Is the following statement about why banks can fail correct?if banks use there excess reserves to make loans,then that means they use the depositors money to make the loans.so how can banks...

Is the following statement about why banks can fail correct?

if banks use there excess reserves to make loans,then that means they use the depositors money to make the loans.so how can banks create money if they are using the depositors money.you are basically using the same money over and over again.that is why if people are not confident and they want to remove there money from the bank, the bank fails and closes its doors because it loaned out the people's money, it does not have that money in the bank. is this correct?

Asked on by hjhgkygj

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pohnpei397's profile pic

pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted on

If you are mainly asking about why banks fail and whether they can fail in the situation you describe, you are absolutely right.

Banks do not keep their depositors' money on hand in their vaults.  They lend it out so they can make money.  If all of a bank's depositors demanded their money at the same time, the bank would fail because it could not get enough money to pay them all.

Because of that, our banking system is based largely on confidence and trust.  That is one reason the Congress created the FDIC back in the Depression -- so that no one would need to worry about losing their money if their bank went broke.

krishna-agrawala's profile pic

krishna-agrawala | College Teacher | (Level 3) Valedictorian

Posted on

The whole question appears to be somewhat confusing. Perhaps the best way to clear the various doubts expressed in the question is to describe some basic facts about the banks and how they may or may not fail.

Firs thing to understand that banks primarily lend out of the public money deposited with them. The banks are required by law to have some minimum percentage of their own equity, but a large percentage of the funds they have comes from the depositors who deposit their savings there. There is nothing wrong or undesirable in it. As a matter of fact this one of the major advantage of banks. They help channel savings of individuals to for use by others who require it.

Banks fail primarily for two reasons. First, the the bank unable to recover money form its borrowers. This results in bank making losses in bad and unrecoverable loans. The bank may then fail because it may not have enough money left to repay to all its depositors.

The banks may also fail if too many depositors suddenly withdraw all their deposits. In this case, the bank may not have ready cash to repay all the depositors, because most of the money has been lent out by the bank to borrowers and, although the borrowers are likely to repay the loans when due, it is not possible to get back this money from them immediately. In this case the bank fails more because of panic created among the public, rather than actual lack of funds.

These days banks and governments take some precautionary steps to prevent failure of banks. One important measure is that all banks are obliged by law to maintain some minimum reserve of funds with them which should not be loaned out to borrowers. Part of this fund is used for make payment to depositors against their routine requirements. A substantial portion is deposited with a central bank belonging to government, so that if there is sudden increase in withdrawal, it can be met from this amount with central bank.

Finally, please note that banks do not create any money when they give loans to borrowers. The loan only amounts to transfer of money belonging to bank and its depositors to the borrowers. The borrower also will have to return this money later.

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