Not So Dismal

Making Economics a Little Easier to Understand

Posts Tagged ‘Reserve Requirement

The Pie is Bigger Than it Looks

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So how do runs on the bank work, anyway? To understand how bank runs create a self-fulfilling prophecy, it’s important to understand how banks keep and loan money.

Banks don’t keep all of their deposits on tap. Rather, only a portion of these are kept around at any time. Under normal circumstances, this is fine, because it’s very unlikely that everyone will suddenly ask for their money at the same time. Therefore, just keeping a small percentage on hand is enough for the daily traffic at any branch. Why don’t they keep all of the money on tap at any particular moment? That question strikes to the heart of how banks stay in business at all.

Keeping just a portion of the money on hand, a practice known as having a fractional reserve system, means that the bank can use most of their funds to make loans to other people, to businesses, and to other banks. This also leads to an expansion of money behind the scenes. The Federal Reserve sets the reserve requirement; we’ll say it’s 10% for this example:

You deposit $1,000 at your bank. The bank is required to keep $100 of that on hand as its reserve, but is free to loan out the other $900. So they do: your bank also issues credit cards, and I walk into Home Depot with their card to purchase a washer and drier that cost $1,400 together. I put $900 on my card, which means that Home Depot will receive this money. However, the store offers a special no-interest deal for the remaining $500. They can afford to lend this credit, ironically, in part because of the other $900 that I just gave them. Home Depot only uses part of that money, though, and also takes out a loan at a favorable rate to help cover the financing. They do this by drawing on someone else’s savings.

Confused yet? That’s what makes the current situation difficult to understand: everybody owes everybody else somehow, and it all started with just a few green pictures of Ben Franklin.

An economist would tell you that a 10% reserve requirement on $1,000 means there’s actually $10,000 out there. The math is simple: either divide $1,000 by 10%, or carry it out all the way. Everyone has to hold onto 10%, meaning $1,000 creates a new loan of $900, and then another of $810, and then another of $729, and so on until the difference is negligible. But this isn’t really how it works. As in the example, sometimes money “sticks” before it has reached its terminal point. Home Depot pockets the majority of the cash from that $900 I put on my credit card. When that happened, the possibility of that money being loaned out again quickly to somebody else decreases significantly.

So that’s the first cause of the current “liquidity” crunch: money gets stuck along the way. In a period of uncertainty like today, this money leaves the economy and goes underneath a mattress somewhere. But this money has been taken out of the system somewhere halfway through. The real trouble starts when the money is taken out from the origin point: your checking or savings account.

Bank runs happen because people are afraid that they won’t be able to get their money back. This could be due to fears over national security, the global economy, or just poor management of a local bank. In any case, a mad rush of withdrawals can quickly wipe out a bank’s “current liquidity”, otherwise known as the 10% they kept on hand from your savings and those of everyone else. And when this happens, the bank quickly becomes broke. They have to tap into money they’d otherwise use to make loans in order to meet withdrawal requests and, piece by piece, have to take apart all of the different, longer-term instruments like bonds or mortgages that they owned as they keep running out of cash.

Welcome to the current situation. The reason why so many mortgages, and we’ll talk about how they’re wrapped up in packages some other time, appear to be worthless now is because a couple banks that were particularly reckless had to dump out of them for pennies on the dollar just so that they could have a little more cash on hand. The mark-to-market rules I keep harping on means that other banks have to pretend like their securities are just as worthless as those sold at firesale, making it appear like they took huge losses when in fact they have plenty of cash left.

The prophecy is fulfilled when people become worried about these banks’ health and withdraw all of their money. Since our economy is based on a monetary system that boils down to little more than keeping tabs on a scoreboard, when the lifeblood of the system is taken out the whole thing breaks quickly. That’s what we’re seeing now.

Written by caseyayers

2 October, 2008 at 7:47 pm