Can We Have Another Banking Holiday?

“But most commercial banking is “deposit banking” based on a gigantic scam: the idea, which most depositors believe, that their money is down at the bank, ready to be redeemed in cash at any time.” Murray Rothbard

One of the most painful and important aspects of the Great Depression was the failure of banks. It has been estimated that before the Depression there were more than 25,000 banks in this country. At the end of 1933, 14,207 were left.

Depositors lost all or much of their money when their bank failed. Most banks were small, not unlike the one depicted in Jimmy Stewart’s classic movie “It’s a Wonderful Life.” When a bank failed in a town, fear spread. A contagion developed that caused depositors to remove money from other banks and “hoard” it. This reaction put pressure on otherwise sound banks and the banking system. A self-reinforcing spiral reduced the availability of money resulting in additional closings.

One of the first New Deal legislative acts was the closing of the banks, known as a national banking holiday. Banks were closed for about a week. Neither deposits nor withdrawals were allowed.

The Federal Deposit Insurance Corporation was formed in 1934. Its intent was to prevent future runs on the banking system that had occurred in the early years of the Depression. Sheila Bair, current Chair of the FDIC, referenced Milton Friedman who “once called the FDIC the ‘single most important structural change’ in the economy since the Civil War.” Bair emphasized that “In the last 75 years, no one has ever lost so much as a penny of FDIC-insured deposits. Not a single penny.”

This background information might lead you to believe that another bank holiday is impossible. While these changes reduce the probabilities of such an event, they don’t preclude it. To explore how something like this might occur, an understanding of how banks operate is necessary.

Our checking and savings accounts are the bulk of a bank’s liabilities. These accounts are short-term liabilities. Checking accounts are known as demand deposits, because you can demand cash from your checking account at any time. Savings accounts are similar, but usually require a notice period before withdrawal. Typically this notice is about 30 days and usually ignored by the banks. Most depositors believe the funds will be provided upon request.

Bank assets, on the other hand, are mostly illiquid and represented by long-term loans and mortgages. By law, banks are required to hold minimal liquid assets known as reserves. These reserves are in the neighborhood of 10% of deposits. Our system is known as a fractional reserve banking (FRB) system because banks hold only a portion of deposits are backed up by reserves.

If, for whatever reasons, enough customers go to a bank and request cash, the bank would be unable to honor the requests. To understand, let’s look at a fictitious bank. If a bank has $1,000,000 in liabilities (checking and savings accounts), it is required to carry about $100,000 liquid reserves. Using these numbers, you might believe that 10% of deposits could be withdrawn before the bank ran out of money. That assumption would be incorrect, because most of the 10% is not held at the bank but at the bank’s account at the Federal Reserve.

Of the 10% reserves, probably about 1% is cash physically held at the bank. It would only take 1% of the depositors to come in on any particular day to withdraw the cash in their accounts ($10,000 in our simple example) to drain the bank of its cash. Requests beyond that could not be satisfied, at least not on demand.

At this point, a minor inconvenience has occurred and only to those customers who were unable to obtain their funds that day. Presumably additional cash will be hurried to the bank so that customers are not again inconvenienced tomorrow. There is little reason to assume that the bank is in trouble. Furthermore, the FDIC guarantee ensures that no customer will lose any money on balances up to $250,000.

While the FDIC provides comfort and assurance for depositors, it does not guarantee that there will be no bank holiday. The risk is that a “run” on a particular bank triggers runs on other banks, creating a systemic problem. If your neighbor tells you that his bank could not provide him with needed cash, it is probable that you would head down to your own bank to take out some or all of your cash, whether you needed it or not. If enough people did that, a bank “panic” would begin.

A bank holiday might be declared because of logistics rather than solvency concerns. Most money in our system is electronic and not physical. Currency represents a very small, almost insignificant portion of this money. But currency is what people consider money and want in such a situation. There is not enough currency available, nor is it necessarily in the place where it is wanted or needed.

Should a sudden increased demand for currency develop, it is likely that a bank holiday would be imposed while additional cash was printed up and then allocated around the country to each and every bank. Under such conditions, it is likely that individuals would not have access to cash for a few days or a few weeks. Declared or not, a de facto banking holiday would occur.

Whether this type of run could develop in such a fashion that it would also affect the use of credit cards and check usage is not determinable, at least by me. The point is that a “banking holiday” could occur despite the FDIC. Whether it will or not is anyone’s guess, but in unstable situations it takes only a grain of sand to start an avalanche.

Banks are apparently concerned. As reported by Ira Stoll:

Seen on a recent Citibank (C) statement: “Effective April 1, 2010, we reserve the right to require (7) days advance notice before permitting a withdrawal from all checking accounts. While we do not currently exercise this right and have not exercised it in the past, we are required by law to notify you of this change.”

If you wanted to start a bank panic, it would be difficult to design a better way than what Citi did. One must marvel at the apparent stupidity. Even if Citi were viewed as Fort Knox, this action could (should?) provoke fear on the part of depositors.

Stoll indicated that Citi subsequently explained that the notice was supposed to only apply to customers in Texas, even though it went out to all customers. Why would they do this in Texas? If this isn’t scary enough, remember we are all “investors” in Citi via the bailouts. No taxpayer should be comforted by this display of “management.” Depositors at any bank should be unnerved.

A final comment pertains to the Federal Reserve. Should a shift in demand for currency occur (either up or down), the Fed’s job of managing the money supply and steering through these rough waters becomes infinitely more complicated. The risks of inflationary or deflationary mistakes are then increased substantially. Reasons why are beyond the scope of this piece. It is mentioned only to emphasize the instability of the current economic situation.