Bank deposits, of course, are >100% backed (by a mix of assets), the 10% reserve ratio is just specifying a minimum amount of one kind of asset (central bank reserves). Most countries don’t have the same kind of explicit reserve requirement and most have plenty stable banking systems.
> Bank deposits, of course, are >100% backed (by a mix of assets),
The reserves are there to provide liquidity for people who want to withdraw their funds in normal times.
The assets are mostly loans. The lenders sometimes fail to repay the loan, and the collateral may not be worth as much as initially estimated.
The bank has capital requirements, so that if loans are not replayed, the bank shareholders take the hit.
If the capital is depleted beyond a certain point, the regulators (and the FDIC in the US) take over the bank, wipe out the shareholders, and install new management. Depositors are repayed up to the insured amount and if there are remaining funds they go to the insured depositors, creditors, and shareholders in that order.
That's of course how thing are supposed to be done. In reality, large connected banks are often bailed out.
The system is so fragile that politicians and central bankers don't want to imagine the potential chain reaction that the failure of a big bank would result in. The only solution is to prevent banks from becoming too big in the first place and bigger banks should have more stringent reserve and capital requirements to discourage monopolization.
What does it mean here that “the shareholders will take a hit?” Do the shareholders normally receive some regular payments that would stop (or be reduced) in that situation?
I know nothing about finance, but the stories unfolding this week have me interested to learn more about how all this works.
The bank has deposits and capital from its shareholders.
The bank promises to pay the depositors interest, and the bank collects interest from the loans it makes.
If the bank made good loans, the difference between the interest it pays and the interest it collects increases the bank's capital, and at some point it may pay dividends to the shareholders.
If the bank made bad loans, and some of them are not repayed, the losses come out of the bank's capital.
If the capital goes below some regulatory threshold, a corrective action must be taken. The bank can raise more capital, or get acquired. If a corrective action is not taken, the FDIC takes over the bank, and either sells the bank, or closes it and distributes the remaining assets as follows:
First, to cover deposits up to the insured limit, which is $250K per account. Then to deposits above the insured limits, then to creditors according to seniority, and finally, if there's anything left, to shareholders.
In other words, shareholders takes the first hit, then creditors, then deposits above the insured limit, and finally deposits below the insured limit.
If the deposits below the insured limit take a hit, the FDIC covers that from its insurance fund.
