Friday, October 10, 2008

The Bank Bailout

The latest twist in the bailout is Henry Paulson's plan to buy an ownership stake in banks to help banks raise capital. How is it possible that banks need more money, given that banking reserves are exploding?

Evidently, a bank is more than the sum of its deposits. A bank holds the deposits of its customers without owning these deposits. To pay its employees, a bank draws out of its own, separate corporate account. This corporate account is normally filled by interest that the bank earns when it loans out the deposits of its customers. But when the business is bad, the bank doesn't earn much interest, or lots of loans fail and the corporate account runs low. This is when the bank needs to raise money by taking loans from other banks or selling more stock in the bank.

In theory, it might be possible for a bank to take a loan for itself from out of its customer deposits. But auditing rules prevent banks from doing this secretly. What would you do if you found out that your local bank is spending your checking account to pay it's employees? You would quickly go get all your money out of the bank, putting the bank out of business.

Therefore, having a high level of reserves is basically useless for a bank on the brink of failure.

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