How safe is your money in a bank?
R. Ramanujam, Azim Premji Institute, Bengaluru
What happens when you put money in a bank? You probably have some cash to spare which you don't need immediately. But instead of putting it away in your cupboard, you go and deposit it in a bank. Why?
For every person who has some extra cash to spare, there is (at least) one person who needs it! Instead of letting your money lie in your cupboard, you can lend it to her. But how do you know you are going to get it back? And what advantage is there for you to do so? 
The answer to the first question lies with the banks. Let us say that Annapurni wants to borrow money from the bank for some reason. The banks "vet" the person and make sure that she has the capability to return it. If she already has the money, why then does she want to borrow it? Actually, she is most probably a business-woman who wants to expand her business, or she may want to start a new business venture and so needs a large lump-sum of money, called capital. Such people are sure that if you lend them money, they will make a substantial profit. So they will not only return your money, but an extra amount as well, which the bank charges as interest.
Now comes the second answer: since the banks have made a profit by lending your money to Annapurni, they give you some part of it as your interest. So the money that would have sat idly in your cupboard is actually making some more money for you, all without your doing any work. Since the bank does all the intermediate work, it also makes some money out of the deal, which it uses to pay its employers. So your little bit of money is channelled to investments which usually make money for everyone!
What happens if you are the one in need of money? Well, you have money in the bank; it is your money, and so you can withdraw it any time you like. You may have seen your parents withdraw cash from the bank using a withdrawal slip or a cheque. But wait a minute. Didn't the bank lend your money to Annapurni? Until she pays it back, how can the bank give you any money? This is where banks are different from individuals. Many many people have put their money in the bank. All of them may not want it at the same time. Also all of them may not want all of their money at one time. So the bank will simply shuffle the amounts around and will have enough money to pay you out whatever you may want.
All this depends on people feeling that their money is safe in the bank and that they can count on withdrawing it in a crisis. What happens if you lose this confidence? From time to time you may have heard of banks writing off large loans. For instance, a businessman may have borrowed a huge amount of money and found himself unable to pay it back, even in the interest, let alone the capital. At such times, the banks decide whether to pursue the money or write it off as a bad deal. Usually the banks absorb such losses since they also have a profit margin.
But if it happens too often, then the bank may be actually dipping into your savings to write off the loan. If this happens too often, people get jittery and may prefer to take their money out of the bank. Of course, if everybody were to ask for their money back at once, the bank will not be able to honour the requests and so the bank will collapse. The people who had money in the bank will also lose all their money.
Sometimes it is not necessary for such bad loans to occur. Even a rumour that the bank is doing badly can trigger such a "run" on the bank. In other words, banks are susceptible or vulnerable in times of such financial crisis. One way of avoiding this is to regulate the financial markets where such borrowing and returning occurs. Another is for the government to provide deposit insurance and as a last resort, to lend the required money to banks. In fact, nationalised banks in India such as the State Bank of India or Punjab National Bank are owned by the government of India.
Modern banking research clarifies why we have banks, how to make them less vulnerable in crises and how bank collapses make a financial crisis worse. The foundations of this research were laid by Ben Bernanke, Douglas Diamond and Philip Dybvig in the early 1980s. Their analyses have been of great practical importance in regulating financial markets and so they have been awarded the Nobel Prize in Economics, 2022, for their research.
Ben Bernanke analysed the Great Depression of USA which occurre in the 1930s. It was one of the worst economic crisis in modern history. Among other things, he showed how bank runs were a decisive factor in the crisis becoming so deep and prolonged.
At the heart of it, the function of a bank is to channel your saving to people who need them to grow the economy. When the banks collapsed, valuable information about borrowers was lost and could not be recreated quickly. So society’s ability to channel people's savings to productive investments was thus severely reduced. The work of Diamond and Dybvig show how banks offer an optimal solution to this problem. By acting as intermediaries that accept deposits from many savers, banks can allow depositors to access their money when they wish, while also offering long-term loans to borrowers. Diamond showed how banks perform another societally important function. As intermediaries between many savers and borrowers, banks are better suited to assessing borrowers’ creditworthiness and ensuring that loans are used for good investments.
The citation for the Nobel reads as follows:
"The Royal Swedish Academy of Sciences has decided to award the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2022 to Ben S. Bernanke, The Brookings Institution, Washington DC, USA, Douglas W. Diamond, University of Chicago, IL, USA, Philip H. Dybvig, Washington University in St. Louis, MO, USA, “for research on banks and financial crises”.
Their discoveries improved how society deals with financial crises.
Source: https://www.nobelprize.org