The vast majority of people who live in first world countries keep their money in banks. But few people actually know how banks work. In this article, we take a closer look at the banking system. We examine the risks of keeping your money in banks and discuss how to protect yourself in the event of a bank failure. Is your money safe in banks or not? The answer isn’t black and white. Even if you trust your bank, there are steps you can take to reduce your risk in case there is a bank run or your bank unexpectedly goes bankrupt.
Banks emerged as the result of precious metal custody. Many years ago, gold and silver were money. Since it wasn’t safe or convenient to store or transport large amounts of gold and silver, people began depositing it at gold smiths and in return received paper certificates.
These certificates and notes were redeemable for real money in the form of gold or silver. Having paper certificates overcame a major flaw of precious metals. It made money more portable and easier to store.
People could now deposit gold or silver, receive a paper certificate and travel across the country without having to carry actual silver or gold.
They could go to any bank, present their paper certificate and redeem it for silver or gold. Since paper certificates were convertible into real money, they were trusted and widely adopted.
Banks, in their earliest form, made money by offering people a place to store their precious metals.
Depositors would deposit their silver or gold, and the bank would charge a fee for storing and protecting the depositor’s money. Banks could also charge fees for exchanging currencies, notary services and handling the transfer of payments between customers.
This is known as full-reserve banking. The Bank of Venice in 1587 as well as the bank of Amsterdam in 1609 operated on these principles.
When banks realized that they could make even more money by lending out the money people had deposited, the modern banking system was born. Instead of running a business based on fees, banks began only keeping a small portion of the money on hand.
In most cases, banks kept 1-10% of the depositor’s money and lend out the rest to other people in order to earn interest. The problem with this practice is that the original depositor and other people have a claim on the same money.
Let’s use an example to illustrate this. Person A deposits $100 at a bank. The bank keeps $10 and lends the other $90 to person B. Person B now takes his $90 and deposits it at a different bank.
So if person A and B both want their money at the same time, the banks can’t pay them both.
This is known as fractional reserve banking.
In reality, it’s a lot more complex because the second bank that got the deposit from person B will also only keep 10% and lend $81 to person C. Person C then deposits the money at a third bank, which keeps 10% and lends $72.90 to person D and so forth.
This way banks “lend money into existence”. By doing so, they owe more money than they actually have. If many depositors demand their money at the same time, banks can’t keep their obligation to repay depositors, run out of money and go bankrupt.
Since all banks engage in this risky type of business, one large bank failure or a general loss of trust in banks can lead to a bank run. Just like a game of musical chairs, those who withdraw their money first might be in luck.
Those who withdraw their money last will stand in front of an empty ATM. The bank is insolvent and withdrawals are halted.
In 1913 the Federal Reserve was founded to help prevent bankruptcies and panics which frequently occurred under the fractional-reserve banking system.
But instead of outlawing the business practice, the Federal Reserve nationalized it.
As part of the Federal Reserve System, all banks had to keep their excess reserves at the Federal Reserve, the United States central bank. If a person deposited $100, the bank lent out $90 and held the remaining $10 at an account with the Federal Reserve.
Since all banks were forced to do this after the Federal Reserve Act of 1913, the Federal Reserve could provide struggling banks with liquidity. If a bank was close to failing due to overextended loans, it could take overnight loans from other banks that had more reserves.
This was meant to stabilize the fragile fractional-reserve banking system and prevent bank runs and panics.
In 1929 the stock market crashed and the Great Depression led to many bankruptcies and defaults. Individuals couldn’t pay their mortgages and loans because they had no more money.
As people defaulted on their loans, banks quickly ran out of money to pay depositors.
Banks started going bankrupt on a daily basis. Gripped by panic, depositors lined up at banks to withdraw their savings. But the banks didn’t have the money anymore and couldn’t pay depositors.
The more depositors demanded their money, the more pressure the banks came under. This led to many bankruptcies and bank closures. Many people lost all their savings.
In 1933, Roosevelt became president of the United States. In an attempt to prevent further bank runs and bankruptcies, he ordered a national bank holiday.
All banks temporarily closed their doors and depositors weren’t able to get their money out.
Once the bank holiday was over, many banks never opened again. And those that did imposed strict limits on withdrawals to prevent the banks from collapsing.
The Federal Reserve was still relatively young at the time and failed to bail out banks and prevent a systematic collapse of the fractional-reserve banking system.
Roosevelt took some important steps though, including calling the Federal Deposit Insurance Corporation (FDIC) into life.
The FDIC, which still exists in the United States today, insures bank deposits in case of a bank failure. This was partially a necessary step because depositors had lost faith in banks after the Great Depression.
The FDIC insurance guarantees deposits up to $250,000. This means, if a bank goes bankrupt, it will either be bought by another bank, and if that is not possible, the FDIC covers up to $250,000.
If a person holds $1,000,000 at the bank, the insurance covers $250,000 and the rest is lost. At least this is how it works in theory. In reality, the FDIC is underfunded, which means if there is a cascade of bank failures, the fund likely can’t cover all losses.
And secondly, the system hasn’t been thoroughly tested in practice. It is not certain how quickly depositors receive their money back. It could be a matter of months or years until all legal proceedings have concluded.
Many countries have bank deposit insurance similar to the FDIC in the United States with varying insurance coverage. Check whether your country offers deposit insurance and how much.
In case a “Too Big To Fail” bank is facing bankruptcy, such as was the case during the Global Financial Crisis in 2008, the Federal Reserve or the respective country’s central bank can bail out the insolvent bank.
This means, even if bank deposit insurance is underfunded, systemically important banks and their depositors’ money can be protected by printing money.
Although there is some debate about this, printing money can cause inflation. If a central bank prints billions or trillions of dollars to save one or multiple banks, the existing money in circulation can lose value.
In this sense, the general public bails out the bank by losing purchasing power. While each depositor might get back his or her money, the purchasing power of their money might be significantly lower.
There is no guarantee that a central bank will bail out the bank that you hold your money in. People in Cyprus had to learn this the hard way.
In 2013, Cyprus was on the brink of bankruptcy. Not just a particular bank but the entire country. The government asked the European Central Bank for a bailout. But the request was denied in favor of a bail in.
Rather than the central bank printing all the money and giving it to Cyprus, the government ordered a national bank holiday. In a next step, the government announced that a percentage of money in excess of €100,000 would be converted into bank stocks and used to save the bank.
Hundreds of thousands of people couldn’t get their money out of the banks anymore. Their deposits were converted into bank shares that immediately plummeted and lost most of their value.
More recently, people in Lebanon, Afghanistan and Russia experienced similar problems.
When the Taliban invaded Afghanistan, there was a bank run. Many people tried to get their money out of the bank and flee. As depositors lined up in long ques at ATMs and bank branches, banks ran out of money and many Afghans lost all their savings.
When the West imposed sanctions on Russia because of its invasion of Ukraine, Russians lined up at ATMs to get their money out.
The problem is that under the fractional-reserve banking system banks don’t have enough money to pay back depositors if a large number of them attempt to withdraw their funds at the same time.
It’s estimated that if only 1% of the world’s population were to withdraw their money from banks at the same time, the entire banking system would collapse.
This shows how leveraged banks are today.
Whether your money is safe in banks depends on which country you live in, what bank you keep your money at and how much money you have deposited.
If you live in an economically or politically unstable country, it’s less safe to keep money in the bank.
And if you keep your money in a “Too Big To Fail” bank, your money is probably safer than if you keep it in a systemically unimportant bank that governments might let go belly up.
The amount of money you keep in the bank matters as well. It isn’t recommended to keep more money in the bank than is insured in the event of a bank failure.
And finally, if you live in Europe where governments can’t print their own money and only the European Central Bank can bail out banks, don’t be surprised if you find yourself in a similar situation as many people did in Cyprus in 2013.
It’s probably best to only keep as much money in the bank as you’re comfortable holding there. This depends on your net worth, your bank, the economic and political stability of the country you live in and the laws and regulations surrounding deposit insurance.
Given the instability of the fractional-reserve banking system, keeping money in banks always comes with counter-party risk.
Counter-party risk means that the counter-party, in this case the bank, could default on its obligation to pay you back for a number of reasons.
The only way to completely remove counter-party risk is self-custody.
Taking custody of your money comes with its own risks, but since you are solely responsible for securing the money, there is no counter-party risk. The physical cash you hold is really there and yours, unlike the digits in your bank account.
Let’s talk about how you can become your own bank and stay in control of your money.
The easiest way is to keep an emergency stash of physical cash in a safe at home or hidden somewhere. Another way to remove counter-party risk is to convert your money into bitcoin and keep your funds in self-custody.
Bitcoin doesn’t come with counter-party risk as long as you don’t keep it on an exchange.
Some people also like to convert their money into gold and silver and store it in a safe at home or in a private safety deposit box. But keep in mind that transporting gold and silver isn’t as convenient.
It is likely that you’ll need to use banks in some way. Keeping some money in the bank, withdrawing some physical cash as an emergency fund and holding your own bitcoin, gold or silver is probably the best way to hedge against the fragile nature of the banking system.
Unfortunately most people don’t understand how banks work. They don’t realize that the $100 they deposit at their bank isn’t stored somewhere for them in a vault.
It is lent out several times over. This also means the digits you see in your online banking mean nothing.
Whatever digits you see isn’t your money, held somewhere secretly for you, ready to withdraw whenever you need it. It’s simply a promise that the bank will pay you back the money.
This is probably why Henry Ford said:
It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.
Henry Ford on Fractional-Reserve Banking
Now that you understand how banks work and why they are risky, let’s wrap up this article with some practical steps and guidelines.
If you’re asking yourself “should I keep my money in the bank or at home?”, the answer isn’t as black and white as some people think.
Regardless how much you trust your bank, here are some steps you can take to protect yourself form a worst-case scenario:
By following these steps, you should be optimally protected in case there is a bank run and your bank goes bust.