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A run on the bank

This image is a photograph of people lining up outside of a bank in hopes of withdrawing their funds during the Great Depression.
Bank runs during the Great Depression only served to worsen the economic situation. (Credit: National Archives and Records Administration)

The risk of bank runs created instability in the banking system. Even a rumor that a bank might experience negative net worth could trigger a bank run and, in a bank run, even healthy banks could be destroyed. Because a bank loans out most of the money it receives, and because it keeps only limited reserves on hand, a bank run of any size would quickly drain any of the bank’s available cash. When the bank had no cash remaining, it only intensified the fears of remaining depositors that they could lose their money. Moreover, a bank run at one bank often triggered a chain reaction of runs on other banks. In the late nineteenth and early twentieth century, bank runs were typically not the original cause of a recession—but they could make a recession much worse.

Deposit insurance

To protect against bank runs, Congress has put two strategies into place: deposit insurance    and the lender of last resort. Deposit insurance is an insurance system that makes sure depositors in a bank do not lose their money, even if the bank goes bankrupt. About 70 countries around the world, including all of the major economies, have deposit insurance programs. In the United States, the Federal Deposit Insurance Corporation (FDIC) is responsible for deposit insurance. Banks pay an insurance premium to the FDIC. The insurance premium is based on the bank’s level of deposits, and then adjusted according to the riskiness of a bank’s financial situation. In 2009, for example, a fairly safe bank with a high net worth might have paid 10–20 cents in insurance premiums for every $100 in bank deposits, while a risky bank with very low net worth might have paid 50–60 cents for every $100 in bank deposits.

Bank examiners from the FDIC evaluate the balance sheets of banks, looking at the value of assets and liabilities, to determine the level of riskiness. The FDIC provides deposit insurance for about 6,509 banks (as of the end of 2014). Even if a bank fails, the government guarantees that depositors will receive up to $250,000 of their money in each account, which is enough for almost all individuals, although not sufficient for many businesses. Since the United States enacted deposit insurance in the 1930s, no one has lost any of their insured deposits. Bank runs no longer happen at insured banks.

Lender of last resort

The problem with bank runs is not that insolvent banks will fail; they are, after all, bankrupt and need to be shut down. The problem is that bank runs can cause solvent banks to fail and spread to the rest of the financial system. To prevent this, the Fed stands ready to lend to banks and other financial institutions when they cannot obtain funds from anywhere else. This is known as the lender of last resort    role. For banks, the central bank acting as a lender of last resort helps to reinforce the effect of deposit insurance and to reassure bank customers that they will not lose their money.

The lender of last resort task can come up in other financial crises, as well. During the panic of the stock market crash in 1987, when the value of U.S. stocks fell by 25% in a single day, the Federal Reserve made a number of short-term emergency loans so that the financial system could keep functioning. During the recession of 2008–2009, the “quantitative easing” policies (discussed below) of the Federal Reserve can be interpreted as a willingness to make short-term credit available as needed in a time when the banking and financial system was under stress.

Key concepts and summary

A bank run occurs when there are rumors (possibly true, possibly false) that a bank is at financial risk of having negative net worth. As a result, depositors rush to the bank to withdraw their money and put it someplace safer. Even false rumors, if they cause a bank run, can force a healthy bank to lose its deposits and be forced to close. Deposit insurance guarantees bank depositors that, even if the bank has negative net worth, their deposits will be protected. In the United States, the Federal Deposit Insurance Corporation (FDIC) collects deposit insurance premiums from banks and guarantees bank deposits up to $250,000. Bank supervision involves inspecting the balance sheets of banks to make sure that they have positive net worth and that their assets are not too risky. In the United States, the Office of the Comptroller of the Currency (OCC) is responsible for supervising banks and inspecting savings and loans and the National Credit Union Administration (NCUA) is responsible for inspecting credit unions. The FDIC and the Federal Reserve also play a role in bank supervision.

When a central bank acts as a lender of last resort, it makes short-term loans available in situations of severe financial panic or stress. The failure of a single bank can be treated like any other business failure. Yet if many banks fail, it can reduce aggregate demand in a way that can bring on or deepen a recession. The combination of deposit insurance, bank supervision, and lender of last resort policies help to prevent weaknesses in the banking system from causing recessions.

References

U.S. Department of the Treasury. “Office of the Comptroller of the Currency.” Accessed November 2013. http://www.occ.gov/.

National Credit Union Administration. “About NCUA.” Accessed November 2013. http://www.ncua.gov/about/Pages/default.aspx.

Questions & Answers

If a good is a normal good, which of the following statment is correct
Mhmad Reply
bigman. xarbi
Bigman
why did nominal GDP rise by morethan real GDP during Q3 of 2020? what accounts for the difference?
Alara Reply
nominal GDP is not adjusted to the inflation, real GDP is adjusted.
Aisha
Which countries' nominal GDP?
Anton
or global GDP? gross world product :) I think that is a relevant detail
Anton
nominal GDP use current year in calculation of GDP while real GDP use base year in calculation of GDP,
HASHIM
what is trade
Aqsa Reply
exchange of goods and services
Uzair
how do u understand real income
lubega Reply
Income that earned by factor of production is called National income
Piyush
what is trade balance
Aqsa
.
Bigman
whatsap
Bigman
anyone to shade more light on elasticity demand?
Ashraf Reply
How are the diminishing marginal utility and negatively sloped demand curve related
Siva Reply
what are the types of trade cycle
riziwani Reply
no saving and tax always subtract from NDPmp
Piyush Reply
these are not part of national income
Piyush
how so?
SUB
but it was given
Keyrene
tax always subtracted from?
Keyrene
tax are always subtracted from what?
Asante
keynesian consumption function explain and function
Abdullah Reply
is saving and direct taxes part of income method?
Keyrene
no
Piyush
then where should it belong?
Keyrene
what is the rules of macroeconomics
Amadou Reply
Q1. Discuss the comparative analysis of different economic systems which are prevalent around the world. Give detail examples of different countries where different economic systems are in operation. Also discuss how these countries solve the three basic economic problems of what, how and for whom to produce.
Sami Reply
as interest rates increase what happens to planned investment and aggregate expenditures
Patrick Reply
what is applied economic
Micheal Reply
what is the Demand curve
Patrick
how does one analyze a market where both demand and supply shift
Reymark Reply
explain and justify the effect of the event to the demand and supply for direction then apply the elasticity concepts for extent , support with diagrams
samantha
objective of macro economic
saroj Reply

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Source:  OpenStax, Macroeconomics. OpenStax CNX. Jun 16, 2014 Download for free at http://legacy.cnx.org/content/col11626/1.10
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