Fractional Reserve Banking and Insolvency
You bet if it was so simple. This is when financial acumen comes into its true form. The bank would never ever want to go insolvent. What it does is, take insurance against the borrower defaulting.  Remember the financial crisis of 2008 which was the outcome of borrowers defaulting. The banks had created derivatives based on the loans distributed. CDO, CDS are some of the simple derivatives banks sell to cover their backs in case of defaults. There are derivatives using these derivatives as underlyings which they then sold it across to other buyers including other banks. Google for Fabrice Tourre and you would realise how much deep the banks go to save themselves from defaulters. If everything fails then go to the government for help. That was what happened when the US government doled out $600 billion to save the financial sector. It certainly is possible for a run on the bank to drive it into insolvency.  And yes, if the bank makes some bad loans, it can magnify the problem. Generally, this does not happen, though.  Remember that banks usually have lots of customers, and people are depositing money and making mortgage payments every day, so there is usually enough on-hand to cover average banking withdrawl activity, regardless of any bad loans they have outstanding. Banks have lots of historical data to know what the average withdrawl demands are for a given day.  They also have risk models to predict the likelihood of their loans going into default.  A bank will generally use this information to strike a healthy balance between profit-making activity (e.g. issuing loans), and satisfying its account holders. In the event of a major withdrawl demand, there are some protections in place to guard against insolvency. There are regulations that specify a Reserve Requirement.  The bank must keep a certain amount of money on hand, so they can't take huge risks by loaning out too much money all at once.  Regulators can tweak this requirement over time to reflect the current economic situation. If a bank does run into trouble, it can take out a short-term loan.  Either from another bank, or from the central bank (e.g. the US Federal Reserve).  Banks don't want to pay interest on loans any more than you do, so if they are regularly borrowing money, they will adjust thier cash reserves accordingly. If all else fails and the bank can't meet its obligations (e.g. the Fed loan fell through), the bank has an insurance policy to make sure the account holders get paid.  In the US, this is what the FDIC is for.  Worst case, the bank goes under, but your money is safe. These protections have worked pretty well for many decades.  However, during the recent financial crisis, all three of these protections were under heavy strain.  So, one of the things banking regulators did was to put the major banks through stress tests to make sure they could handle several bad financial events without collapsing.  These tests showed that some banks didn't have enough money in reserve.  (Not long after, banks started to increase fees and credit card rates to raise this additional capital.) Keep in mind that if banks were unable to use the deposited money (loan it out, invest it, etc), the current financial landscape would change considerably. A bank is insolvent when it can no longer meet its short-term obligations.  In this example, the bank is insolvent when depositors withdraw more cash than the bank can pay out. In this case, it's probably something in the range of $600-700k, because the bank can borrow money from other banks using assets as collateral. In the US, we manage this risk in a few ways. First, FDIC insurance provides a level of assurance that in a worst-case scenario, most depositors will have access to their money guaranteed by the government. This prevents bank panics and reduces the demand for cash. The risk that remains is the risk that you brought up in your scenario -- bad debt or investments that are valued inappropriately. We mitigate this risk by giving the Federal Reserve and in some instances the US Treasure the ability to provide nearly unlimited capital to get over short/mid-term issues brought on by the market. In cases of long-term, structural issues with the bank balance sheets, regulators like the FDIC, Federal Reserve and others have the ability to assume control of the bank and sell off its assets to other, stronger institutions. The current financial regime has its genesis in the bank panics of the 1890's, when the shift from an agricultural based economy (where no capital is available until the crops come in!) to an industrial economy revealed the weakness of the unregulated model where ad hoc groups of banks backed each other up. Good banks were being destroyed by panics until a trusted third party (JP Morgan) stepped in, committed capital and make personal guarantees. "Your question points out how most fractional reserve banks are only a couple of defaults away from insolvency. The problem arises because of the terms around the depositors' money.  When a customer deposits money into a bank they are loaning their money to the bank (and the bank takes ownership of the money).  Deposit and savings account are considered ""on-demand"" accounts where the customer is told they can retrieve their money at any time.  This is a strange type of loan, is it not?  No other loan works this way.  There are always terms around loans - how often the borrower will make payments, when will the borrower pay back the loan, what is the total time frame of the loan, etc..  The bank runs into problems because the time frame on the money they borrowed (i.e. deposits) does not match the time frame on the money they are lending."
Doesnt mean that equity or even debt holders wouldn't lose their investment.  Those money and banking texts are presently useless post GFC given the incredible moral hazard and how all of the traditional bankruptcy rules were ignored. Yeah, and what blows my mind most is that there was a very easy out for regulatory relief that would have actually brought us closer to compliance with BCBS rules. In the US the threshold for Basel rules is $50B in assets, while under Basel III and in most of the world its €250B. Just adopting this standard would give small banks relief. As an aside, the new law would also make it harder for the Fed to adopt the Basel III finalization rules, which are incredibly advantageous to US banks and which we fought hard for. This article talks about State controlled banking, before 1913 - the power of printing money and all that was under control of the State (Congress). If they shut down the Federal Reserve, they would then be able to eliminate the fractional reserve banking method and government wouldn't have to pay intertest to borrow in their own currency. If thats how you feel (its how I feel )  then the last thing you want bankers doing is accepting deposits from people who think their money is not being risked, then making loans with it (fractional reserve banking).  And fdic is not an answer to that fundamental problem. How can banks be expected to make good decisions when they are not responsible for creating their own reserve? Do you think that the banking system could run without FDIC? And why? And what is your opinion on local banking vs. big corp banking? Your question contains two different concepts: fractional reserve banking and debt-based money.  When thinking of these two things I think it is important to analyze these items separately before trying to understand how the whole system works. Fractional Reserve Banking As others have pointed out fractional reserve banking is not a ponzi scheme.  It can be fraudulent, however.  If a bank tells all its depositors that they can withdrawal their money at any time (i.e. on demand) and the bank then proceeds to loan out some portion of the depositors' money then the bank has committed fraud since there is no way they could honor the depositors' requests for their money if many of them came for their money at one time.  This is true regardless of what type of money is deposited - dollars, gold, etc..  This is how most modern banks operate. Debt-based money Historically, the Fed would introduce new money by buying US Treasuries.  This means Federal Reserve Notes (FRN) are backed by US Treasuries.  I agree that this seems strange.  Does this mean if I take my FRNs to the Fed I could redeem them for US Treasuries?  But US Treasuries are promises to pay FRNs in the future.  This makes my head hurt.  Reminds me of the definition for recursion: see recursion. Here is an experiment.  What if we wanted to recreate FRNs today and none existed?  The US government would offer a note to pay 100 FRNs in one year and pay 5% interest on the note.  The Fed would print up its first 100 FRNs to buy the note from the US government.  The US government would spend the FRNs.  The first 100 FRNs have now entered into circulation.  At the end of the note's term the Fed should have 105 FRNs since the government agreed to pay 5% interest on the note.  But how is the US government going to pay the interest and principal on the note when only 100 FRNs exist?  I think this is the central point to your question.   I can come up with only two answers: 1) the Fed must purchase some assets that are not debt based 2) the US government must continue to issue debt that is purchased by newly printed FRNs in order to pay back older debt and interest.  This is a ponzi scheme. The record debt levels seem to indicate the ponzi scheme option was chosen. as in, the person you made the agreement with can no longer fulfill the contract's requirements. It's the same thing as if they went bankrupt, you would have to pursue legal channels to recover your dues.      Granted in an FX forward you would only have to deliver your part at expiration, so you could hold out if you *know* the counterparty is dead/bankrupt. "Why would a bank buy government bonds? Why couldn't they just deposit their money in another bank instead?  Generally, banks are limited by laws and regulations about how much they must set aside as reserves. Of the money they receive as deposits, they may loan a certain amount, but must keep some as a reserve (this is called ""fractional reserve banking""). Different countries have a different amount that they must set aside in reserves.  In countries where bank deposits are guaranteed, there is almost always some upper limit to how much is guaranteed. The amount of money that a bank would deposit in another bank would be far greater than the guarantee." Everyone understands the necessity of those bailouts today. But I still contest that they were a net negative for the common man and a HUUUUUUUUUGE positive for the bank executives. In fact, the fallout from it - the conceptualisation of TBTF and GSIB etc - is basically a blank check for these banks. Oh yes, so many stringent regulations that we know for a fact that these banks will flout at the first opportunity available to them. And then, assuming it doesn't bring the global economy to its knees, someone will slap a billion dollar fine on them and let them go on their merry way. I don't know much about the convertible debt space, but it seems like this regulation may be a positive sign that the government is being proactive in preventing financial institutions from developing overly complex debt structures (at least on an on-going basis) that get the global economy back into trouble.  Does anyone with a more informed opinion than my own have something to share? "SIPC is a corporation - a legal entity separate from its owners. In the case of SIPC, it is funded through the fees paid by its members. All the US brokers are required to be members and to contribute to SIPC funds. Can it go bankrupt? Of course. Any legal entity can go bankrupt. A person can go bankrupt. A country can go bankrupt. And so can anything in between. However, looking at the history of things, there are certain assumptions that can be made. These are mere guesses, as there's no law about any of these things (to the best of my knowledge), but seeing how things were - we can try and guess that they will also be like this in the future. I would guess, that in case of a problem for the SIPC to meet its obligation, any of the following would happen (or combinations): Too big to fail - large insurance companies had been bailed out before by the governments since it was considered that their failure would be more destructive to the economy than the bailout. AIG as an example in the US. SIPC is in essence is an insurance company. So is Lloyd's of London. Breach of trust of the individual investors that can lead to a significant market crash. That's what happened in the US to Fannie Mae and Freddie Mac. They're now ""officially"" backed by the US government. If SIPC is incapable of meeting its obligation, I would definitely expect the US government to step in, even though there's no such obligation. Raising funds through charging other members. If the actuary calculations were incorrect, the insurance companies adjust them and raise premiums. That is what should happen in this case as well. While may not necessarily solve a cashflow issue, in the long term it will allow SIPC to balance, so that bridge loans (from the US government/Feds/public bonds) could be used in between. Not meeting obligations, i.e.: bankruptcy. That is an option, and insurance companies have gone bankrupt before. Not unheard of, but from the past experience - again, I'd expect the US government to step in. In general, I don't see any significant difference between SIPC in the US and a ""generic"" insurance coverage elsewhere. Except that in the US SIPC is mandatory, well regulated, and the coverage is uniform across brokerages, which is a benefit to the consumer." Cyprus could be *forced* into such a position because the deposits are euro-denominated and the issuing central bank sits outside the sovereign authority of Cyprus. So they could go, hat in hand, to the ECB asking them to backstop deposits. A lender of last resort function that is more or less a given in countries with their own sovereign currencies.  In a country like the US, where deposits are denominated in US dollars and the US is the issuer of the dollar, there would always be a option. Bail-ins are certainly possible as a political choice but they'd never be the only option. Which is why you didn't see them or depositor losses of any kind in spite of hundreds of bank failures in the wake of the 2008 crisis. Most national banks are required by the regulations of their host countries to hold significant reserves in the form of government debt. A default would likely wipe out their capital and your common stock would become worthless. The common stock only has positive value today because of the option value based on the possibility the host country will evade a default. "It's helpful to remember that Charles Ponzi started with a legitimate arbitrage (international postal remittances).  Once purveyors of arbitrage reach a certain scale, there's a natural tendency to become lazy and just forgo the arbitrage and just use new investor money to pay off previous investors.  Banks wouldn't be any different if it weren't for central banks and government participation.  Indeed, the primary reason that the FedResInk came into existence is **because** of ponzi-like bank failures (bankers call them ""a run on the bank"").  Neoclassical economics is about using the synthesis of state sovereignty and central bank monetary theory to keep the system they've developed intact.  ...and, as fun as it might be to sit back and calculate just how much debt can be created from a life-time of labor proceeds (a couple million for the average person-- completely hypothetical back of the envelope inflation excluded, 4.5x10^14, which is still in middle of the trillions), it would be wise to keep in mind that the last banking crisis, while fundamentally caused by the inability to collect future labor proceeds, was precipitated, not by individuals, but by repurchase agreements propping up extremely leveraged positions made by and between massive investment banks.  So, the thing to remember is that fractional reserve debt issuance banking is like a 10 to 1 transistor that has a fundamental tolerance requirement on the source signal, but that when the source signal fades, it can draw from the surplus signal created by the 10 to 1 amplification (up to a certain point and then the transistor goes up in a puff of smoke)." Have you ever considered how much faith and confidence play a role in the financial sector?  The calling in of swaps could cause issues similar to a Bank Run, which may or may not involve others coming into play.  While this is cleaning up the mess from a few years ago, there is something to be said for how complicated are various financial instruments in this situation. If you want something similar to ponder, what would make any institution be considered major and would this be agreed by various countries given how connected things are within the world?  What makes an institution major in the United States may not be quite the same standards in Brazil and this where one has to consider how to maintain faith in the system that could unravel rather badly if everyone tries to cash out at the same time.  The Bank Run link above is something to consider that could cause a bank that appears fine to suddenly have speculators cause more disruptions which isn't likely to help.  The global credit markets aren't likely to freeze overnight and thus there can be the question how does this get handled if another mess could arise. The idea here is to set up the framework to prevent the panic that could lead to a global depression.  The idea is to create for derivatives something similar to the stock market's trading curbs that exist to contain panic on a macro level.  The psychology is quite important in figuring out how to handle the obligations of a company that was perceived to be infallible as well as making sure what is agreed works across various cultures and currencies.