As noted in Money, Money, Money, Money, the banking system evolved as the logical way to store money safely and allow people to transact business across distances. Initially, banks simply stored money for a fee and helped people pay for goods and services. But soon they also began to loan some of that money out.
Early bankers realized that most of those deposits were just sitting there most of the time. Since not all customers needed their money at once, bankers figured they could earn some income on that money while it was sitting there. They could do that by making interest-bearing loans or investments with their excess deposits, then share part of the earned interest with the customer to encourage them to keep their money in the bank, and keep the rest of the earnings as an additional stream of revenue.
To make this work, bankers had to make estimates of exactly how much money they needed to keep on hand to pay their depositors, taking into account their history and experience with depositors in the past. That calculated balance is called a reserve. Once banks established a reasonable reserve to keep on hand, they could go ahead and make investments and loans with the rest of their deposits.
This system of only keeping only a part of their deposits on hand and investing the rest is called the fractional reserve banking system. There are several benefits of a fractional reserve banking system, but there are also some risks. The big benefit to the bank is that they can earn money to support their operations, and it gives them a way to hang on to their customers by paying interest to depositors. If it wasn’t for this system, banks would not be able to pay interest on deposits.
But there is another benefit to the fractional reserve banking system. The fractional reserve banking system is a money multiplier for the economy. For instance, someone might deposit $100,000 in a bank. Now the depositor has $100,000 that they can spend, but the bank might also make an $90,000 loan from those deposits. The person who got the $90,000 loan now has $90,000 to spend and the original depositor still has $100,000 to spend, so there is a total of $190,000 of money available in the economy. Money multiplies even more from there. The person who got the $90,000 loan could deposit those funds in yet another bank, and that other bank might make another $80,000 loan from those proceeds, which would then add up to $270,000 of money created from the original $100,000 deposit. So the fractional reserve banking system has the capacity to inject lots of money into the economy. That is one reason why the government works hard to keep banks in business.
On the other hand, there are downsides of a fractional reserve banking system. One is that the bank might make bad loans or bad investments, and lose some of that money, because they’ve introduced risk that they didn’t have when they simply held on to the deposits. Additionally, they have to be prepared for runs on the bank. If many depositors show up wanting to pull their deposits out all at once, and their deposits total up to more than the cash the bank has in on hand, the bank will have to liquidate their investments and call in their loans in to generate cash to pay depositors. Liquidation sales usually only return a fraction of the original investment, and they also take time. Neither of those helps if there is a run on the bank. Bad investments and bank runs can easily, and very quickly, put a bank out of business.
Banks in a fractional reserve system never have enough currency on hand to pay all depositors immediately, so, if everyone panics and runs to pull their money out at all at once, the depositors who cash out early will get their money back, but those who wait may get nothing but a promise. That’s why runs can quickly accelerate and are highly contagious. The old movie “It’s a Wonderful Life” illustrates it perfectly. When people see a bank run, they pile in fast and ask questions afterward. When everyone wants their money out all at once, the run itself can put an otherwise solvent bank out of business. Deposit insurance is designed to quell depositor worries about losing their deposits and hopefully prevent runs from even happening.
The country has seen significant bank failures several times in modern history, notably the Great Depression in the 1930’s, the savings and loan crisis in the 1980’s, the Great Financial Crisis of 2008, and the Silicon Valley Bank crisis of 2023. In the earlier crises the most notable statistic was the number of mostly smaller banks that failed. In the crises after the year 2000 we experienced fewer numbers of failures, but those failures were exponentially bigger in size.
In the United States, banks have evolved in three distinct groups. Banks, savings and loans, and credit unions. Banks are owned by private investors. They can be small community or regional organizations or huge publicly listed corporations. They are for-profit corporations and are run to make a return for their investors. Their deposits are insured by the Federal Deposit Insurance Corporation (FDIC), currently up to $250,000 per account. They make commercial and business loans as well as consumer loans, and offer many other services, like trust services.
Savings and loans, also called thrifts, look a lot like traditional banks, but they may be member-owned or shareholder owned. They were initially created to focus on home mortgages for middle income Americans at a time when banks weren’t very interested in that market. By the 1980’s half of all home mortgages in the US were held by savings and loans. The savings and loans industry had its own insurance agency, the FSLIC, until the FSLIC went insolvent in the Savings and Loan crisis of the 1980’s. The FDIC now insures both banks and savings and loans up to $250,000 per account.
Credit unions are non-profit and member owned. Their members have something in common, like a common employer. Since they have no stockholders that expect to make a return, they often can provide slightly better interest rates and terms for their deposits and loans, and they return to members any profits that they make. They focus on consumer loans like car loans. They are insured by the National Credit Union Administration (NCUA), which currently provides deposit insurance up to $250,000 per account.
The Great Depression of the 1930’s
The stock market crash of 1929 and the Great Depression of the 1930’s put tremendous pressure on the banking system. At the time, there was no deposit insurance. As the economy tanked, questions rose about the safety of the banks and their ability to stay in business. About 9,000 banks went out of business between 1930 and 1933. The prospect of failure generated bank runs all over the country. There were so many runs on so many banks that every state had to shut banks down with periodic bank holidays to try to restore order. Finally President Roosevelt used his emergency powers to declare a national bank holiday in March of 1933, shutting down all the banks in the country for four days.
Franklin then worked with Congress to establish the Emergency Banking Act of 1933, which, among other things, created Federal deposit insurance, initially providing depositors with $2,500 of protection for their deposits. The Act also created the Federal Deposit Insurance Corporation (FDIC), which is the agency that is responsible for managing the deposit insurance program. The goal of deposit insurance was to reassure depositors that they didn’t need to run to the bank to get their money back, and prevent bank runs from even starting.
Deposit insurance and other new regulations worked. The number of bank failures dropped to about 50 per year from 1934-1941, and annual failures dropped even further to single digits from the 1940’s through the 1970’s.
The savings and loan crisis of the 1980’s
The savings and loans industry got into big trouble in the 1980s when the Fed funds rate soared from 5% to almost 14% in about 2 years. At that time, the interest rates that savings and loans could pay on savings were capped by regulation, and in some states the rates they could charge on mortgages was also capped.
The fixed rate mortgage loans they held on their books were worth less and less as interest rates rose. The only way to pay off a lot of depositors all at once was to sell or foreclose on their mortgages, but as the value of the mortgages dropped, thrifts couldn’t even do that.
Many thrifts became insolvent (their liabilities were greater than their assets). At first insolvent thrifts were allowed to remain open and regulations were loosened to allow them to make riskier investments, in an effort to try to give thrifts a chance to recover. That led to more failures and even fraud in the industry, which was followed by high profile bailouts of failing savings and loans. Throughout the 1980’s about 500 savings and loans a year were technically insolvent, and around 1,000 eventually went out of business.
The Great Recession and Great Financial Crisis of 2008
By 2008, the banking industry was making increasingly risky loans. They lowered standards for home mortgages, allowing people to borrow with little or even no down payment. The easy credit caused home prices to increase, and the higher prices triggered the need for easier mortgage terms so people could pay those higher prices. The whole bubble was predicated on the idea that national average home prices would never go down, so there would always be collateral behind these loans. Everyone understood that regional home prices might ebb and flow, so mortgages were sliced and diced into packages that combined mortgages across regional areas to lower the risk. But then the impossible happened, home prices went down everywhere at once. Banks were left holding mortgages that the owners couldn’t afford and that nobody else would take off their hands. Homeowners were under water, as home prices dropped below the amount they owned on the mortgage. Some homeowners just walked away, leaving their banks high and dry. The bank failures during this time mostly resulted from banks with high numbers of risky mortgage loans that left them insolvent.
The Silicon Valley Bank crisis of 2023
The Silicon Valley Bank crisis in March of 2023 has some things in common with previous crises. Like the 1930’s, it was triggered by a run on a bank and it looked like it was going to lead to many more bank runs. Like the 1980’s, the insolvency originated from having long term assets on the books at low, fixed, interest rates, when they had lost a lot of their market value due to high interest rates. In the 1980's, the assets that had lost value were mostly home mortgages. In 2023, the assets were low interest rate long term treasury bonds accumulated during years of low interest rates. As with previous bank failures, the government stepped in to protect depositors and stave off further bank runs. At this point, in the fall of 2023, things seem to be settled down. However, the problems on the banks' balance sheets will remain until and unless long term interest rates drop again.