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I'd like to ask this question in two different ways just to help clarify the issues.

Scenario 1. There is no deposit insurance and the central bank take no special action in response to the bank failure.

Scenario 2. In the real world, i.e. there is some deposit insurance and a central bank may take some kind of action.

I realise that the answer to these questions may be quite complicated so I am happy to simply be pointed to a paper that discusses these issues.

EDIT: The reason I ask, is because I have noticed that governments will rarely rescue companies if they are not banks however large they are whereas when a bank is in trouble there appears to be a sense in which it is almost imperative that they must be rescued. My suspicion is that at significant part of this imperative is due to the potential shrinkage of the money supply but this appears rarely mentioned. Basically, in order to understand the panic measures, I'd like to fully understand what it is that is being averted.

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What happens to the money supply when a bank is allowed to go bust

This depends on definition of money supply. I will use M2 Fed definition because it is very common.

Scenario 1. There is no deposit insurance and the central bank take no special action in response to the bank failure.

M2 unambiguously declines because some portion of deposits will be lost during bankruptcy, and by definition of M2 that means there is smaller money supply.

Scenario 2. In the real world, i.e. there is some deposit insurance and a central bank may take some kind of action.

The effect will be indeterminate because of lack of information.

  • Deposit insurance is limited, so without knowing if any accounts exceed it we can't say what happens.
  • monetary policy has an effect on M2, so regardless what happens in one bank failure overall M2 can increase, decrease or stay constant depending on various policies central bank decides to pursue. Since what exact policy CB pursues is not specified nothing more can be said about this.

The reason I ask, is because I have noticed that governments will rarely rescue companies if they are not banks however large they are whereas when a bank is in trouble there appears to be a sense in which it is almost imperative that they must be rescued. My suspicion is that at significant part of this imperative is due to the potential shrinkage of the money supply but this appears rarely mentioned. Basically, in order to understand the panic measures, I'd like to fully understand what it is that is being averted.

Central banks do this to prevent collapse of money supply, since Friedman and Schwartz (1963) showed that Great Depression was precipitated by collapse of money supply in US, caused by bank runs/failures and by Fed further reducing money supply through tight monetary policy.

However, you are incorrect in stating that government officials are not open about this. Bernanke literally openly talks about this in his speech that became basis for so called 'Bernanke doctrine'. In his 2002 speech Bernanke claims:

  • no 1. job of central bank is to keep prices stable which means not just fighting inflation but also preventing deflation
  • the way how you prevent deflation is by A) expansion of money supply (hence not only collapse of money supply should be prevented, money supply should be explicitly expanded). B) provision of sufficient liquidity. C) by keeping interest rate low.

Bernanke doctrine is not some secret and central bankers talk about it openly. You might never hear it in news because it might not be sexy for journalists to report on such matters, but it is simply not true that is is not explicitly discussed.

In addition, the reason why central banks rush to help of banks is that some banks are systemically important. Collapse of a single interconnected bank my cause financial meltdown and hurt even 'healthy' banks. So preventing bank failure is considered prudential, even if overall money supply can be expanded in spite of allowing single bank to collapse.

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  • $\begingroup$ You say "some portion" but exactly what portion could be quite critical 1%? 50%? 99%? especially if the bank is very large. If this is too much detail to go into or it depends on too many unspecified things then I'm perfectly happy to look at a paper which discusses these things - surely there must be one (or several). $\endgroup$
    – Mick
    Commented Apr 15, 2023 at 20:45
  • $\begingroup$ @Mick 1. that won't be discussed in any paper because it is too specific. That is like asking for a paper that discusses number of people that will retire this year of a single random unspecified 'bakery'. Nobody would do research like that as such paper would have no scientific value. 2. you can check statistics for number of uninsured deposits per bank visualcapitalist.com/… $\endgroup$
    – 1muflon1
    Commented Apr 15, 2023 at 22:24
  • $\begingroup$ Maybe my edit to the OP will clarify where I'm coming from. $\endgroup$
    – Mick
    Commented Apr 16, 2023 at 11:44

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