How can a bank go bankrupt?

American banks certainly went bust in the Great Depression: 659 in 1929, 1,352 in 1930 and 2,294 in 1931. The question is: How?

The thing was that the American boom, farms and their equipment, the new factories and their machinery, the new roads, the huge department stores, and the purchase of shares, buying ‘on the margin’, was largely financed by borrowing. And who lent much of the money? That’s right, the banks. Just with regard to the buying of shares, banks lent $9 billion in 1929 alone.

Now banks use the money from the savings accounts they hold. That’s why, we pay more in interest for a loan than we will earn from our savings account. It’s how banks make money: they lend to me, at say 10%, and they pay you 8% for saving with them. But if they make bad decisions in lending money, or if something out of their control happens that affects the loans they have given, then they can find themselves short of fluid capital. To put it simply, they can find themselves without money in the bank.

And to make it personal, it can mean that the money you had collecting 8% from your savings account has been lent to me, and if I can’t pay it back and neither can other people, and the bank has over-extended itself in its loans (looking to maximise its profits), then the bank goes bankrupt and you lose your savings. It sucks, but there you are, and that’s where many banks, and many savers, found themselves in the Great Depression.