Question

What do you think would happen if all the depositors went to ask for their money at the same time?

Answer 1

Instructions:

• First, we will try to understand how the credit system works
• Then, we will explain how banks give loans as against deposits
• Finally, we will learn why a bank would fail if all depositors would withdraw at the same time.

Solution:
Banks are a part of the financial system that work as intermediaries between lenders (people with surplus money) and borrowers (people who need money).

Banks accept surplus money from depositors who park their money from banks in return of a nominal rate of return. They use this excess money to lend to borrowers in the form of loans at an interest.

Thus, this fine balance between lenders and borrowers helps banks to function seamlessly. It helps banks to meet the obligations of its creditors and depositors at the same time.

Banks only keep a small percentage of deposits with themselves and lend out the rest as loans. So, when all depositors withdraw their money from the bank in a short period of time, it is highly possible that the bank will fail to meet the obligations of all its deposits, eventually running out of cash and leading to a bank default.

A bank default can lead to a systemic banking crisis leading to a full blown financial crisis.

Thus, it is the responsibility of the government to maintain the credibility of the banks and prevent loss of confidence in the banking system.