A new bank is incorporated with initial capital of £10m.
The bank issues bonds for £10m, checkable deposits for £15m and must hold 5% of assets in reserves at all times. The remaining funds are loaned out.
The bank collects interest of 5% on loans and pays 4% to bondholders.
The housing market turns sour. Borrowers stop paying interest, but the bank must honour its obligation to bond holders. It pays 4% to bondholders but collects no interest.
The value of loans falls by 10%.
Depositors read on the news that the housing market is under strain. They worry the bank may not honour its deposits, so they rush to the bank and withdraw £5m deposits.
