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US Dollar

The US Dollar, How does it Work!

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The US Dollar

After the abandonment of the gold standards, the paper money only has a value because the people agrees among themselves that it has value and the federal reserve said it.

Fractional Reserve Banking

Overview

The money you think you have in your bank is not actually there, Surprised? Hold on. I will explain!

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The fact is that, the banks lends out your money to many of the bank’s other customers. And banks have the permission to do this because of the fractional reserve system.

Banks have to keep a certain amount of liquidity in relations to the loan they give to customers, this minimum liquidity reserve would meet the often demand of the bank’s customers to withdraw money from ATMs or a deposit kept with the bank.

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Fractional Reserve Banking
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Rehypothecation

This fancy term in finance would suggest the practice that banks and also brokers use the money of any customer for their own purposes in an exchange of a compensation through lower cost of borrowing.

What the banks hopes in this situation is that only a small proportion of their users will actually withdraw their money. Hence, they keep a small liquidity in their deposits in this case.

The bank run

Well, You would probably conclude that Rehypothecation is incredibly risky! Yes, it is.

What happens if all depositors come at once and request their money back? Well than you get what is called, a bank run.

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The bank run happens when all people rush to withdraw their money all at once which will result in a liquidity crunch where the bank can not pay back all its depositors.

The bank crunch happens more usually because of rumors that a bank is facing a shortage of funds, which leads to people to run to withdraw all their money at once, which is pretty scary.

Bank Run
Bank Run
FDIC

Not only banks with short liquidity but also those who are in strong position are susceptible for a bank run. People hear about one bank facing a run, so they rush their own banks to withdraw their funds.

This panic due to the bank runs, lead to the formation of the FDIC or the Federal Deposit Insurance Corporation, an insurance that coverage the loss of balances of less than $250K per depositor, per insured bank for each account ownership category. Those of balances above that average are still at risk of a loss.

The best example of a bank run was in 2008 with Lehman Brothers, where financial institutions started to withdraw their deposits which leads to a massive liquidity crunch. Moreover Euro crisis in Greece and Cyprus in 2010. So much so that the government had to place a limit of the amount of people could withdraw from ATMs, only 60 Euros per a day.

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