It’s hardly the whole story, but here is a clearly-written explanation (from the final report of the Sharman Inquiry) of why one of the basic purposes of banks – maturity transformation – makes them inherently unstable:
“…the business model of banks is to perform a financial intermediation role, known as maturity transformation – on the whole, channelling collective funds obtained through shorter term borrowing into longer term loans and investments. This creates a maturity mismatch between the dates on which the bank’s liabilities fall due for payment and the dates on which it can call for repayment of its assets. This makes banks’ funding models inherently unstable.
Confidence in the bank’s solvency is what sustains this business model in the face of such instability. Depositors and other lenders roll over their loans to the bank, or other lenders replace them, when they are confident that the bank will continue to be solvent and viable. On the other hand, fear about the future viability and solvency of the bank provokes expectations of delayed or non‐repayment and precipitates withdrawal of loans by existing lenders and deters others from replacing them. Gearing, market‐based funding models, potential off‐balance sheet exposures and other complexities in their operating models may further exacerbate these fears.
Given that a bank has limited liquid resources compared to its liabilities, a run results from knowledge that its liquid assets will be insufficient to fund repayment to all lenders when due, exposing those who linger to increased risk of delayed repayment and a greater share of the risk that losses on the remaining assets will exceed capital. There is a rush to the exit at the first hint of going concern issues. A bank’s business model cannot be sustained in these circumstances and it will fail. In the banking business, such failure can be infectious and rapidly spread to other banks.
The banking system provides a range of financial services (payment systems, savings accounts and credit), which oil the wheels of the economy. There is a significant public interest in preventing disruption to these services but there would also be a moral hazard in protecting them at all costs. This might encourage irresponsible risk taking in the knowledge that society would protect them against the costs of failure. A balance has to be struck.
The Bank of England, amongst others, is responsible for protecting and enhancing the stability of the UK financial system. It works within a balanced framework set by law which recognises not only the importance of stability but also that the possibility of failure engenders market discipline. Where support can be justified, it is provided (if necessary, at cost to the public purse with HM Treasury approval) whilst seeking to avoid rewarding commercial failure.
Whereas protection from solvency issues resulting from poor commercial practice (such as weak lending models) cannot be justified, measured support to mitigate temporary system‐wide or entity‐specific liquidity shocks experienced by solvent and viable banks is a critical ingredient of the financial stability toolkit. When a bank is judged not to be solvent or viable, support is not justified, failure ensues and the objective is to minimise the impact of that failure on the financial system and the economy.”
See also: The Quiet Coup – The Atlantic