Banking Collapse and the Withdrawal of money

Readers Question: What do you think would happen if all depositors of a bank requested their deposits?

The Banking would probably collapse – unless it could secure unlimited funding from a Central Bank or other banks.

If a bank has deposits of £10billion. The bank will keep perhaps 1% in liquid assets (i.e. cash that can quickly be given to customers who demand it. Therefore, out of £10 billion, the bank will have cash reserves of say £100million. We say it has a liquidity ratio of 1%. Therefore, if customers asked for £100 million to be withdrawn the bank could do it. However, once customers require more cash, it faces a problem – The bank doesn’t have the deposits in a liquid form.

What banks do is they lend out deposits to other people. This is how they make a profit.  They pay you 2% a year to save money, then lend to someone else and charge 7%. They can do this because usually people don’t want to suddenly withdraw all their money and it is more profitable than simply keeping money behind the counter.

Run on the Bank

Suppose you hear that a certain bank is in trouble let’s call it the Northern Rock. You have £10,000 worth of savings and you hear there is a possibility the bank will go out of business. A rational decision is to take out the money and deposit it elsewhere. However, once people start doing this it increases the likelihood the bank will have a shortfall and therefore other customers try to take money out. There can soon come a point when the bank can’t meet customers demands because they don’t have the liquid assets.

Bank Of England – Lender of Last Resort

In the great depression of the 1930s many small and medium sized banks did go bankrupt for the above reason. However, it is very bad for a bank to go bankrupt because it undermines the entire financial sector (people will want to start hoarding in cash under the bed if they fear banks will go bankrupt) Therefore, in the UK, the Bank of England says it will act as lender of last resort. Therefore, if a Bank is short of money and it can’t raise in on the interbank markets it can always borrow from the Bank of England. The argument is because there is no possibility of a bank going bankrupt there is no chance of a ‘run on a bank’

Therefore, in theory the Bank of England should secure all the deposits of any British Bank. Therefore, the Bank should be able to survive.

I have to say it has never happened to a really big bank.


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