement of the economy.
Ways to mitigate against cash drains.
Clearing houses.
This serve as watchdogs in the commercial banking sector and ensures that banks have sufficient liquidity to meet cash needs as they arrive. Standards are set and every member of the clearing house has to adhere to them. Clearing houses even serves as the lender to struggling banks and this is so done to avoid system’s collapse.
Buffer stock of cash.
The cash reserve requirements ensures that banks have adequate capacity to negotiate cash withdrawals by depositors. Basel II and III makes provisions of ensuring sufficient cash reserves by commercial banks. The banking crisis that followed the sub prime crisis were an eye opener in many .There are so controversial economists who argue that the economic crisis during the ECONOMIC DEPRESSION were triggered by the commercial banks having not enough liquidity. But that’s another story altogether.
Commercial banks in the modern money system faces almost if not similar scenarios of cash drains. Banks operating in the gold standard system of money faced similar cash drain situation like their peers in the fiat money sytsem.

Cash needs of commercial banks.
The fact that commercial banks apply the system of fractional reserves in the creation of demand deposits doesn’t make then immune to cash requirements. If commercial banks were to finance demand deposits with their cash balance instead of issuing new demand deposits, this would leave little available as cash reserves and thus hamper the important duty of stimulating economic activity by ensuring that there is enough cash to go around in the market.
Commercial banks need for cash even when financing demand deposit with newly created deposits rather than cash for the following reasons.
1).Cash drain. I would not elaborate on this as the matter was sufficiently dealt with above.
2).Heightened demand for cash. Again this was explained above.
Cash is second nature to commercial banks, it’s impossible for a commercial bank to be in existence without cash. The tight international and local regulations as to cash reserve requirements ensures that commercial banks are sufficiently liquidated to need cash needs as they arise.
Again the globalization of trade ushered in an era of international bank settlement and this needs to be in cash and they can happen anytime i.e. John might decide to buy shoes in Istanbul and his bank will have to honour the payment to a different bank in Istanbul in cash.
Without cash commercial banks will find it difficult if not unregulatory in creation of demand deposit. As mentioned somewhere in this essay, the creation of demand deposits requires sufficient cash reserves. A bank operating with less than sufficient cash will not see the light of day with the existing robust legislation to protect consumers against banking system instability.