a bank means the ability to meet its financial obligations
as they come due. Bank lending finances investments in relatively
illiquid assets, but it funds its loans with mostly short term
Thus one of the main challenges to a bank is ensuring its own liquidity
under all reasonable conditions.
Asset Management Banking
Commercial banks differ widely in how they manage
small bank derives its funds primarily from customer deposits, normally
a fairly stable source in the aggregate. Its assets are mostly
to small firms and households, and it usually has more deposits than it
can find creditworthy borrowers for. Excess funds are typically
in assets that will provide it with liquidity such as Fed funds loaned
and U.S. government securities. The holding of assets that can
be turned into cash when needed, is known as asset management
In contrast, large banks generally lack sufficient
deposits to fund
their main business -- dealing with large companies, governments, other
financial institutions, and wealthy individuals. Most borrow the
funds they need from other major lenders in the form of short term
which must be continually rolled over. This is known as liability
management, a much riskier method than asset management. A
bank will lose potential income if gets its asset management
A large bank that gets its liability management wrong may fail.
Key to Liability
The key to liability management is always being
able to borrow.
Therefore a bank's most vital asset is its creditworthiness. If
is any doubt about its credit, lenders can easily switch to another
The rate a bank must pay to borrow will go up rapidly with the
suspicion of trouble. If there is serious doubt, it will be
to borrow at any rate, and will go under. In recent years, large
banks have been making increasing use of asset management in order to
liquidity, holding a larger part of their assets as securities as well
as securitizing their loans to recycle borrowed funds.
A bank run is an overwhelming demand for cash by a
With the advent of deposit insurance, bank runs by small depositors are
largely a thing of the past. Insurance is limited to $100,000 per
deposit, which provides complete coverage to about 99% of all
But it covers only about three-fourths of the total amount of deposits
because many accounts far exceed the insurance limits.
A large depositor assumes a risk and needs to know
something about the
bank's own balance sheet. However a healthy balance sheet does
eliminate all risk. Even if the depositor knows the bank has
liquidity, others may not. Large depositors must therefore be
about what others are likely to believe. A rumor about a bank,
though unfounded, can trigger a run that causes a solvent bank to
The problems with deposit insurance could be solved by
coverage to risk-free narrow banks or narrow deposits.
A narrow bank would offer checking deposits and would be allowed to
only in safe liquid assets such as T-bills. It could operate as a
separate institution or as a subsidiary of a bank holding
Only narrow banks would be eligible for deposit insurance.
Narrow deposits would be checking deposits that could be
any licensed institution on condition that they were secured
by safe liquid assets. Only narrow deposits would be eligible for
deposit insurance. Thus narrow banks or narrow deposits would be
fully collateralized, and deposit insurance would be redundant and
Ending deposit insurance would greatly reduce the moral hazard problem
Both of these alternatives are closely related to the
in the article The Case for a Single National Depository.