Bank Panic–A.D. 1907
[courtesy Google Images]
The Associated Press recently published an article entitled “The Latest: Will Greek banks have all their money next week?” That headline hints at the danger in fractional reserve banking.
As I understand it, in the US, the fractional reserve ratio is about 10:1 meaning that out of every ten dollars deposited into bank accounts, the bank holds one dollar in its vault to hand out to depositors and lends the other nine to borrowers.
The advantage and even necessity for fractional reserve banking is that it prevents currency from being hoarded in banks and shrinking the money supply needed to keep the economy growing. Instead, fractional reserve banking allows 90% of the currency saved to be loaned back into the economy to circulate and stimulate economic activity.
The danger in fractional reserve banking is that if an emergency arises when only 10% of the deposits are actually kept in the bank vault, and more than 10% of US depositors want to simultaneously withdraw all of their currency from their bank accounts, then there’ll be a “bank run”.
If enough depositors join the bank run, the bank will be unable to provide the funds owed to depositors since 90% of their deposits have been loaned out to others. Once the bank is shown to be unable to meet the depositors’ demands, the bank will be deemed to be insolvent and may be closed.
Although depositors might later be able to regain their deposits, for the immediate future, 90% of depositors will be unable to access any of their savings. Without access to their bank deposits, bank customers may have no money to buy groceries, pay their mortgages, or get to work. They’ll tend to panic. The economy may tend to collapse.
Fractional reserve banking is both necessary to a modern economy and also dangerous. If a nation’s depositors all try to withdraw their funds at once, they won’t be able to access their funds. They’ll tend to panic, throw things, riot, light fires and shoot.
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