How it works
A bank takes in money for safekeeping and lends it out at the same time. Depositors never all come at once, so a small reserve is enough. As long as people believe in the system, it works.
But once a rumor of insolvency appears, depositors come all at once. By definition, the reserve is not enough, and a bank that may have been perfectly healthy goes under in a matter of days.
A bank cannot pay everyone at once, and that is not fraud, but how it is built. So trust here is not decoration, but a condition of existence.
Three collapses
- 1340sTwo of Florence's biggest companies go bankrupt when the English Crown refuses to repay wartime loans.
- 1490sThe most famous banking house collapses because of bad loans made by its branches and the loss of contact with them.
- 1720A stock market crash among companies trading on promises of future profits ruins thousands of depositors.
- 19th centuryThe idea of a central bank emerges, providing money during a panic to stop a run on deposits.
The first line shows a vulnerability that has not gone away. A large borrower, too important to turn down, builds up debt, and refusing to pay brings down the lender. For a medieval bank, that borrower was a sovereign.
The second line is about another problem: managing from a distance. Branches in different countries issued loans that headquarters learned about months later, and by the time the losses became visible, it was too late to save the bank.
The last line describes the solution that was found. If, in a moment of panic, someone provides the bank with money against its sound assets, the run stops on its own: depositors no longer have any reason to rush.
Deposit insurance was added later, for the same reason: it works not by paying out money, but by removing the reason to rush for it first.
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Sources
- The bankruptcies of Florentine companies in the 1340s are linked to the English Crown's refusal to repay wartime loans
- the ideas of a lender of last resort and deposit insurance arose in response to the self-reinforcing nature of a run on deposits