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I'm just starting to learn about the fractional reserve banking system. Suppose a bank has deposits of $100 and the reserve requirement is 10%. The bank gives the remaining $90 as loans. Now suppose on that day, there is a net withdrawal of $2. So now deposits are $98 and the new reserve requirement is $9.8 but the bank only has $8 in cash. How will it finance this $1.8 gap?

I figure it might use the interest payments it's getting on the loans or the actual loan being repaid. Is this true or is there something I'm missing?

  • Part of the challenge in your scenario is that you're flattening a bank's entire business into "cash" and "loans." In reality, it's not black and white, there's a spectrum of assets with different levels of liquidity, and both reserves and other assets are held in different forms according to perceived risk levels. Your $2 withdrawal would be responded to very differently depending on if it was isolated vs part of a recession or other major event. – dwizum Jun 28 at 13:22
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    The simple answer is "they borrow it from the government and/or other banks". – D Stanley Jun 28 at 13:28
  • Be careful about questions like this. I asked one about how banking system regulation works in practice and it was closed and deleted by a moderator even though it had community upvotes. Moderation is very arbitrary here. – jww Jun 28 at 21:33
  • What you're describing is a "run" on the bank (losing multiple percent of their cash in a single day). The short answer is that most banks cope with this sort of scenario very poorly and usually collapse. – Valorum Jun 28 at 22:25
  • @jww sorry if it seems arbitrary. Can you tell me how you feel this current question is on topic? How would the answer help the OP or future visitors with their personal finances? – JTP - Apologise to Monica Jun 29 at 0:33
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When bank liquidity is in trouble, one way to overcome the issue is through Inter-bank loan. That's why you heard something like Inter bank rate.

Since not all Bank reserve have the same surplus/deficit, they can give a loan to each other with a margin.

However, this mechanism is never mean to work over the long term. If any bank that constantly runs into credit crunch(if no private entity wants to inject funds) for Inter-bank loan, it is a signal that it is going down the drain. It is just a matter of time that all banks providing the loan will get into the trouble if they are not careful (because it is a lucrative business) and cause a widespread domino effect.

If the problem is caused by short and mid-term (rather than intermittent) liquidation problem but all the loan business is sound, the government may resort to injecting funds into the bank using various mechanism. Although such bail-out should not happen in the first place if banks are well regulated.

Many bankers argue that the reserved ceiling is the cause of the liquidation problem. But without the reserved ceiling, bankers are even bolder with bad loans or even fraud: since those deposits are other people's money.

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    "the government may resort to injecting funds into the bank" - The European Central Bank strategy is to start with a bail in - the bank's shareholders and other investors in the bank are first hit, before public money is used. After that, the ECB may sell the valuable loans to other banks to raise liquidity. – MSalters Jun 28 at 14:29
  • @mootmoot, I understood all of this except the paragraph on 'short and mid-term liquidation problem'. What do you mean by these terms? – Sal_99 Jun 29 at 7:58
  • @Sal_99 I just add "rather than intermittent" to clarify it. In dire conditions, even a constant short term (2 weeks ~ 1 month) interbank loan can be devastating to a bank, which interest fees can rack up millions of dollar a day. – mootmoot Jul 1 at 9:15
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In your example, the bank is unlikely to receive $1.80 in interest on $90 of outstanding loans in one day. So it will need to raise new capital, by going back to its existing shareholders for (at least) $1.80 more or by issuing and selling new shares worth $1.80 (and thus diluting the existing shareholders). Or perhaps by selling assets, such as companies it owns, or doing a sale-and-lease-back on its premises. Banks don’t like to do that, especially not in a rush, and so they keep their reserves above the legal minimum at all times. In practice, your bank wouldn’t lend out more than $80 or $85, so as to keep a buffer.

ETA: One more option that I forgot is that the bank could call in some of its loans. If the terms & conditions of the loan contract permit, it could require $2 to be repaid immediately by one of its borrowers.

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    This is not how US banks maintain their reserve. They borrow it from the Federal Reserve or other banks. – D Stanley Jun 28 at 13:32
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You're probably mixing two different reserves.

A bank has to have a certain capital reserve itself. Its shareholders must invest $10 to allow the bank to take $100 in deposits, which it could then loan to other customers. If if some of the loans would not be repaid, the shareholders would be the first to feel the squeeze.

A second reserve is the cash reserve. The bank must indeed keep some liquidity at hand so it can pay out that $2 withdrawal from your example.

These are not the same reserves, nor do they add up. They overlap. The first reserve is typically a long-term reserve, because many loans are long-term loans. The second reserve is typically a short-term reserve, because it covers the day-to-day fluctuations in deposits and withdrawals.

In reality, calculating both types of reserves is a bit more complicated because the real world isn't entirely black&white. For the first type of reserve, the bank needs to take into account the risk of the loan. A mortgage is better than an unsecured personal loan, and a car loan is somewhere in the middle. For the second type of reserve, cash at hand is best, government bonds are almost as good as cash, and publicly traded corporate bonds are also pretty liquid (easy to sell for cash).

  • since I am new to this, this is the first time I've heard of a capital reserve requirement. I'll look into them and get back to you. – Sal_99 Jun 29 at 8:10

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