Question

Suppose that assets of the First Bank consist of reserves held in cash and it has enough to meet the reserve requirement; long term loans the First Bank made in the past were to reliable borrowers and should eventually be repaid in the future, and low risk long-term U.S. Government bonds. Is it correct to say that since the First Bank has invested its assets wisely, the bank will be fine if there is a run on all banks and the depositors at the First Bank immediately close their accounts and withdraw cash? Why or why not? What could the Federal Reserve do to help?

Answer 1

If the wiseness of the strategy undertaken by the First Bank is judged in terms of risk averseness or safety from risk and volatility, then one can 'safely' conclude that it is wise. First Bank has not made any risky bet by adhering to the reserve requirement and making loans only to reliable borrowers and investing in long-term US Government Bonds which comes with a lot of safely and stability albiet, with moderate or even low returns. This means that First Bank has got strong assets in its books, making it financially solid and dependable.

For the sake of argument, if we consider a case of bank run on First Bank ( though its safe investment strategy and strong financial books makes it a very unlikely scenario) , it can turn out in the following way.

1. The bank run erodes the reserves that First Bank has kept to meet the reserve requirement but it manages to pay the customers without having to liquidate its assets.

2. First Bank is unable to pay its customers with the existing reserves and it has to liquidate its long term assets vis-a-vis, the US government bonds. The bank is likey to incur a considerable loss in this case.

So, depending in the extent and magnitude of the bank run, First Bank can get a minor hiccup and depleted reserve or it might have to bring in emergency liquidity by diluting its long term assets which can increase its financial liability and put it into doldrums.

The Federal Reserve can step in and help First Bank in this crisis, considering its pre-existing financial goodhealth and adherence towards good banking behaviour. The Federal Reserve could provide an emergency relief in the form of short term loan to provide enough cash to enable First Bank to tackle the Bank Run. The Federal Reserve could rely on the safe long term loans and the investments in US government bonds kept by First Bank as collateral for the loan.