Bank Runs

Question 1

What is a bank run?

Answer 1

A rumor that more depositors are about to withdraw their money than the bank can cope with can become a self-fulfilling prophecy. In the worst cases, a bank run can cause a bank to collapse.

Question 2

Why does maturity transformation give rise to banking fragility?

Answer 2

Bank deposits are on demand, so all depositors may face liquidity shock and withdraw their funds at the same time, but if a bank needs to sell all their assets before maturity, hen it will get significantly less amount than invested.

Question 3

What is maturity transformation?

Answer 3

Maturity transformation delas with the temporal aspects of assets and liabilities, focusing on the timing of their maturity and expiration.

It is the act of taking the deposits and tying them up in long-term investments.

Question 4

what is liquidity transformation?

Answer 4

Liquidity transformation refers to the practice where banks hold liquid liabilities (deposits that can be withdrawn on demand) while investing in less liquid assets (loans and long-term investments). This means banks provide short-term liquidity to depositors but rely on the stability of these deposits to invest in longer-term less liquid assets

Question 5

Why does liquidity transformation give rise to banking fragility?

Answer 5

When a bank faces sudden, massive withdrawals that it cannot meet due to the mismatch between its liquid liabilities (such as deposits) and its illiquid assets (such as loans and investments)

Question 6

Why does liquidity transformation give rise to banking fragility?

Answer 6

If depositors lose confidence in the bank’s ability to return their money and start withdrawing en masse, the bank may struggle to convert its liquid assets to cash quickly enough to meet these withdraw demands. This can lead to a bank run as the banks inability to provide the required liquidity reinforces depositor fears prompting even more withdrawals and potentially causing a bank to fail.

Question 7

How to solve bank runs

Answer 7

• Reserves (100% would be ideal but then there will be no loans made)
• Suspension of convertibility of deposit
• Intervention by central bank
• Deposit insurance

Question 8

Pros and Cons of Deposit Insurance

Answer 8

• reduces incentive of depositors to monitor banks
• may also encourage excessive risk
• High interest rates to earn high returns from high-risk loans
• Moral hazard