UNDERSTANDING BASIC BANKING-
Banking is a business who works as mediator between savers (who save money and deposited into the bank to make more money) and people (businesses,individuals,governments etc.) who want to use capital for their own purposes known as borrowers. Bank generally give less interest to the depo
sitors and charges more interest from the borrowers and this difference is the revenue to the banking business.In short bank is a channel between savers and borrowers.
WHY FRAGILE?
1.BORROW SHORT LEND LONG.
Because depositors have short term maturity (3 to 10 years) to their deposits and borrowers generally borrow for the long term (15 to 30 years) and if bank lent out major part of capital (they put some reserve aside from deposited money to satisfy those short term obligation of depositors) then if depositors want their money back then bank may be in a position not able to pay those depositors because they lent out major part of capital. This mismatch is called liquidity constraints for the bank. To remove this liquidity constraints central banks comes into play and provide extra capital to banks to pay those depositors. But keep in mind central bank does not give money in free to banks. Banks must have to come with some assets generally government securities (as well as loans to their books) on which central bank lend money to the banks. And in some cases people who borrowed from bank also defaults hence this also create problems to pay money to the depositors and reduces confidence in central bank to lend money to the particular bank in the problem.
2.ARTIFICIALLY LOW INTEREST RATES
When central banks in influence of central governments try to put interest rate low to review the economy then savers (who put money in the bank) and investors try to find ways of high return on their capital and bet on risky assets with leverage. And when leverage comes into play due to less regulation then system becomes more fragile because on the default of fewer loans (loans are assets for banks) all the equity capital become worthless.Some people may think that this is the case for investment banks only not with consumer banking but due to interconnections between these, the system become fragile for consumer banks as well.
- TRUST.
Whole banking system is build on trust and if anything breaks it system become vulnerable.And it is very easy to break the trust. Warren Buffett once said "It takes 20 years to build the reputation but not more than 20 minutes to ruin it"
HOW TO REDUCE FRAGILITY ?
In case of liquidity problem bank have to attract capital from it's equity investors (people who gave money to open that bank with stake in it) and try to lessen the risky loan write downs to it's borrowers.Bank must have to keep in mind short term panic from depositors and have clear data on the how much capital they have and how much they can lent out if panic occurs.Do not try to artificially reduce interest rate at lower level artificially (by central bank), leave it to market forces.Never break trust with your customers by playing them for your firm's benefit.