What is a Bank Run?
A bank run takes place when consumers simultaneously withdraw their deposits in the fear that the bank is not solvent influencing more consumers to withdraw their funds and most likely causing the bank to default.
Definition: A bank run is a series of unexpected cash withdrawals caused by a sudden decline in depositor confidence or fear that the bank will be closed by the chartering agency, i.e. many depositors withdraw cash almost simultaneously. Since the cash reserve a bank keeps on hand is only a small fraction of its deposits, a large number of withdrawals in a short period of time can deplete available cash and force the bank to close and possibly go out of business.
A bank run (also known as a run on the bank) occurs when many clients withdraw their money from a bank, because they believe the bank may cease to function in the near future. In other words, it is when, in a fractional-reserve banking system (where banks normally only keep a small proportion of their assets as cash), numerous customers withdraw cash from deposit accounts with a financial institution at the same time because they believe that the financial institution is, or might become, insolvent; they keep the cash or transfer it into other assets, such as government bonds, precious metals or gemstones. When they transfer funds to another institution, it may be characterized as a capital flight. As a bank run progresses, it generates its own momentum: as more people withdraw cash, the likelihood of default increases, triggering further withdrawals. This can destabilize the bank to the point where it runs out of cash and thus faces sudden bankruptcy. To combat a bank run, a bank may limit how much cash each customer may withdraw, suspend withdrawals altogether, or promptly acquire more cash from other banks or from the central bank, besides other measures.
What Does Bank Run Mean?
A banking panic or bank panic is a financial crisis that occurs when many banks suffer runs at the same time, as people suddenly try to convert their threatened deposits into cash or try to get out of their domestic banking system altogether. A systemic banking crisis is one where all or almost all of the banking capital in a country is wiped out. The resulting chain of bankruptcies can cause a long economic recession as domestic businesses and consumers are starved of capital as the domestic banking system shuts down.
According to former U.S. Federal Reserve chairman Ben Bernanke, the Great Depression was caused by the Federal Reserve System, and much of the economic damage was caused directly by bank runs. The cost of cleaning up a systemic banking crisis can be huge, with fiscal costs averaging 13% of GDP and economic output losses averaging 20% of GDP for important crises from 1970 to 2007.
Several techniques have been used to try to prevent bank runs or mitigate their effects. They have included a higher reserve requirement (requiring banks to keep more of their reserves as cash), government bailouts of banks, supervision and regulation of commercial banks, the organization of central banks that act as a lender of last resort, the protection of deposit insurance systems such as the U.S. Federal Deposit Insurance Corporation, and after a run has started, a temporary suspension of withdrawals. These techniques do not always work: for example, even with deposit insurance, depositors may still be motivated by beliefs they may lack immediate access to deposits during a bank reorganization.
Bank Run Example
Let’s say a bank has 10 savers, and each of them deposited $5,000 in the bank. Now the bank has a total available capital of $50,000 collected from the saver.
If there is a 10 per cent reserve requirement, the bank can provide loans up to $45,000. The bank keeps $10,000 in cash for daily operations and provides $35,000 to its borrowers. After a while, two of the savers withdraw their deposit with a total value of $10,000 (each deposit is $5,000). In this situation, the bank has liquidity issues since it has no cash on hand.
The other depositors have heard somewhere about the liquidity problem the bank is facing. They all rush to the bank to withdraw their deposits with a total value of $35,000. The bank is not able to cover these withdrawals because the funds are tied up in the loans provided. Accordingly, a bank run happens.
The First Bank Runs
The United States stock market crash in 1929 left the public susceptible to rumors of an impending financial crisis. There was a decrease in investment and consumer expenditure, which led to increased unemployment and a decline in industrial production. A wave of banking panics worsened the situation, with anxious depositors rushing to withdraw their bank deposits. The simultaneous withdrawals forced banks to liquidate loans and sell their assets to meet the withdrawals.
The first bank run started in Nashville, Tennesse, in 1930 and this triggered a wave of bank runs in the Southeast as customers rushed to withdraw their deposits. Banks hold only a fraction of their total deposits, with the rest of the deposits being loaned out to other clients. Due to a cash shortage, banks were forced to liquidate loans and sell assets at rock-bottom prices to supplement the mass withdrawals. Other bank runs followed in 1931 and 1932. Bank runs were most rampant in states whose laws mandated banks to run only a single branch, and this increased the risk of failure.
The biggest casualty of the banking crisis was the Bank of the United States in December 1930. A customer walked into the New York branch of the bank and asked to sell off his stock in the bank. However, the bank advised him against selling the stock since it was a good investment. The customer left the bank and started spreading rumors that the bank had refused to sell his stock and it was facing insolvency. Within hours, the bank’s customers lined up outside the bank and made withdrawals totaling $2 million in cash.
In the 1930s, the US saw numerous bank runs. The causes of this were:
- Growth in credit during the 1920s. For example, many consumers bought shares ‘on the margin,’ i.e. borrowed money to buy shares.
- There was no lender of last resort for commercial banks
- Banks were local and focused on a particular region. When a local business went under, everyone knew it would affect their local bank.
- The Wall Street Crash of 1929 caused stock market investors to lose money – especially those who bought on the margin. Many ‘paper millionaires became broke – owing more than they owed. This caused an increase in bank withdrawals.
- More seriously, banks also lost money from lending people money, which they now couldn’t pay back after the stock market fall.
- Agricultural recession. Throughout the 1920s, US agriculture was in recession with many farmers going out of business due to low prices and poor harvests.
- Great Depression. The economic panic caused consumers to cut back on spending and firms to cut back on investment. Economic growth and GDP fell sharply, leading to firms going bust and unemployment to rise.
- Regional banks saw a deterioration in their balance sheet. Their assets fell due to loan defaults and falling asset prices.
- Some regional banks started to struggle to meet the demand for withdrawals. This created a loss of confidence in the local, regional banks and investors became sensitive to news their bank would be next. Any negative news would create an incentive for people to rush to the bank and withdraw money before they went out of business.
Even the smallest negative news could cause problems. In Dec 1930, the New York Times reported a small merchant was advised by the Bank of the United States that his stock was a good investment. But, the merchant took this as a warning that the bank was refusing to sell his stock. The news spread like wildfire and within hours, 3,000 depositors had withdrawn $2 million.
Recovery from Bank Runs
After assuming office in 1933 as the 32nd President of the United States, Franklin D. Roosevelt declared a national bank holiday. The holiday allowed for federal inspection of all banks to determine if they were solvent enough to continue operations. The president also called on the US Congress to come up with new banking legislation to help the ailing financial institutions.
In 1933, President Roosevelt gave speeches that were broadcast on the radio, assuring American citizens that the government would not want to see other incidents of bank failures. He assured the public that the banks would safeguard their deposits once they resumed operations and that it was safer to keep money in the bank than to keep it under the mattress. Roosevelt’s actions and words marked the start of a restoration process where citizens would trust the banks again.
The Banking Act of 1933 led to the formation of the Federal Deposit Insurance Corporation (FDIC). The act gave the body the authority to supervise, regulate, and provide deposit insurance to commercial banks. The body was also responsible for promoting sound banking practices among banks and maintaining public confidence in the financial system. To avoid triggering a bank run, the FDIC performs takeover operations in secret and closed banks re-open in the next business day under new ownership.
Causes of a Bank Run
When savers invest money in a bank. The bank doesn’t keep all the deposits in cash reserves. It is more profitable for a bank to lend a high percentage of deposits in the form of loans. It is lending money to homeowners and business, which allow the bank to make a profit on its deposits. If a bank had deposits of $1 billion, it might lend out $0.95 billion and keep only a reserve of $0.5bn (or 5% of deposits)
If savers all demanded their cash at once, the bank wouldn’t be able to meet the demand for cash. It would have to call in loans or sell its assets. However, the bank relies on this not occurring. In normal circumstances, the bank can predict how much cash savers will need to withdraw.
However, suppose the bank lent out money to a business, but there is a recession. Firms go out of business and its bank loans default. Also, if house prices fall and consumers can’t meet mortgage repayments, the banks will lose on its mortgage loans. In other words, the bank is losing money on its loan. Its balance sheet deteriorates, and its liabilities (deposits) could become greater than its assets (loans).
If consumers hear bad economic news and news that a bank may be going out of business, then there is an incentive for consumers to withdraw their money before the bank does go out of business. When news spreads that other savers are withdrawing money, it creates a snowball effect and encourages other savers to also want to withdraw money.
Prevention and Mitigation
In response to the turmoil of the 1930s, governments took several steps to diminish the risk of future bank runs. Perhaps the biggest was establishing reserve requirements, which mandate that banks maintain a certain percentage of total deposits on hand as cash.
Additionally, the U.S. Congress established the Federal Deposit Insurance Corporation (FDIC) in 1933. Created in response to the many bank failures that happened in the preceding years, this agency insures bank deposits. Its mission is to maintain stability and public confidence in the U.S. financial system.
But in some cases, banks need to take a more proactive approach if faced with the threat of a bank run. Here’s how they may do it.
Now several techniques have been used to help prevent or mitigate bank runs.
Some prevention techniques apply to individual banks, independently of the rest of the economy:
- Banks often project an appearance of stability, with solid architecture and conservative dress.
- A bank may try to hide information that might spark a run. For example, in the days before deposit insurance, it made sense for a bank to have a large lobby and fast service, to prevent the formation of a line of depositors extending out into the street which might cause passers-by to infer a bank run.
- A bank may try to slow down the bank run by artificially slowing the process. One technique is to get a large number of friends and relatives of bank employees to stand in line and make many small, slow transactions.
- Scheduling prominent deliveries of cash can convince participants in a bank run that there is no need to withdraw deposits hastily.
- Banks can encourage customers to make term deposits that cannot be withdrawn on demand. If term deposits form a high enough percentage of a bank’s liabilities its vulnerability to bank runs will be reduced considerably. The drawback is that banks have to pay a higher interest rate on term deposits.
- A bank can temporarily suspend withdrawals to stop a run; this is called suspension of convertibility. In many cases the threat of suspension prevents the run, which means the threat need not be carried out.
- Emergency acquisition of a vulnerable bank by another institution with stronger capital reserves. This technique is commonly used by the U.S. Federal Deposit Insurance Corporation to dispose of insolvent banks, rather than paying depositors directly from its own funds.
- If there is no immediate prospective buyer for a failing institution, a regulator or deposit insurer may set up a bridge bank which operates temporarily until the business can be liquidated or sold.
- To clean up after a bank failure, the government may set up a “bad bank”, which is a new government-run asset management corporation that buys individual nonperforming assets from one or more private banks, reducing the proportion of junk bonds in their asset pools, and then acts as the creditor in the insolvency cases that follow. This, however, creates a moral hazard problem, essentially subsidizing bankruptcy: temporarily underperforming debtors can be forced to file for bankruptcy in order to make them eligible to be sold to the bad bank.
Some prevention techniques apply across the whole economy, though they may still allow individual institutions to fail:
- Deposit insurance systems insure each depositor up to a certain amount, so that depositors’ savings are protected even if the bank fails. This removes the incentive to withdraw one’s deposits simply because others are withdrawing theirs. However, depositors may still be motivated by fears they may lack immediate access to deposits during a bank reorganization. To avoid such fears triggering a run, the U.S. FDIC keeps its takeover operations secret, and re-opens branches under new ownership on the next business day. Government deposit insurance programs can be ineffective if the government itself is perceived to be running short of cash.
- Bank capital requirements reduces the possibility that a bank becomes insolvent. The Basel III agreement strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage.
- Full-reserve banking is the hypothetical case where the reserve ratio is set to 100%, and funds deposited are not lent out by the bank as long as the depositor retains the legal right to withdraw the funds on demand. Under this approach, banks would be forced to match maturities of loans and deposits, thus greatly reducing the risk of bank runs.
- A less severe alternative to full-reserve banking is a reserve ratio requirement, which limits the proportion of deposits which a bank can lend out, making it less likely for a bank run to start, as more reserves will be available to satisfy the demands of depositors. This practice sets a limit on the fraction in fractional-reserve banking.
- Transparency may help prevent crises spreading through the banking system. In the context of the recent crisis, the extreme complexity of certain types of assets made it difficult for market participants to assess which financial institutions would survive, which amplified the crisis by making most institutions very reluctant to lend to one another.
- Central banks act as a lender of last resort. To prevent a bank run, the central bank guarantees that it will make short-term loans to banks, to ensure that, if they remain economically viable, they will always have enough liquidity to honor their deposits. Walter Bagehot’s book Lombard Street provides influential early analysis of the role of the lender of last resort.
The role of the lender of last resort, and the existence of deposit insurance, both create moral hazard, since they reduce banks’ incentive to avoid making risky loans. They are nonetheless standard practice, as the benefits of collective prevention are commonly believed to outweigh the costs of excessive risk-taking.
Techniques to deal with a banking panic when prevention have failed:
- Declaring an emergency bank holiday.
- Government or central bank announcements of increased lines of credit, loans, or bailouts for vulnerable banks.