If there was any point drilled home by Larry Smith in my ECON102 class, it would be that the entire basis of theÂ financial system is, in effect, imaginary; for example, the worth of money or the perception that we can always get our deposits from a bank. In fact money only has worth in that everyone accepts it as a certain value (usually enforced by the federal reserve banks. That’s where the statement on your $20 bill that goes something along the lines of ‘this note is legal tender’ comes from. We’re ‘forced‘ to accept cash as a form of payment! Furthermore, banks certainly do not hold in their vaults enough money for everyone to withdraw their deposits at once. But that’s not the point. If everyone regularly withdrew all their money at the same time, there’d be little need for banks. You could simply stash your cash under your mattress.
See it all boils down to the reserve ratio (ratio of legal notes held at a bank versus transaction deposits). No bank has a 1.0 reserve ratio. That means it’s impossible for everyone to withdraw their deposits at the same time. In reality, reserve ratios for banks in many developed countries is very low, typically in the low to mid single digit percentages. And so enter the danger of a ‘run’ on a bank.
When the masses sense impending danger at a bank, they typically rush to their nearest branch and attempt to withdraw a lot of money. This has been especially prevalent in recent months, as even large financial institutions have shown they’re not immune to the effects of the credit crisis. Washington Mutual, the latest banking failure in the United States, had around $16 billion of deposits withdrawn, or nearly 10% of all deposits! Capital is the lifeblood of the banks and when liquidity is squeezed by mass withdrawals, it’s pretty much the end of the story.
But you might also be able to see the paradox in the system. It’s a huge feedback system. A bank gets into a tight spot due to a financial crisis, but perhaps one it could work its way through. All of a sudden, customers hear of the problem and make a run on the bank, withdrawing deposits. Then, what was possibly a manageable problem turns into a nightmare as all capital dries up at the bank, making it unable to do business. It’s what happened at Northern Rock, Washington Mutual, and as word comes out of Europe, what will possibly happen at Fortis, a major bank in the Benelux countries and one of the largest financial institutions in the world. Because the financial system is based on trust and a belief, fear can in effect destroy it.
That’s why some form of a rescue package for these banks is so important. The trust of the Americans in their financial system is teetering. A further deterioration in the financial system there will have catastrophic effects on the entire world.