7

When talking about fractional reserve banking, if we take a contrived example.

1,000 people deposit US$1,000. Deposit total are $1m.

Then the bank subsequently loans US$ 900,000 via a series of commercial, resident and other secured loans of relatively good standard, meeting the reverse requirement ratios. The T book still balances okay since these are essentially assets to bank (your promise to pay back).

Now if economic conditions worsen and a significant amount of loans default (with poor recovery) and equity in the assets is wiped out, if this happens to a significant degree then presumably the bank has to write down these loans, previously they were worth 900,000+ now they are worth 600,000.

Technically then the bank is insolvent? Deposit customers are holding 1m of its debt, yet its liquid assets are 100k and its has 600,000k in other assets and that its??

I appreciate its not as simple as this but is that the general take?

  • The problem starts when at least 101 people go and ask for their money. This will trigger domino effect. – Andrey May 5 '11 at 11:37
7

You bet if it was so simple. This is when financial acumen comes into its true form. The bank would never ever want to go insolvent. What it does is, take insurance against the borrower defaulting.

Remember the financial crisis of 2008 which was the outcome of borrowers defaulting. The banks had created derivatives based on the loans distributed. CDO, CDS are some of the simple derivatives banks sell to cover their backs in case of defaults. There are derivatives using these derivatives as underlyings which they then sold it across to other buyers including other banks. Google for Fabrice Tourre and you would realise how much deep the banks go to save themselves from defaulters. If everything fails then go to the government for help. That was what happened when the US government doled out $600 billion to save the financial sector.

6

It certainly is possible for a run on the bank to drive it into insolvency. And yes, if the bank makes some bad loans, it can magnify the problem.

Generally, this does not happen, though. Remember that banks usually have lots of customers, and people are depositing money and making mortgage payments every day, so there is usually enough on-hand to cover average banking withdrawl activity, regardless of any bad loans they have outstanding.

Banks have lots of historical data to know what the average withdrawl demands are for a given day. They also have risk models to predict the likelihood of their loans going into default. A bank will generally use this information to strike a healthy balance between profit-making activity (e.g. issuing loans), and satisfying its account holders.

In the event of a major withdrawl demand, there are some protections in place to guard against insolvency.

  1. There are regulations that specify a Reserve Requirement. The bank must keep a certain amount of money on hand, so they can't take huge risks by loaning out too much money all at once. Regulators can tweak this requirement over time to reflect the current economic situation.

  2. If a bank does run into trouble, it can take out a short-term loan. Either from another bank, or from the central bank (e.g. the US Federal Reserve). Banks don't want to pay interest on loans any more than you do, so if they are regularly borrowing money, they will adjust thier cash reserves accordingly.

  3. If all else fails and the bank can't meet its obligations (e.g. the Fed loan fell through), the bank has an insurance policy to make sure the account holders get paid. In the US, this is what the FDIC is for. Worst case, the bank goes under, but your money is safe.

These protections have worked pretty well for many decades. However, during the recent financial crisis, all three of these protections were under heavy strain. So, one of the things banking regulators did was to put the major banks through stress tests to make sure they could handle several bad financial events without collapsing. These tests showed that some banks didn't have enough money in reserve. (Not long after, banks started to increase fees and credit card rates to raise this additional capital.)

Keep in mind that if banks were unable to use the deposited money (loan it out, invest it, etc), the current financial landscape would change considerably.

  1. Free checking accounts would go away. Why would a bank want to assume the risk of watching your money if they couldn't get something out of it?
  2. Interest bearing deposits like Savings Accounts and CDs would go away. The bank is able to pay you interest because they are doing stuff with that money which yelds a profit for them (of which you get a cut in the form of interest).
  • 2
    I think you're confusing insolvency with cashflow problems. A run on the bank will break even a bank with no bad debts. In contrast the original question was about insolvency, where bad debts mean that the bank couldn't even repay its depositors after the loans it has issued expire. – Ganesh Sittampalam May 5 '11 at 13:47
  • I think the issues are connected. Even if the bank makes bad loans, money is still coming in the form of deposits that can be used to pay account holders. And the bank can still borrow money. This is one of the things the stress tests were trying to cover (high rates of mortgage defaults). I'll try to edit my answer to be a little more clear. – myron-semack May 5 '11 at 13:57
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    I thought the bank has to put up assets (illiquid or not) to borrow money. So in this case they can't put up 600m of illiquid assets to borrow 900m of liquidity (even on the best terms) to satisfy the withdrawl demands. The Fed would be 300m completely exposed – matt f May 5 '11 at 14:10
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    In your doomsday scenario, the FDIC would be exposed to $300M (not the Fed, there is a difference). And if so, it's like any other insurance. The insurance company has been collecting premiums to pay for it. – myron-semack May 5 '11 at 14:14
3

A bank is insolvent when it can no longer meet its short-term obligations.

In this example, the bank is insolvent when depositors withdraw more cash than the bank can pay out. In this case, it's probably something in the range of $600-700k, because the bank can borrow money from other banks using assets as collateral.

In the US, we manage this risk in a few ways. First, FDIC insurance provides a level of assurance that in a worst-case scenario, most depositors will have access to their money guaranteed by the government. This prevents bank panics and reduces the demand for cash.

The risk that remains is the risk that you brought up in your scenario -- bad debt or investments that are valued inappropriately. We mitigate this risk by giving the Federal Reserve and in some instances the US Treasure the ability to provide nearly unlimited capital to get over short/mid-term issues brought on by the market. In cases of long-term, structural issues with the bank balance sheets, regulators like the FDIC, Federal Reserve and others have the ability to assume control of the bank and sell off its assets to other, stronger institutions.

The current financial regime has its genesis in the bank panics of the 1890's, when the shift from an agricultural based economy (where no capital is available until the crops come in!) to an industrial economy revealed the weakness of the unregulated model where ad hoc groups of banks backed each other up. Good banks were being destroyed by panics until a trusted third party (JP Morgan) stepped in, committed capital and make personal guarantees.

2

Your question points out how most fractional reserve banks are only a couple of defaults away from insolvency.

The problem arises because of the terms around the depositors' money. When a customer deposits money into a bank they are loaning their money to the bank (and the bank takes ownership of the money). Deposit and savings account are considered "on-demand" accounts where the customer is told they can retrieve their money at any time. This is a strange type of loan, is it not? No other loan works this way. There are always terms around loans - how often the borrower will make payments, when will the borrower pay back the loan, what is the total time frame of the loan, etc.. The bank runs into problems because the time frame on the money they borrowed (i.e. deposits) does not match the time frame on the money they are lending.

  • I heard a story that in some country banks did barely legal (or even maybe not legal at all) tricks to force you to either pay all loan for car or give car to bank. Reason was that bank ran out of money, because people started withdrawing deposits. – Andrey May 5 '11 at 11:41
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    You mention that "most fractional reserve banks" are on the brink of insolvency. What are the other types of banks, and what are they doing? – duffbeer703 May 6 '11 at 16:38
  • @duff - I guess I should of say "all banks". You're right...all banks are fractional reserve banks. Fractional reserve banking could be drastically improved if most deposits were CDs. This way the customer and the bank would have time frame terms regarding the deposits which would allow the bank to match up loans with similar time frames. Hey...you ever pop up into the chat room? I would really like to hear your opinion on some current events. – Muro May 7 '11 at 13:13
  • don't disagree... old fashioned deposit-based banking sounds like a positive thing to me, but folks whose wealth is tied up in real estate probably wouldn't agree! i didn't realize there was a chat room, i'll check it out! – duffbeer703 May 8 '11 at 23:12

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