A significant amount of legislation passed in the 20th century sought to reduce the risk of future economic events like the liquidity crisis experienced by banks during the Panic of 1907. Which of the following policies would increase the risk of a liquidity crisis?
Banks in need of cash are offered low-interest loans from the Federal Reserve.
Banks are required to store a larger percentage of depositor funds in their vaults.
Banks are required to store a smaller percentage of depositor funds in their vaults.
Banks in need of cash are offered low-interest loans from other banks.
The policy that would increase the risk of a liquidity crisis is "Banks are required to store a smaller percentage of depositor funds in their vaults." This policy reduces the amount of reserves that banks hold, which makes them more vulnerable to a sudden demand for withdrawals. In times of financial stress, depositors may rush to withdraw their money, and if banks have insufficient reserves, they may not be able to meet these demands, resulting in a liquidity crisis. The other policies listed would help to prevent or mitigate liquidity crises.
To determine which of the following policies would increase the risk of a liquidity crisis, we need to understand what a liquidity crisis is and how these policies relate to it.
A liquidity crisis arises when banks and financial institutions experience a shortage of cash or available funds to meet their immediate obligations. During such crises, banks struggle to meet depositor withdrawal demands or to honor their payment obligations, which can lead to financial instability and even economic recessions.
Let's analyze each policy and its potential impact on the risk of a liquidity crisis:
1. Banks in need of cash are offered low-interest loans from the Federal Reserve.
This policy would decrease the risk of a liquidity crisis. By providing banks with low-interest loans, the Federal Reserve ensures that they have access to additional funds to meet their immediate liquidity needs. This reduces the chances of a shortage of cash and helps stabilize the financial system.
2. Banks are required to store a larger percentage of depositor funds in their vaults.
This policy would also decrease the risk of a liquidity crisis. When banks are mandated to keep a larger portion of depositor funds in their vaults, they are maintaining a higher level of reserve requirements. This acts as a buffer against potential withdrawals, reducing the risk of cash shortages during times of market stress.
3. Banks are required to store a smaller percentage of depositor funds in their vaults.
In contrast to the previous policies, this policy would increase the risk of a liquidity crisis. When banks are required to store a smaller percentage of depositor funds in their vaults, it means they have fewer reserves available to meet withdrawal demands. If a large number of depositors simultaneously withdraw their funds, the bank may not have enough cash to honor those requests, leading to a liquidity crisis.
4. Banks in need of cash are offered low-interest loans from other banks.
This policy would decrease the risk of a liquidity crisis. By allowing banks to borrow from other banks, they gain access to additional cash, especially during times of stress when liquidity is scarce. This interbank lending helps prevent liquidity shortages and helps stabilize the banking system.
Based on our analysis, the policy that would increase the risk of a liquidity crisis is when banks are required to store a smaller percentage of depositor funds in their vaults (option 3).