QUESTION: If I open a bank and first customer deposit 100$ , I put 10% in reserve and lent out 90$ , he repaid 90$ with interest . Now do I need 100$ deposit ? if customer withdrawal 100$ after I got 90$ with interest , does bank run happen ?
ANSWER: If you don't mind, I'll just list the process so that it is easy to read.
Interest Paid: 1% annually
In Reserve: $10
Loan Issue: $90
Interest Earned: 2% annually
After 1 Year -
Bank pays $1 in interest. That is a 1% increase in the total deposits. In order to maintain a 10% reserve ratio, the bank must increase their reserve to $10.10.
Bank gets $91.80; the original $90 back, plus $1.80 interest. This belongs to the bank, will not go into deposits, so it will not influence the reserve.
Also note that the bank paid $1 in interest, but earned $1.80 for interest on the loan. This is how banks generate revenues; they charge higher interest rates than they pay using deposits.
[an error occurred while processing this directive]---------- FOLLOW-UP ----------
QUESTION: Thank you very much . But after bank gets $91.80 , the original $90 back , plus 1.80 interest , customer wants to withdrawal
$100 deposit , do bank run happen ? If so , how to avoid bank run ?
Ah, sorry about that. I wasn't clear. The bank would get $91.80, but they must return $90 of it to the customer. The bank only earns $1.80 of it. Since they pay the customer an extra $1 in interest, the bank has profits of $0.80. I hope that clarifies it better.
Now, let's say the customer wants to withdrawal all $100 before the bank gets their money back from the loan. This chance of this happening is a type of risk called liquidity risk. The bank has value because it is going to have money in the future, but the customer wants their money back now, so the bank is now insolvent, which means that they cannot pay their bills with the amount of money they have right now. This happened during the 2008 financial collapse, where many companies loaned money to people who then defaulted on their loans (in the subprime market, which is about credit risk) and these companies couldn't afford to pay back their own loans anymore, so they went out of business. Lots of them, too. During The Great Depression, so many people lost faith in the banks that they all withdrew all their money and put the banks out of business.
Both cases were preventable, though. The banks could have used better risk management, so they failed. The federal reserve could have required higher reserve ratios, so they failed. Borrowers could have been more financially literate, so they failed. The government could have utilized better economic policy, so they failed. Any one of those could have helped prevent these economic catastrophes.