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As George Bailey knew, bank system depends on trust

  • Published Thursday, July 5, 2012, at 12 a.m.

If you want to understand how the slow-motion train wreck called the euro system will play out, revisit the classic movie “It’s a Wonderful Life.”

Remember the run-on-the-bank scene?

Now realize that there seldom is a Jimmy Stewart character to come in and ease the fears of panicky savers. Also realize that stopping a bank run on an entire country or monetary system is enormously more daunting that stopping one on a single bank or banking system.

That said, understanding the basic psychology of bank runs is where we must start.

Banks are financial intermediaries. They accept deposits from one group of people and make loans to another group. When you take your money to a bank, they don’t just lock it up in a safe, as Jimmy Stewart’s George Bailey character reminded us. And when you get a loan, the bankers are not lending you their own money. It necessarily comes from some depositor.

Banks then are marvelous social institutions that move temporarily unneeded resources from one group, savers, to another group, borrowers. A safe banking system allows for faster economic growth because more people can have more of their needs and wants met with the same basic set of resources.

However, the system depends on trust. Depositors have to trust that they will be able to get their money back when they need it. The greater any uncertainty about this, the less willing savers are to deposit their money in a bank. The fewer such deposits, the scarcer loans must be for borrowers or the higher the interest rates.

The greater any wedge between savers and borrowers, the less efficiently resources are used in the economy.

Many factors, real or imagined, can impair trust. If depositors in a bank observe that the bank managers are lending money in a careless manner, or if a large loan customer of a bank goes unexpectedly bust, these depositors have good reason to wonder if their money is safe.

Moreover, regardless of fact, the mere perception that these sorts of things may be happening can erode trust. As confidence in the bank falls, some depositors decide to err on the side of safety and remove their funds.

If others observe or hear of such withdrawals, the general level of confidence falls further. More depositors stand in line, withdrawal slips in hand, visible to everyone else that they are voting with their monetary feet.

It then becomes a vicious circle, as it does for the Bailey Bros. Building & Loan in the Jimmy Stewart movie. This is a classic “run on a bank.”

Now if the bank just warehoused money, placing dollar bills in a vault, or even bought only perfectly safe Treasury securities that could be converted to cash instantaneously, little harm would result from a run.

Banks, however, are not storage facilities. Only a small fraction of funds is kept in reserve to meet normal fluctuations in withdrawals. Once withdrawals exceed expected rates, there is no way a bank can suddenly call back in its loans. It must close down or at least “suspend payment” of withdrawals to depositors.

In either case, the public perception is that the bank has gone broke and money is lost.

As long as only one bank suffers a run, damage is limited. But long lines at one bank inevitably cause disquiet in the general community. The problem can easily spread.

That is what happened in 1836, 1873, 1907, 1933 and myriad other “panics” in U.S. history.

Note that the same general phenomenon can occur on Wall Street.

Now take it one step further. It is bad enough if many people in a country simultaneously and collectively lose confidence in their individual banks. But what if they lose confidence in their ability to withdraw their deposits from any bank in the same currency in which the deposits were made, a currency that is legal tender in 16 other countries and broadly accepted around the world?

What if they fear that their euro deposits will be withdrawable only as new drachmas, pesetas, escudos or lira that will have drastically less buying power?

This happened in Argentina in 2002. And what if this danger exists not only for ordinary bank deposits, but for any financial instrument now denominated in euros?

The natural impulse, as for George Bailey’s customers, is to move the money out now while you still can. Euros in Greece may turn into drachmas of questionable value overnight, but if moved to Germany or Holland now, they will always be euros.

And moving into dollar-denominated U.S. Treasury bonds would be even safer.

Not all fears are unfounded. Central banks can be lenders of last resort, and deposit insurance may reassure small savers. But it is exceedingly difficult, if not impossible, to backstop an entire country, even ones as financially tiny as Greece or Portugal. Talk about Spain or Italy, and it is much worse.

Economist Edward Lotterman teaches and writes in St. Paul, Minn. Write him at ed@edlotterman.com.

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