Comments on: Your Money 101: Why a Bank Exists? http://www.dominica-weekly.com/investing/your-money-101-why-a-bank-exists/ Ramblings From The Nature Paradise of Dominica Mon, 01 Dec 2008 21:42:07 +0000 http://wordpress.org/?v=2.6 By: Dan http://www.dominica-weekly.com/investing/your-money-101-why-a-bank-exists/#comment-11109 Dan Fri, 04 Apr 2008 13:52:04 +0000 http://www.dominica-weekly.com/?p=1379#comment-11109 That explanation is a good start, but omits a critical factor -- leverage. A bank can lend out more money than it takes in in deposits, because the probability of all its depositors calling for their funds simultaneously is low. The multiple of loans out to deposit in is the leverage. In the US, since the Great Depression, the government guarantees deposits (up to a certain amount per account per depositor, presently $100,000 in federally chartered banks) but covers its insurance bets by requiring the insured banks to maintain a liquidity (cash or cash-equivalent) reserve; this is equal to the maximum leverage. For example, a 20% reserve would mean that a bank could lend out at most five times its deposits. When depositor confidence becomes low enough, a run on the bank can commence. That is what the Federal Deposit Insurance Commission (FDIC) prevents. Because of the FDIC insurance, regular depositors don't run on the banks in a panic to get their money. But since the Great Depression, the nature of banking in the US and the world has changed. The big investment banks (such as Bear Stearns) are not regulated and are not insured. And a collapse of such a bank could have catastrophic effects on the world's financial markets. That is why the US Federal Reserve Bank stepped in and "rescued" the bank anyhow. It is beyond the scope of this note to go into, but the rescue raises many new questions. That explanation is a good start, but omits a critical factor — leverage. A bank can lend out more money than it takes in in deposits, because the probability of all its depositors calling for their funds simultaneously is low. The multiple of loans out to deposit in is the leverage. In the US, since the Great Depression, the government guarantees deposits (up to a certain amount per account per depositor, presently $100,000 in federally chartered banks) but covers its insurance bets by requiring the insured banks to maintain a liquidity (cash or cash-equivalent) reserve; this is equal to the maximum leverage. For example, a 20% reserve would mean that a bank could lend out at most five times its deposits.

When depositor confidence becomes low enough, a run on the bank can commence. That is what the Federal Deposit Insurance Commission (FDIC) prevents. Because of the FDIC insurance, regular depositors don’t run on the banks in a panic to get their money. But since the Great Depression, the nature of banking in the US and the world has changed. The big investment banks (such as Bear Stearns) are not regulated and are not insured. And a collapse of such a bank could have catastrophic effects on the world’s financial markets. That is why the US Federal Reserve Bank stepped in and “rescued” the bank anyhow. It is beyond the scope of this note to go into, but the rescue raises many new questions.

]]>