Question

a bank faced with a large and sudden loss of deposits is likely to shut down despite a fundamentally sound balance sheet. why could this be? a. banks have accountants that are too optimistic. b. banks purposely lie about their balance sheets in order to attract more clients. c. many bank assets are illiquid and cannot be sold quickly to meet deposit obligations without substantial loss to the bank. d. many banks operate on a budget that exceeds their actual reserves. e. many banks will shut down to preserve their interest profits.

Answer 1

A bank can shut down despite a sound balance sheet due to illiquid assets and the risk of a bank run. The asset-liability time mismatch means assets cannot quickly cover deposits if many withdrawals occur.

Step-by-step explanation:

A bank faced with a large and sudden loss of deposits is likely to shut down even with a fundamentally sound balance sheet due to the fact that many bank assets are illiquid and cannot be converted to cash quickly. This situation is often referred to as a bank run, where the fear and uncertainty of a potential bank failure lead to many depositors withdrawing their funds simultaneously. Banks typically do not keep a majority of deposits on hand because they invest in longer-term assets like loans and bonds which yield interest. These assets can take years or decades to mature, thus creating an asset-liability time mismatch. In scenarios where interests rates rise, banks need to balance the interest they pay to depositors and the interest they receive from loans, as paying out more in interest than receiving can lead to insolvency.