Banks work together as a system in bringing together savers and borrowers. They accomplish this by lending and borrowing directly from each other. Sometimes banks may have excess reserves, but businesses or households may not be willing to borrow. Assume that Bank East is holding excess reserves, but has no opportunities to lend in its region. Bank West has no excess reserves, but has businesses and consumers clamoring for loans. Bank West can borrow from Bank East in the fed funds market and provide loans for its customers. Bank East profits by earning the fed funds rate, and Bank West profits by earning the higher interest rate it charges its customers. Everyone is happy happy happy.
If a bank is low on reserves and will not fulfill their daily reserve requirement, they are able to borrow from other banks overnight in the fed funds market. For example, assume that Acme Bank has a customer who withdraws her entire life savings at the end of the business day so she can run off to Cozumel with her next-door neighbor. Because banks do not hold reserves against savings deposits, this might leave Acme Bank without the required reserves it must hold against checking deposits. Roadrunner Bank, however, may have excess reserves available only earning minimal interest in their reserve account with the Fed. For Roadrunner Bank, it is profitable to lend its excess reserves to Acme Bank at the higher fed funds rate.
Bank runs or bank panics have occurred multiple times throughout American history. Because banks operate with far less than 100% required reserves, it is possible that if enough customers demand their account balances on a single day, the bank will not be able to meet the demand. This of course would be catastrophic for the bank and its customers. The bank would be insolvent and the customers unable to withdraw their funds would be broke.
What would cause customers to demand their account balances all at once? Fear, whether based in truth or not. Many bank panics have been caused because of rumor or speculation about a bank’s financial health. If enough people believe the rumor, they will logically want to withdraw their funds and move them to another financial institution or stuff them under the mattress. Once the line starts forming at the bank’s door, other customers will notice and the rumor will spread. Banks can avert a run if they are able to borrow from other banks and provide their customers’ balances. However, if the speculation or rumors are pervasive, then banks may become unwilling to lend to each other. When this happens, it sparks even more speculation, and can create a run on the entire financial system.
Prior to the Civil War, banks were chartered by the states and were capable of issuing their own currency. In response to the government’s need for revenue to pay for the war, Congress passed the National Bank Act of 1863, which created federally chartered banks capable of issuing the new national currency and government bonds.
A security that is a promise from a borrower to pay a lender on a specified date with interest.
To ensure liquidity in case of a crisis, larger banks accepted deposits from smaller banks that could be withdrawn in case the smaller banks experienced a bank run. The system was premised on the notion that a small bank run could be handled by tapping into a much larger bank’s reserves. However, the system failed to recognize the possibility that a small bank run could create a contagion that would lead to a systemic run on the banks.
A widespread bank panic in 1907 led Congress to pass the Federal Reserve Act of 1913, which created the modern Federal Reserve System, America’s version of a central bank. The Fed serves as the nation’s chief bank regulator. The Federal Reserve Board of Governors regulates member banks while the Federal Reserve district banks supervise and enforce the board’s regulations. Unfortunately, the Fed did not respond appropriately to the run on banks that occurred during the Great Depression. Instead of providing needed liquidity, the Fed dried up credit, prolonging (at least in some economists’ opinion) the Depression.
Another test of the banking system came in the 1980s with the savings and loan crisis. Aggressive lending by the savings and loan industry and lax underwriting led to a series of savings and loan failures. Similar to the FDIC, the Federal Savings and Loan Insurance Corporation (or FSLIC) paid depositors whose institutions had failed. The American taxpayer was ultimately the loser as billions were spent to clean up the financial mess and refund depositors.
Throughout the twentieth century, the American economy grew and industry began to increase in size and importance. Soon, local and regional firms were competing against national firms. American businesses that were national in scope were being served by a banking system that was fragmented and regional. Bank regulation kept American banks relatively small compared to banks in other countries. The banking sector effectively lobbied for deregulation in order to grow and compete at a national and even international level.
The deregulation of banking that occurred in the late twentieth century allowed banks to operate nationwide and also allowed them to expand the level of services they provided. Eventually certain regulations were repealed and banks engaged in the business of speculative investment. As the walls separating traditional banks from bank-like institutions came down, the seeds for another financial crisis were sowed. Today, the banking industry is in flux. A push for regulation to prevent future bank crises exists. As the line between banks and other financial institutions has blurred, the task for lawmakers is to create a regulatory framework that encompasses all bank-like activities. History will show whether or not they were successful.