Hardly had the Bank of Mauritius (BoM) raised the Cash Reserve Ratio (CRR) from 4% to 6% than our commercial banks inched up their prime lending rate by 25 basis points. Instead of reducing their profit margin, they compensate for the incremental operational cost due to the hike in the CRR. They have actually widened their interest spread as deposits rates remain the same. They also keep non-interest charges high. While I reckon that greed is a natural feature of capitalism, what worries me is the apparent reliance of our banks on the greed motive for the successful workings of their industry.

In the contemporary banking system based on fractional reserve, banks are allowed to create money: they constantly keep a fraction of their deposits and they lend the rest against collateral and remuneration. The whole structure of the system hinges on the trust of depositors that they will recover their initial money, for they can withdraw their deposits at any moment. In that respect, the method of calculating the reserve requirement ratio is crucial. The BoM defines the CRR as a percentage of total deposits, which comprise demand deposits, savings deposits and time deposits.

The problem of fractional reserve banking system is that it will always tend towards a more or less uncontrolled expansion of money. If the BoM is seriously concerned about controlling it, it should consider establishing the condition that banks keep, at all times, a reserve of one hundred percent of the amount of money obtained as demand deposits. The rationale behind it is simple: money received in a current account is fungible money (also called irregular deposit) as it can be withdrawn at any moment through a cheque.

It is unacceptable that a bank considers the funds deposited in a current account as belonging exclusively to itself. If banks were not allowed to lend something which had been deposited with them as a demand deposit, then they would give credits on the basis of real savings according to the relative scarcity of capital. This would put a stop to banking abuses and, consequently, to high inflation.

The old Roman Law had a long standing principle that custody, in irregular deposits, consists precisely of the obligation to have always an amount equal to that received at the depositor?s disposal. This means that all acts that grant credits against fungible money are a violation of that principle and an illegitimate act of undue appropriation.

The eighteenth century witnessed a convergence of theory and practice on the one hundred percent reserve requirement. David Hume defends it in his essay ?Of Money? (1752) where he states that ?no bank could be more advantageous than such a one that locked up all the money it received, and never augmented the circulating coin, as is usual, by returning part of its treasure into commerce.?

At that time, the prestige of the Bank of Amsterdam was based on the belief that it held a reserve of one hundred percent. Adam Smith reported that in ?The Wealth of Nations? (1776): ?The Bank of Amsterdam professes to lend out no part of what is deposited with it, but for every gilder which it gives credit in its books, to keep in its repositories the value of a gilder, either in money or bullion.?

The proposal to establish a banking system with a one hundred percent reserve was mooted by Ludwig von Mises in The Theory of Money and Credit (1953): ?The main thing is that the government should no longer be in a position to increase the quantity of money in circulation and the amount of checkbook money not fully ? that is, one hundred percent ? covered by deposits paid in by the public.?

The Austrian business cycle theory describes how the fractional reserve banking system generates economic recessions endogenously and recurrently. When a central bank sets short-term interest rates at such a low level that it causes credit to expand artificially, businesses overestimate the value of long term investments and generate a boom led by what Friedrich Hayek calls ?malinvestment?.

Such an investment-led boom, where a plethora of money is locked into excessively capital intensive projects, sows the seeds of its own destruction. It ends in bankruptcies, a crash in capital spending and an inability for producers to increase prices. Banks call in bad loans and are reluctant to extend credit. Firms liquidate wrongly induced investment projects while households scramble for cash and government securities. Overall, investment and consumption fall.

The Mauritian economy appears to be experiencing this artificial boom as credit to the private sector has nearly trebled its annual growth rate to 24% in the year ended July 2008. It is the role of the BoM to take a sanguine view on the soundness of the banking system, but it needs to gear up its supervision vigilance on defaults of payments. It must also take further corrective actions to remove liquidity out of the system. The severe correction of the Mauritian stock market, after a long bubble phase, constitutes an eye-opener.

Mopping up liquidity is a sine qua non for a return to monetary stability. The BoM can achieve it only if the CRR becomes a function of one hundred percent reserve on demand deposits. Since the latter represent 9% of total deposits, the CRR should be raised further to 9%.

As the Governor of the BoM is not a firm believer in cash ratio, he would support additional increases in the Repo Rate instead of the CRR. He had argued for 100 basis points but got only 25 last time. As a two percentage point hike in CRR is equivalent to a quarter point rise in the lending interest rate, he is likely to propose 50 basis points at the next rate-setting meeting. The quantum seems justified to me although I would prefer to have it in two consecutive steps.