Banks are vital financial institutions that hold funds and facilitate the smooth flow of money through lending. However, if a bank fails, it can destabilize the financial system and cause a major shock to the economy as a whole.
Are banks the heart of the economy, or a ticking time bomb?
On March 10, 2023, Silicon Valley Bank (SVB) in the U.S. went bankrupt. This was the second-largest bank failure in U.S. history, and it caused significant turmoil in global financial markets, including the subsequent bankruptcy of Signature Bank two days later. Bank failures (bank runs) caused by financial market instability or mismanagement are not common occurrences. Even in the U.S., a bank run of this magnitude was the first since the 2008 financial crisis.
While banks and other financial institutions play a vital and unique role in a market economy, banks, by their very nature, are inherently unstable and precarious entities. Banks are highly vulnerable to economic fluctuations or external shocks if managed even slightly poorly, and because a bank’s bankruptcy, driven by market principles, can have significant ripple effects on the economy, government regulation and intervention are absolutely necessary.
Connecting the supply and demand of funds through banks
The most basic role that ordinary consumers expect from a bank—and what traditionally comes to mind when thinking of a bank—is that it is a “place to deposit money.” Since people have nowhere else to store large sums of money, they deposit it in banks and withdraw it as needed. Therefore, banks must hold cash reserves at all times to ensure they can pay out when customers need it. However, since it is highly unlikely that all depositors would withdraw their money simultaneously, banks do not need to hold all of it.
Consequently, banks set aside only a portion of deposits as reserve requirements and use the remainder to lend to businesses or individuals, or to invest in specific financial products to generate profits. This is known as the “fractional reserve system.” Thanks to this system, banks do not exist merely as vaults but serve as intermediaries connecting the supply and demand for funds. For example, consider an entrepreneur who receives a $30,000 investment for a business and plans to repay the money starting three years later. Without banks, this entrepreneur would have to personally seek out investors with more than $30,000 in spare funds and prove his own creditworthiness. However, banks, which hold deposits entrusted by the public, professionally assess creditworthiness to determine whether to grant a loan. In other words, in a market economy, financial institutions—including banks—and the fractional reserve system play a pivotal role in facilitating business activities and people’s daily lives by connecting those who need money with those who have it to spare. Therefore, the claim that financial institutions do not create any added value stems from a lack of understanding of the market economy. While attempts are emerging to directly connect the demand and supply of funds through technological advancements, they have not yet been able to fully replace the role of banks. Banks are that important.
However, banks are inherently unstable. Because banks collect large amounts of money and then lend it out, they are immediately exposed to risk if depositors begin withdrawing funds en masse. Just as banks meticulously verify the repayment capacity of borrowing companies and individuals when granting loans, people’s decision to deposit money with banks is based on the belief that the bank will safeguard their funds and return them at any time. If that trust collapses, the bank literally collapses.
Bank Instability and the Need for Government Regulation
Bank deposits also carry credit risk. While the risk is usually low and difficult to perceive under normal circumstances, even a slight economic tremor or a minor lapse in bank management can easily trigger and spread anxiety among the public. The problem is that even if the bank itself is sound, once anxiety takes hold, the bank can become vulnerable.
If anxiety spreads and everyone starts withdrawing their money, the bank may have to recover its loans or sell assets to cope; if the situation worsens, it could even go bankrupt. A bank’s bankruptcy leads to a loss of confidence in the financial system, negatively impacting other banks and dealing a blow to the national economy as a whole.
Thus, while banks play a vital role in the market economy, they also harbor inherent risks. Consequently, the government regulates banks to ensure they maintain a minimum level of reserve requirements and prevents them from investing excessively in risky assets. Under normal conditions, banks have an incentive to reduce their reserve requirements and maximize lending and investment; when the economy is thriving, they are also tempted to invest in risky assets to pursue high returns. However, if the proportion of risky assets increases and reserve requirements decrease, banks become vulnerable to crises.
Another system designed to enhance bank stability is the deposit insurance system. While this system aims to prevent depositors from suffering losses, it also serves to stabilize the financial system, as a mass withdrawal by depositors could destabilize a bank. For example, in South Korea, if a bank goes bankrupt, the Korea Deposit Insurance Corporation protects depositors’ funds up to 50 million won. Additionally, regional financial institutions in the secondary financial sector—such as the National Agricultural Cooperative Federation (NACF), the National Federation of Fisheries Cooperatives (NFFC), Saemaul Credit Unions, and Credit Cooperatives—also provide protection of up to 50 million won through separate funds rather than the Korea Deposit Insurance Corporation. However, because this coverage limit is significantly lower than in other developed countries, there are constant calls to expand the deposit insurance limit. Furthermore, amounts exceeding 50 million won, as well as bonds or stocks issued by banks, are not protected; therefore, the economic shock caused by a bank failure does not disappear entirely. Consequently, when depositing money in a bank, one must be aware of these risks and choose a bank carefully. However, there is also criticism that the existence of deposit insurance leads people to place their trust in it and deposit money in riskier banks.
High Interest Rates and Financial Market Turmoil
The global economic shock triggered by the spread of COVID-19 in 2020 led to rising asset prices—dubbed the “COVID bubble”—and rapid inflation. As central banks implemented high-interest-rate policies to curb inflation, financial institutions became extremely unstable. The bankruptcy of SVB in the U.S. was also influenced by this deteriorating economic environment. Furthermore, whereas in the past, a bank run would see people lining up outside banks to wait for withdrawals, today, with the widespread use of mobile and internet banking, a bank run can occur in an instant.
When the bank run occurred, the Biden administration responded relatively quickly. While the U.S. deposit insurance limit is $250,000, the government announced that it would protect the full amount of deposits in the SVB bankruptcy case. However, the U.S. government emphasized that it would not protect stocks or bonds, that the management would be dismissed, and that no taxpayer money would be used. As explained earlier, the bankruptcy of financial institutions must be prevented because it has a negative impact on the economy, and in particular, it is essential to prevent people’s fear and anxiety from spreading to other banks. The Biden administration’s announcement that it would, as an exception, protect the full amount of deposits appears to have been made with these factors in mind. At the same time, the decision not to provide financial support to SVB or bail out executives responsible for mismanagement seems intended to prevent public dissatisfaction with such political decisions and to preempt moral hazard among executives at other financial institutions.
