Have you ever lent a complete stranger hundreds or thousands of dollars, trusting them at their word they’re going to pay you back? Before you answer no, also ask yourself if you have a bank account. If the answer to that second question is yes, then that’s exactly what you have done.
We all know money doesn’t grow on trees, so how then are banks able to give you interest on the money you have in an account with them? Well, if you open an account tomorrow at Bank of America (BOA), put in $1,000 and receive a 1.5 percent interest rate, BOA will then turn around and give out a loan for one thousand dollars from which the bank will earn interest at three percent. Badda bing badda boom –– profit.
Banks are a key component of the modern financial system because they are able to transfer capital between those who have extra and those who need a loan. What makes banks viable is that, unlike you and me, they have the resources to ascertain who is a good candidate for a loan and who is not.
Banks profit by investing, lending and leveraging money to all sorts of people. At any time, a bank may have customer accounts that total to hundreds of billions or trillions of dollars, but only a small percentage of that money is available to pay out when people come to collect their money.
The United States currently requires that all major banks hold 10 cents for every dollar in all transaction deposits, such as savings or checking accounts that can be collected at any time. On the other hand, bonds and other long-term accounts that you can only collect after a set amount of time are not required to have a cash reserve.
Generally, this works out well for society. Banks are able to lend out a huge portion of their capital, which enables them to make money and offer better interest rates. This also means there is more money available for those seeking to get a loan, therefore enabling some people to get loans when they otherwise would not.
On occasion, however, the lack of reserve can lead to problems. One of the leading causes of the Great Depression was something known as a bank run, which led to a banking crisis.
When the public believes that banks are in trouble, they “run” to their banks in order to withdraw their money in fear that the bank will go bankrupt. This produces a snowball effect –– as more people try to withdraw their money, it becomes more likely that the bank will actually fail, so even more people who previously believed in the bank then go withdraw their money, too. When enough people do this, the bank runs out of money and cannot pay out to all account holders, resulting in the bank going bankrupt.
In the last hundred years, a lot has been learned about banking and effective monetary policy that has resulted in fewer bank failures. However, excessive risk-taking (by the greedy one percent) can still result in catastrophe. Recent examples are, of course, the infamous collapse of the banking system in the United States in 2008, and a much more recent collapse of the huge Royal Bank of Scotland at the end of last year.
The answer to this problem is tricky. With better regulation, most of these crises could be avoided. With too much regulation, however, banks will not be able to earn as much profit, which in turn means worse interest rates for you and me. The key is striking the balance where banks have enough room to take chances, but not enough freedom to, oh, say, collapse the economy. I think we would all agree that we would rather receive slightly worse interest rates than pay trillions of dollars in bailout money.
For now, all we can do is hope for the best since keeping your money in banks is still a lot better than putting your entire life savings of $74.32 in your wallet (and losing it at the movies like my 7-year-old self). I’m pretty sure I was the only one leaving that theatre whose tears had nothing to do with Jack and Rose.
Let DANNY BRAWER know what you think of the titanic sinking of banks and the financial system at dabrawer@ucdavis.edu.
