What would happen if banks were allowed to have negative balances?
## The Role of Negative Balances in Banks
### Wouldn’t this prevent bank runs and benefit the economy?
Curious about the potential impact of banks having negative balances? Here’s what you need to know:
– Should banks be permitted to have outstanding loans exceeding deposits?
– Is it similar to the short-term loans provided by the Fed?
– What if reserve requirements were eliminated?
– Could it lead to a zero-interest-rate environment?
– Would this result in inflation due to increased money creation?
– How would fraud be prevented in cases of large negative balances?
Explore these questions and more about the implications of negative balances in banks without compromising economic stability. #banking #economics #negativebalances #Fedloans #inflation #reserverequirements
I think it’s easiest to conceptualise all of this if we just think about physical bank notes, and the mechanisms aren’t fundamentally different anyway.
So let’s say the bank has $1000 in cash but $10000 in deposits. A full on bank run would mean that customers demand the full $10000 from the bank.
Of course the bank can only pay out $1000, the vault is literally empty after that.
It’s true that it can borrow more from other banks and it’s also true that the central bank always acts as a lender of last resort.
Although there actually isn’t a formal reserve requirement in the US, there are capital requirements, so the bank still has capital it can borrow against.
Say the bank has another $3000 in capital and other banks deliver a bunch of trucks with $3000 in extra cash.
Well, now the bank is still $6000 short.
Okay, but the fed always lends, right? Even if we take that to be literally and absolutely true, it doesn’t do so for free. Sure, you could borrow $6000, but then what? You liquidated everything you can and not only are you left without anything, you are also faced with a huge loan you have to pay off. How do you do that after losing all trust of your depositors and essentially having no business to speak of?
That’s ultimately the problem. The fed can support any bank indefinitely if it chooses to do so, it can create money at will after all. But the bank eventually faces costs of trying to stay in business that are higher than the cost of bankruptcy.
Maybe your next thought is “but why doesn’t the fed just give the bank money for a really low interest rate or even for free”. Moral hazard is the answer. You don’t want banks to make mistakes and get bailed out for free since that just enables risk-taking that ultimately society as a whole would pay the price for instead of the bank who took on that risk.