A Run on the Banks

This is a very broad question, but I’ll do my best to give you a high level overview of what would happen.

A bank makes money by bringing in deposits, which they may pay interest on, and in turn lending out that money at a higher interest rate. This difference is their ‘spread’ and is the primary function and source of income for banks. The money that is lent out may be lent for the long term (mortgages will longer amortizations) or the short term (auto loans, credit cards, etc).

One of the causes of the Great Depression was a ‘run on the bank’ where people would go to their bank and withdraw their money. At that time, if a bank lent money to someone to buy a home, they wouldn’t have that money at the bank, as it had been lent to the borrower, who paid the seller of the home for the house. If enough people withdrew their money, the bank would at some point run out of funds on hand. They could then try to call loans due, demanding repayment, but if someone didn’t have the money the bank could do nothing but foreclose.

That is the purest form of a ‘run on the bank’. Since that time, a number of changes and safeguards have been put into place to stop this process from repeating. First, FDIC insurance. This states that a persons deposits, to a certain level are guaranteed by the FDIC, even if the bank were to go under, they will get their money from the FDIC.

Additionally, loan securitization exists now. This allows banks to retain a customer (accept payments, service a loan) but to sell the asset to another entity. This means the bank gets their money back to lend to someone else, as opposed to have a safe full of deeds to property that they have lent on and no funds on hand.

Back to the FDIC, the FDIC requires that a bank maintain a certain amount of liquid capital reserves so that bank customers can freely access their accounts. It’s not possible for a bank to have every dollar of every customers money available, if that was the case they would have no money to lend and would go out of business from paying interest. However, a well capitalized bank will have ample reserves to meet day to day cash requirements.

Lastly, in regards to some of the FDIC closures recently. In these cases the banks had fallen below the FDIC reserves level, and been in contact with the FDIC prior to the bank closing. In most cases, the FDIC is able to arrange for another bank to purchase the failed bank, in which case nothing changes for the customer but the banks name. In other cases, such as IndyMac, the FDIC will actually close the bank and run it’s operations while it sells the banks assets. Either way, the FDIC is able to make certain that no ones money is at risk in a bank failure, and is the most significant difference between banking now, and banking when a bank run could cost customers their savings.