a) When can we say that a withdrawal of cash from a bank, or a loss due to bad i

Question

a) When can we say that a withdrawal of cash from a bank, or a loss due to bad investment by the bank, will not be a problem for the overall banking system?

b) When do we say that a large withdrawal of cash from most banks at every end of the year is also not a problem for the overall banking system?

c) Assuming the Central Bank does not do anything, what should we expect to happen at the end of the year when the withdrawals in b) take place?

d) Again in the case of a large withdrawal of cash from most banks as in c): what could go wrong and create a financial crisis?

Explanation / Answer

a) A withdrawal of cash from a bank or loss due to bad investment by the bank will not be a problem for the central banking system if the loan defaults are up to the amount of its shareholder equity and the bank’s liquidity can meet its depositor’s demand.

b) A large withdrawal of cash from most banks at the end of the year is also not a problem for the overall banking system because the banks anticipate such a withdrawal at the year-end. Towards the end of the year, the banks increase their liquidity to meet the higher anticipated demand. Towards the year-end, the central bank also remains prepared to make short-term loans so that banks can meet the year-end demand for cash.

c)If we assume that the Central Bank does not do anything, we should expect that banks increase their liquidity in a planned manner to meet the increased demand for cash at the year-end. The banks use past data and current market information to forecast the demand for cash at the year end and they either liquidate their investments or borrow cash before year end to meet the consumer demand.

d) if the capital of a bank is tied up in investments, and the bank’s liquidity is unable to meet the demand for cash there can be a financial crisis. When the bank is unable to pay even a few customers, the number of customers who withdraw cash from banks at the same time will increase because they believe that the bank may become insolvent. If the bank is unable to pay the depositors, more and more people withdraw cash increasing the likelihood of default and financial crisis.

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