Question

Given the danger of bank runs, why do banks not keep the majority of deposits on hand to meet the demands of depositors?

Short answer

Banks do not keep the majority of deposits on hand due to reasons like profitability, economic growth, liquidity management, and deposit insurance. Lending out the majority of deposits helps banks earn interest income and generate profits while stimulating economic growth. They manage liquidity through practices such as holding reserves at the central bank, interbank lending, and maintaining liquid assets. Additionally, deposit insurance schemes protect depositors in case of bank failure, maintaining confidence in the banking system and reducing the likelihood of a bank run.

Step-by-step solution

Understand the concept of a bank run.

A bank run occurs when a large number of customers withdraw their deposits from a bank simultaneously, due to concerns about the bank's solvency or financial stability. This type of event can lead to a severe liquidity crisis and, in extreme cases, the failure of the bank. Bank runs can spread panic among the general public, causing even more withdrawals and potentially leading to the collapse of other banks as well.

Know how banks operate and manage deposits.

Banks operate under a fractional reserve banking system, which means they are only required to hold a small percentage of their total deposits in reserve, typically around 10%. This allows banks to lend out the remaining majority of their deposits to borrowers, who will pay interest on those loans. The fraction required to be held is determined by the central bank or regulatory authority. Banks earn profits through the spread between the interest they pay on deposits and the interest they charge on loans. This system of lending is the primary way banks create credit and stimulate economic growth.

Understand the reasons for not keeping the majority of deposits on hand.

1. Profitability: By lending out the majority of their deposits, banks can earn interest income and generate profits. Holding all deposits on hand would make it difficult for banks to earn a profit and provide the services demanded by their customers. 2. Economic growth: Lending is a crucial aspect of economic growth, as it enables businesses and individuals to access credit to finance investments, purchases, and other expenditures. If banks were to hold the majority of deposits on hand, this could significantly limit the availability of credit and hamper economic growth. 3. Liquidity management: Banks employ various practices and instruments to manage their liquidity and ensure they have enough cash on hand to meet the demands of depositors. These measures include holding reserves at the central bank, participating in the interbank lending market, and keeping highly liquid assets such as government bonds. 4. Deposit insurance: In many countries, deposit insurance schemes have been established to protect depositors in case of bank failure, reducing the risk of bank runs and the need for banks to hold large amounts of reserve. Deposit insurance helps maintain confidence in the banking system and reduces the likelihood of a bank run occurring. In conclusion, while bank runs pose a danger to the financial system, banks do not keep the majority of deposits on hand because it limits their profitability and ability to stimulate economic growth. Instead, they rely on liquidity management practices and deposit insurance to mitigate the risk of bank runs and maintain the confidence of depositors.