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Sunday, April 19 - 11:49amSanction this postReply
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The author later states:

Since every bank borrows short term and lends long term, they are vulnerable to bank runs.  Banks make long-term loans or investments, but they borrow from depositors who can withdraw money at any time. Consequently, if depositors suspect that the banks cannot pay them back, they rush to withdraw their money. But since the deposits are lent out, or invested in non-liquid assets designed to earn money over the long run, they are not available for withdrawal.  And if a bank cannot pay back its depositors, it goes out of business. This is why governments insure deposits. And, normally, insurance prevents bank runs because investors know that the government will guarantee their deposits. But in this case, Iceland's deposit guarantees were several times its entire national income. Consequently, the government insurance did little to reassure depositors.  ...  When the bank run came, everything fell apart.  ...  Today, Iceland is broke.

I found it curious that he tacitly supported deposit insurance by governments given his largely Randian leanings in the textbook.



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Sunday, April 19 - 12:13pmSanction this postReply
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Banks make long-term loans or investments, but they borrow from depositors who can withdraw money at any time. Consequently, if depositors suspect that the banks cannot pay them back, they rush to withdraw their money.

 

A way to mitigate bank runs is less demand deposits (e.g. checking accounts) and more time deposits. A bank can refuse to redeem time deposits until their maturity.



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Sunday, April 19 - 1:56pmSanction this postReply
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The author said, "This is why governments insure deposits."  He could have followed it by something like this: "(Note: this is a function that could be provided by private insurance companies and depositors could chose higher interest-bearing accounts if they wanted to forego insurance.)"

 

And, like Merlin indicated, banks choose the ratio of short to long term deposits and loans. Also, there a couple of other factors to keep in mind. A great many loans are made as money deposited to a checking account and there are a great many loans that are not long-term (most businesses take out short term loans (3 to 6 months) to purchase inventory. And many loans to contractors are short term.  That's longer than a demand deposit, but not as bad as the typical mortgage.



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