What happens to the economy if people lose faith in the safety and security of financial institutions?
However, it is worth noting that the whole system of finance depends on public confidence and a deep belief in the system. In case depositors start losing confidence in banks and start worrying that their deposits may come into the risk of being lost or them being unable to access their own money, it may lead to the spread of a tremor over the economy.
Must Read: Nearly one-quarter of Americans would part ways with a financial institution after an organizational misdeed.
Bank Runs and Financial Crisis
If worries about the bank's solvency and regulation hit the breaking point, investors can start to have a bank run. A bank run is a phenomenon in which a significant number of depositors place withdrawal requests at the same time out of concerns related to the bank’s financial well-being. This leads to a depletion of the bank's cash liquidity, and in a way, the bank ends up failing even when it was solvent earlier.
In bank runs, it is not unusual for failures at one bank to spark fears and contagion in other banks, which then spread financial panic across the banking system. These two things just as the Great Depression of the 1930s when both formed and made the money supply as well as credit frozen and severely disrupted the usual way of doing businesses.
Disruption of Lending Function and Spending.
The bank collapse and the systemic risk is not the only thing that can cause problems before this scenario, but already the slight lack of confidence in the financial institutions can cause problems. If there is a so-called confidence crisis which would make people be concerned about the safety of their bank deposits, some of them may pull money out of banks and hold it in their vaults which they think are safer.
This results in the declining loans that banks have to give to small businesses, home buyers, and other borrowers who use credits for their business growth which by turns is the economy growth, just the opposite of the effect of the rate cut. This is pushed forward by the fact that it also decreases the attractiveness of banks for individuals to use their cards and other borrowing services.
The consequence is in less investment on agriculture and consequently on business, less home purchases, low consumer spending, and slow economic growth. As a matter of fact the amount of money flowing at the very economic level would slow down drastically.
Government Intervention
To prevent the eruption of it, the governments should often provide help to strengthen the financial system. This comprises for example ensuring that deposits are insured, injections of needed capital to banks, and making more strict regulations.
On the other hand, the role of the government is to stop further damages in the financial system. Yet, trust has to be earned back from the ordinary people whose properties and assets were lost. When people’s faith in the security and smooth operation of the banking system is overwhelmed by the governing officials that put their own interests first, it is transparency, accountability, and good governance that can gradually win their trust.
To conclude, financial system is of enormous importance to overall economy. When individuals come to be suspicious of the security of financial institutions such as banks, it not only leads to bad consequences, but also acts like a doomsday trigger which unleashes a string of factors like bank runs, credit lockdown, low investments and consumption, and overall economic shrinkage. The Reestablishment of confidence in such institutions is a long yet crucial command in order to attain economic recovery.