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Knowledge Base

Effective Financial Reform



What is equity-financed banking?

Equity-financed banking is a new way finance a bank in a way that prevents financial runs. Traditional banks take short-term deposits and use them to make long-term loans. They rely on debt to finance further operations. They earn money on the spread between short-term holdings and long-term loans and hold just enough capital for a small portion of people to be able to withdraw their money at any one time. If too many people try to get their money out at the same time, there is a “bank run” and the bank will fail.

Equity-financed banks instead take all deposits and immediately purchase risk-free bonds like Treasury bonds that are liquid, visible, and always able to be redeemed. To raise funds for expansion or operations, equity-financed banks could sell equity on the open market or retain any shareholder earnings. The price of equity could rise and fall, but since depositors’ money is backed up by equity, bank runs would be eliminated.

What are bank runs?

Bank runs occur when banks have borrowed too much - and issued so little equity - that losses in the value of bank assets make it unlikely that the bank can pay all its borrowers back.

When the economy or the health of the bank appears to be good, bank runs are unlikely. But once individuals believe that it is possible they won’t be able to get their money back from the bank, too many people try to withdraw funds at the same time. Since many banks keep only a fraction of deposits on hand in order to keep the value of their assets at a stable level, they are at risk of failing.

Why do financial crises happen?

Financial crises are runs, no more and no less. A run occurs when creditors such as depositors or overnight lenders, unsure of a bank’s long-run prospects, demand their money immediately, each anxious to be repaid first. When the bank cannot borrow elsewhere, issue equity, sell assets, or otherwise raise cash to fulfill its promises to such creditors, the bank fails. A crisis is a systemic run: simultaneous runs on many related banks or similar financial institutions.

What is a financial system?

A financial system is a system that covers financial transactions and the exchange of money between investors, lender, and borrowers. A financial system can be defined at the global, regional or firm-specific level.

What is equity financing?

Equity financing is the process of raising money through the sale of shares in an enterprise. It essentially refers to the partial sale of ownership in order to raise funds for business purposes.

What are Treasury bonds?

Treasury bonds are bonds issued by the government to the public in order to finance the government’s spending activities. Treasury bonds make interest payments and come in various maturity terms. They are known as risk-free bonds since it assumed the government would never default. At the very least, it has the ability to print more money.

How is capital different from reserves?

Capital is money that the bank gets by selling stock, which it can use to invest. Reserves are very liquid assets, such as vault cash or accounts at the Fed, that the bank can use to meet sudden demands for withdrawals. Reserves are an asset of the bank and equity is a liability of the bank.