Question

Explain the impact that bank failures have on the money supply and how that effects an economic recession/depression.

Answer 1

Big banks run short of money (liquidity) in a banking crisis. Many banks may go out of business in a serious banking crisis (e.g. Great Depression 1929-32). When banks face shortages of liquidity or worse, it will have a major impact on savers, companies, and customers. Invariably, major banking crisis has an effect on economic growth and can lead to unemployment. Banks cut back on lending in the recent banking crisis. It meant that companies did not have the funds to finance investment.If banks lack liquidity, they will be less willing to lend money to companies and consumers. In general, banks will be hesitant to lend to companies that make risky investments. For this reason, companies that want to borrow money to finance investment may find it very difficult to obtain a satisfactory loan. The organization will therefore minimize spending and employ fewer workers. When investment levels drop dramatically, this will result in lower economic growth and higher unemployment. Investment accounts for approximately 15-20% of aggregate demand, thus having a significant impact on economic activity.

Investment tends to be very cyclical. A decline in investment levels results in lower economic growth, but this lower growth has a knock-on effect; with lower demand, firms are cutting back on investment levels. Many jobs are made redundant from less employment with decreasing income, but as there is also lower economic growth, this triggers job losses in other industries such as retail–which sees a general decline in demand.

Governments were much more reluctant to allow banks to fail in the recent banking crisis (with the exception of Lehman Brothers investment bank). That's why we've had big bailouts from the bank. Although major banks were' saved' from bankruptcy, however, they also changed their behavior and were reluctant to make loans as necessary to recover their losses from previous bad loans. The lack of finance fed into the normal business environment in the banking sector.