From the Economist's Buttonwood blog:
WHEN share and house prices collapsed in 2008, Buttonwood’s
father-in-law asked what happened to the trillions of dollars of wealth
that had disappeared. Uninsured Cypriot bank depositors are asking the
same question about the money that is likely to vanish from their
accounts. The answer to both questions is remarkably similar.
First, those equity and property prices. In a free market, like an
auction, prices are set by the marginal buyer and seller. If there is an
imbalance between willing buyers and sellers (as there was in American,
Spanish and Irish housing in the middle of the last decade), then
prices will rise sharply. The average homeowner feels wealthier as a
result.
But only a small proportion of the housing stock (or of equities)
trades on any given day. The price set by marginal buyers and sellers is
not the price that could be realised if all owners of the asset in
question tried to sell their holdings at the same time. In such a
moment, there will be more willing sellers than buyers, and prices will
plunge.
High house or share prices, relative to personal incomes or profits,
represent a bet that the good times will continue, and that incomes and
profits (and cashflows in the form of dividends or rents) will rise
significantly in future. When that bet proves wrong, the wealth
disappears.
Now to the banks. When a customer deposits money, a bank must do
something with it: buy assets or lend it to businesses. That is the
banking system’s economic function; it transforms short-term liabilities
(deposits that can be instantly withdrawn) into longer-term loans.
Banks have always been at risk of two things: that the loans will not be
repaid, and that customers will want to withdraw their deposits faster
than the bank can turn its assets into cash. Until the 1930s bank
failures, and the resulting losses to depositors, were a recurring
problem.
Depositing money in a bank therefore amounts to a bet that the bank
will lend its money wisely, or that the economy will be strong enough
for bank loans to be repaid, and that confidence in the banking system
will be maintained. In the modern era bank customers have tended to
regard this risk as negligible, thanks to a combination of deposit
insurance and governments’ willingness to rescue failing banks. But in
many countries the banking sector has grown so large, relative to the
economy, that few governments could plausibly guarantee all their
system’s deposits. In such circumstances bank customers, particularly
uninsured depositors, are in effect relying on the governments of other
countries to bail them out in times of trouble—a risky proposition....MORE
