In Part 17, I described how Independent Bank’s shortage of gold coins led to Avaria’s first bank run. In this post, I’ll explain more thoroughly how Independent Bank started running low on gold coins in the first place.
So let’s look at a bunch of different details of the finances of these banks, which I hope will come together by the end of this post to make my point clear.
Bank revenue. These banks in our fictitious society are simplified, so they only have one revenue stream, which is the interest they earn on the money they create and then lend through fractional reserve banking. If you’ll recall, Peppercorn Bank originally charged monthly gold coin storage fees, but let’s assume the banks don’t do that anymore because they are competing to get as many depositors as possible, so instead they charge no storage fees in an effort to get as many deposits as possible, which they can use a reserves to lend out even more money.
Before looking at the other financials banks deal with, let’s take a moment to look more closely at the banks’ single revenue stream. How can they earn as much as possible from it? There are three ways: (1) get more deposits, which increases the total amount of money they can loan out, (2) push their reserve ratios even lower to lend out even more money, and (3) find a way to charge higher interest rates on their loans. And the way to charge higher interest rates is by making riskier loans.
Ok, now back to looking at the other financials . . .
Bank costs. These banks also have many different costs, including building maintenance costs, printing fees, other supplies, wages for security guards, wages for tellers, etc.
Bank profitability. Hopefully the income they earn from their single revenue stream (interest on their loans) is more than their costs. If so, then they have a profit, which either gets reinvested into growing the business or distributed to the owners of the bank.
Money the bank receives. Regardless of whether the debtors are paying their monthly loan payments in specie or receipt money, it’s all the same to Independent Bank. And if someone gives them a Goldnote from Peppercorn Bank, they can simply go down the road to Peppercorn Bank and exchange it for a gold coin. Or maybe Peppercorn Bank has received some of Independent Bank’s Goldnotes as payments, so they could trade Goldnotes for Goldnotes. At this point in Avaria, it’s all the same–every bank’s Goldnotes are equal in value to one gold coin.
Breakdown of the payments banks receive. Each time a debtor makes a monthly loan payment, some portion of the payment goes to paying interest, and the rest goes to paying down the principal. Let’s pretend each bank actually takes each payment and stores the interest portion in the Revenue section of their vault, and the principal portion will be put in the Money to Lend section of their vault.
What is this money in the Money to Lend section? It’s the extra Goldnotes they printed for the sake of lending and have now gotten back. Picture it as a big pile of Goldnotes. They could keep them in their vault (out of circulation) or even burn them, and either way it would be like they’d never printed them in the first place–their reserve ratio would go back up to where it was before, money prices would marginally drift back to what they were before, etc. The only lingering evidence that those Goldnotes had existed at all would be (1) the nice pile of money in the Revenue section of their vault, (2) whatever benefits accrued to society as a result of someone being able to borrow that money and do something with it, and (3) the aftermath of all the costs to society that that additional money induced (discussed thoroughly in Part 15).
Did I just suggest the banker could burn that money he got back? Let’s not be crazy. No self-respecting banker would burn perfectly good money when it could be used again to lend out and start earning interest for him and his investors again! This is why this section of the vault is called the Money to Lend section. The banker is just waiting for enough Goldnotes to accrue in there so he can lend it to a new debtor.
All right, I think those are all the details about bank finances that are needed to better understand the predicament Independent Bank got itself into, so let’s jump into its situation directly.
Remember how Independent Bank, in an effort to be particularly profitable, was pushing its reserve ratio extra low so it could lend out as much money as possible? Let’s also say that it was making fairly risky loans so that the interest it was charging on that loaned-out money was fairly high.
Then the bad crop happened, and a lot of people lost some or all of their annual income. Suddenly a lot of people were defaulting on their loans. And since Independent Bank was making the riskiest loans, it found itself with a higher default rate than its competitors.
This meant that its Money to Lend pile wasn’t growing very fast, which was not immediately a big problem–they just have to wait a little longer before making another loan. But the problem was that its Revenue section was also not accumulating money as fast as it normally does. And since most of a bank’s costs are fixed monthly costs, Independent Bank was still having to spend a lot of money from its Revenue section. Do you see the problem?
Soon enough, Independent Bank’s Revenue section ran dry, and its leaders had three choices. They could (1) default on their payments to suppliers and employees, (2) print more Goldnotes and pay them with those, or (3) pay them directly with specie from the vault. Options 2 and 3 are basically the same–either way, the reserve ratio goes down and the vault gets further depleted of specie.
The leaders of Independent Bank eventually chose to print more Goldnotes (less conspicuous that way), which predictably led to the usual percentage of those Goldnotes being exchanged for specie, and the vault’s piles of gold coins became progressively smaller. This is what led the employee to conclude that they were about to run out of specie altogether, which is why he ran home to tell his family to exchange all their Independent Bank Goldnotes for specie before they become worthless.
Ok, I hope this clarifies how a bad crop (or any other financial shock) can lead to a bank’s reserves getting too low and eventually trigger a bank run.
And just to be explicit about one of the lessons to be learned from this situation, I’ll say this: The lower the reserve ratio, the smaller the financial shock needed to drain reserves enough to trigger a bank run.
In Part 19, we’ll talk about how the bankers respond.
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