1. Start-up Company ABC deposits $100 million in Bank XYZ over the course of several years from 2015-2020. Most of this money is investment capital from the founding partners.
2. Bank XYZ pays out 2% to Company ABC on these deposits during the low-interest environment of that time.
3. The bank takes the $100 million and uses it for both lending activity and reserves. $50 million is used to make loans that pay 5% to the bank. $50 million is invested in long-term U.S. Treasury bills paying 3%. The "spread" between the bank's investments (5% on the loans and 3% on the government bonds) is how the bank pays its bills and makes money.
4. In 2023, Company ABC comes to the bank and says: "We need $20 million to fund a merger/acquisition."
5. Bank XYZ doesn't have $20 million in cash lying around because it has committed the $100 million elsewhere. So it basically has two options: (A) borrow money from another bank through a 30-day, 90-day, or six-month "interbank" loan; or (B) sell off some of its U.S. Treasury bills to raise the $20 million.
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Note that everything I've presented here is exactly how the banking industry has worked for decades. There's nothing unusual about any of this. You'll also note that one option the bank does NOT have is to tap the $50 million it has used to make the loans paying 5%. If you have a 30-year mortgage on your house, the bank can't make you pay it off immediately just because the bank needs the money to meet its obligations to its depositors.
This process fell apart in the last 2-3 years for two basic reasons that relate to the process I described above (and not that neither reason has anything to do with defaults on the bank's $50 million in loans, "risky investments," or anything of that sort) ...
A. Interest rates rose so rapidly from 2021-2024 that when Bank XYZ goes out looking to secure its short-term interbank loan, the rate they have to pay on that loan is 7% or 8% -- which is higher than what the bank is getting on its 5% loans and its 3% Treasury bills. The bank has to run at a loss just to finance manage its cash flow this way.
B. With interest rates rising, existing U.S. Treasury bills paying 3% to their holders lose a lot of value. Who wants to buy an existing U.S. Treasury bill paying 3% when the U.S. Treasury is issuing new debt paying 5%? So the bank's $50 million in Treasury bills aren't worth $50 million right now, and the bank may have to sell about $30 million of those bonds to generate enough cash to fulfill the $20 million of Company ABC's deposits. The bank loses $10 million in its bond portfolio just to make good on a $20 million deposit obligation.
*** Now imagine this happens 100 more times with other corporate customers. ***
This -- and not insufficient bank reserves -- is what has been driving the turmoil in the banking industry since 2022.
The first five steps is how I understand it as well.
When the bank doesn’t have the money off-hand, it will either call in its other branches to keep it afloat by using their reserves or they will contact the local federal reserve to loan them enough to get out of, but that usually takes at least a day.
You get enough small loans doing this, and it’s like a large loan doing it. It’s just that the banks have made a science on how the money flows amongst the small people. They know the approximate rate that money flows in and out from small accounts, so they base what they carry based on how people operate.
I understand your point about large loans, but it operates the same way if a wave of hysteria hits.
It still comes down to a common cause, not keeping enough in their reserves to pay out whomever might want their money back.
It used to be they kept 1 dollar for every nine they had in accounts, but it is now to zero.
https://www.investopedia.com/terms/b/bank-reserve.asp
I presume it’s zero because the federal reserve will print and loan whatever is needed at a moment’s notice.