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An important indicator of the safety of a banking

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Christmas weekend, or a cold Tuesday morning in February. An important indicator of the safety of a banking institution is its ability to meet the demands of depositors at all times. In fact, before and during the Great Depression runs on banks were common. A run on the bank occurs when many depositors all try to withdraw their funds at the same time, in the fear that other depositors will get there first and the bank will run out of funds. Runs are a sign of the failure of liquidity management. One of the most famous examples of a run on a bank is the scene from the film “It’s a Wonderful Life” where George Bailey is trying to convince his customers to keep their money in Bailey Building and Loan. Much more recently, Bear Stearns faced a run in March of 2008. Excess reserves One important practice in liquidity management is the holding of excess reserves. The cost of holding excess reserves is that only a minimal amount of interest is earned on reserves. In 2008, the Fed changed its policy and began to pay interest on reserves, currently at 0.25%. The benefit of holding excess reserves is that excess reserves provide a cushion for unanticipated deposit outflows. To see this, let’s compare two banks, SafeBank and RiskBank. They have the same value of assets, but SafeBank holds excess reserves, while RiskBank holds more interest-bearing assets and no excess reserves. Assume that the required reserve ratio r = .1. SAFEBANK RISKBANK Assets Liabilities Assets Liabilities Reserves $180 Demand $900 Reserves $90 Demand $900 deposits deposits Loans $720 Loans $810 $900 $900 $900 $900 Both SafeBank and RiskBank have $900 in assets, but only SafeBank holds excess reserves. The required reserves for both banks are 0.1 x $900 = $90. RiskBank only holds its required reserves. Everything else has been lent out. SafeBank, on the other hand, holds $90 ($180 - $90) in excess reserves. What if each bank faces a deposit outflow of $50? For SafeBank, no problem. Their excess reserves of $90 will easily cover the outflow of $50. $50 is subtracted from both reserves and from demand deposits, and the value of assets (and liabilities) falls to $850. For RiskBank, there is a big problem. There are no excess reserves, so in order to meet the deposit outflow, it will no longer have enough in reserves. Once the $50 withdrawal is subtracted from each, the $40 in reserves will not be sufficient to cover the $850 in demand deposits. RiskBank will have deficient reserves, and it will be forced to rearrange different parts of its balance sheet to re-establish its required reserves. Excess 94
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Econ 350 U.S. Financial Systems, Markets and Institutions Class 10 reserves provide a cushion to meet the needs of deposit outflows. But again, the cost of holding excess reserves is that they earn only a small amount of interest from the Fed. Maximum Deposit Outflows For SafeBank, what is the maximium deposit outflow that can be sustained without changing other parts of the balance sheet? For SafeBank, reserves are $180 and demand deposits are $900. The reserve ratio is 0.1 (10%). We are asking the question: what is
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