Banks are vital financial institutions that hold deposits and facilitate the smooth flow of funds through lending. However, if a bank fails, it can destabilize the financial system and deal a major blow to the economy as a whole.
Are banks the heart of the economy, or a ticking time bomb?
On March 10, 2023, Silicon Valley Bank (SVB) in the United States went bankrupt. This was the second-largest bank failure in U.S. history, and it triggered significant turmoil in financial markets worldwide, including the bankruptcy of Signature Bank two days later. Bank failures (bank runs) caused by financial market instability or mismanagement are not common occurrences. Even in the United States, a bank run of this magnitude was the first since the 2008 financial crisis.
While banks and other financial institutions play a vital and unique role in a market economy, banks, by their very nature, are inherently unstable and precarious entities. Banks are highly vulnerable to economic fluctuations or external shocks if managed even slightly poorly, and because a bank’s bankruptcy—if allowed to occur according to market principles—would have significant ripple effects on the economy, government regulation and intervention are absolutely necessary.
Connecting the Supply and Demand of Funds Through Banks
The most basic role that ordinary consumers expect from banks—and what traditionally comes to mind when thinking of a bank—is that it is a “place to deposit money.” Since people have nowhere else to store large amounts of money, they deposit it in banks and withdraw it as needed. Therefore, banks must hold sufficient funds at all times to allow customers to withdraw money when they need it. However, since it is highly unlikely that all customers who have deposited money with a bank will withdraw their funds at the same time, banks do not need to hold all of that money on hand.
Consequently, banks set aside only a portion of their deposits as reserve requirements and use the remainder to lend to businesses and individuals or to invest in specific financial products to generate profits. This is known as the “fractional reserve system.” Thanks to this system, banks do not merely exist as vaults but serve as intermediaries connecting the supply and demand for funds. For example, consider an entrepreneur who receives a $30,000 investment for a business and plans to begin repaying that money in three years. Without banks, this entrepreneur would have to personally seek out investors with more than $30,000 in spare cash and prove his creditworthiness on his own. However, banks—which hold deposits entrusted by the public—professionally assess creditworthiness to determine whether to grant a loan. In other words, in a market economy, financial institutions—including banks—and the fractional reserve system play a pivotal role in facilitating business activities and people’s daily lives by connecting those who need money with those who have it to spare. Therefore, the claim that financial institutions do not create any added value stems from a lack of understanding of the market economy. Although attempts are being made to directly connect the demand and supply of funds through technological advancements, they have not yet been able to fully replace the role of banks. Banks are that important.
However, banks are inherently unstable. Because banks pool large amounts of money and then lend it out, they are immediately exposed to risk if depositors begin withdrawing their funds on a massive scale. Just as banks meticulously verify the repayment capacity of borrowing companies and individuals when granting loans, people’s decision to deposit money with a bank is based on the belief that the bank will safeguard their funds and return them at any time. If that trust collapses, the bank will, quite literally, collapse.
Bank Instability and the Need for Government Regulation
Bank deposits also carry credit risk. While the level of risk is typically low and difficult to perceive under normal circumstances, even the slightest economic turbulence or a minor lapse in bank management can easily trigger and spread anxiety among the public. The problem is that even if a bank is fundamentally sound, it can become vulnerable once anxiety takes hold.
If anxiety spreads and people start withdrawing their money en masse, banks may be forced to call in loans or sell assets to cope; if the situation worsens, they could even go bankrupt. A bank’s bankruptcy leads to a loss of confidence in the financial system, negatively affecting other banks and dealing a blow to the national economy as a whole.
Thus, while banks play a vital role in a market economy, they also carry inherent risks. For this reason, the government regulates banks to ensure they maintain a minimum level of reserve requirements and prevents them from investing excessively in risky assets. Under normal circumstances, banks have an incentive to reduce their reserve requirements and lend and invest as much as possible; when the economy is thriving, they are also tempted to invest in risky assets to generate high returns. However, if the proportion of risky assets increases and reserve requirements decrease, banks become vulnerable to crises.
Another system designed to enhance bank stability is the deposit insurance system. While this system aims to prevent depositors from suffering losses, it also serves to stabilize the financial system, as a mass run on banks could destabilize them. For example, in South Korea, if a bank goes bankrupt, the Korea Deposit Insurance Corporation protects depositors’ funds up to 50 million won. Additionally, regional financial institutions in the secondary financial sector—such as the National Agricultural Cooperative Federation (Nonghyup), the National Fisheries Cooperative Federation (Suhyup), Saemaul Credit Unions, and Credit Cooperatives—provide protection of up to 50 million won through separate funds rather than the Korea Deposit Insurance Corporation. However, because this coverage limit is significantly lower than in other developed countries, there are persistent calls to raise the deposit insurance limit. Furthermore, amounts exceeding 50 million won, as well as bonds or stocks issued by banks, are not protected; thus, the economic shock caused by a bank failure is not entirely eliminated. Consequently, when depositing money in a bank, individuals must be aware of these risks and choose their banks carefully; however, there is also criticism that the existence of deposit insurance leads people to place their trust in it and deposit funds in riskier banks.
High Interest Rates and Financial Market Turmoil
The global economic shock triggered by the spread of COVID-19 in 2020 led to rising asset prices—dubbed the “COVID bubble”—and rapid inflation. As central banks implemented high-interest-rate policies to curb inflation, financial institutions became extremely unstable. The bankruptcy of SVB in the U.S. was also affected by this deteriorating economic environment. Furthermore, whereas in the past, when a bank run occurred, people would line up outside banks to wait for withdrawals, today, with the widespread use of mobile and online banking, bank runs can occur in an instant.
When the bank run occurred, the Biden administration responded relatively quickly. While the deposit insurance limit in the U.S. is $250,000, the government announced that it would protect the full amount of deposits in the SVB bankruptcy case. However, the U.S. government emphasized that it would not protect stocks or bonds, that executives would be dismissed, and that no taxpayer money would be used. As explained earlier, the bankruptcy of financial institutions must be prevented because it has a negative impact on the economy, and it is especially important to prevent people’s fear and anxiety from spreading to other banks. The Biden administration’s announcement that it would, as an exception, protect the full amount of deposits appears to have been made with these factors in mind. At the same time, the decision not to provide financial support to SVB or bail out executives responsible for mismanagement seems intended to prevent public dissatisfaction with such political decisions and to avoid encouraging moral hazard among executives at other financial institutions.
