Is Fractional-Reserve Banking Dangerously Gritty?

We’ve all heard the news — Silicon Valley Bank (SVB) failed, and the world is reeling. So why did SVB, a seemingly successful Bank with a stellar track record of success suffer this dramatic downfall? Chalk it up to fractional-reserve banking, dear readers.

Fractional-reserve banking is a banking system that allows banks to keep only a fraction of the deposits in their vault, while loaning out the remaining fraction. In theory, it should be a great system that’s good for business and customers alike — it provides monetary supplies, allowing customers to access funds on demand, and provides banks with income from loan interest. However, it does come with some risks. Let’s take a look at what fractional-reserve banking risk — and why Silicon Valley Bank’s failure is a stark reminder of those risks.

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Interesting Risks

The key risk associated with fractional-reserve banking is a “bank run”. In this scenario, a large number of customers withdraw their deposits on the same day, leaving the bank with insufficient funds to fill the orders. The bigger the loan-to-deposit ratio, the bigger the risk — and in the case of Silicon Valley Bank, it was a whopping 45%. That’s why when customers started placing heavy withdrawals following SVB’s failure, the Bank collapsed.

And of course, fractional-reserve banking also comes with an increased risk of moral hazard. Because banks are only required to store a fraction of the amount deposited, there’s no real incentive for them to hold onto deposits (outside of the promise of interest payments). This can encourage them to spend those deposits in a reckless manner, and eventually lead to a bank run — just like what happened to SVB.

A Cautionary Tale

So what’s the lesson from SVB’s unfortunate fall from grace?

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  • Loans come with risks. It’s important to understand that any loan — even a seemingly safe one — comes with a degree of risk. It’s important to look into the details of any loan before signing up.
  • Watch the loan-to-deposit ratio. When it comes to fractional-reserve banking, the bigger the loan-to-deposit ratio, the bigger the risks. If a bank’s loan-to-deposit ratio is high, consider it a red flag.
  • Research the Bank. If something seems too good to be true, it probably is. Be sure to do your homework when looking for a Bank, and research their historical success and reviews.

At the end of the day, the demise of Silicon Valley Bank is a cautionary tale — and a reminder that, when it comes to banking, not all that glitters is gold. There’s no telling when a bank might take a fall, and it pays to be cautious.

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