An Islamic economics perspective to the role of the fractional reserve banking in economic instability and the potential of full reserve banking as a remedy

The fractional reserve system, which is explained by the concept of money multiplier in economics literature and in which banks create credit money by making loans, constitutes the working mechanism of today's banking system, which is the backbone of modern financial architecture. Reserves held for legal requirements and excess reserves held for hedge and profitable investments constitute a fraction of all deposits that need to be kept, while the remaining fraction of the deposits are lent by banks by which money is created. Fractional reserve banking is inherently weak and fragile against financial instability. This system is based on the trust that commercial banks and central banks will provide sufficient liquidity when necessary. Due to the weak structure of the fractional reserve system, the role it plays in economic instability and the problems it creates, full (%100) reserve banking has been supported in academic circles as remedy and different models have been developed. However, the support needed to vitalize the full reserve banking system was weak. In this study, we scrutinized the problems which are claimed to be emerged in the economies with the exploration of fractional reserve banking, we discussed the feasibility of full reserve banking and its qualification as remedy to solve the problems and we examined the suitability of both systems in terms of Islamic economics and their drawbacks in this manner. In the analysis phase, effects of both banking systems on economic stability was compared using an agent-based simulation model.