Bank run

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American Union Bank, New York City, April 26, 1932 Bank Run on American Union Bank.jpeg
American Union Bank, New York City, April 26, 1932

A bank run or run on the bank occurs when many clients withdraw their money from a bank, because they believe the bank may fail 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. When they transfer funds to another institution, it may be characterized as a capital flight. As a bank run progresses, it may become a self-fulfilling prophecy: 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. [1] To combat a bank run, a bank may acquire more cash from other banks or from the central bank, or limit the amount of cash customers may withdraw, either by imposing a hard limit or by scheduling quick deliveries of cash, encouraging high-return term deposits to reduce on-demand withdrawals or suspending withdrawals altogether.

Contents

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. [2] 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. [3] According to former U.S. Federal Reserve chairman Ben Bernanke, the Great Depression was caused by the failure of the Federal Reserve System to prevent deflation, [4] and much of the economic damage was caused directly by bank runs. [5] 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. [2]

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, [1] and after a run has started, a temporary suspension of withdrawals. [6] 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. [7]

History

10 livres tournois banknote issued by Banque Royale, France, 1720. In 1720, shareholders demanded cash payment, leading to a run on the bank and financial chaos in France. On display at the British Museum. 10 livres tournois banknote issued by Banque Royale, France, 1720. On display at the British Museum.jpg
10 livres tournois banknote issued by Banque Royale, France, 1720. In 1720, shareholders demanded cash payment, leading to a run on the bank and financial chaos in France. On display at the British Museum.
The run on the Montreal City and District Savings Bank, with the mayor addressing the crowd. Printed in 1872 in the Canadian Illustrated News. MontrealBankRun1872.jpg
The run on the Montreal City and District Savings Bank, with the mayor addressing the crowd. Printed in 1872 in the Canadian Illustrated News .

Bank runs first appeared as a part of cycles of credit expansion and its subsequent contraction. From the 16th century onwards, English goldsmiths issuing promissory notes suffered severe failures due to bad harvests, plummeting parts of the country into famine and unrest. Other examples are the Dutch tulip manias (1634–37), the British South Sea Bubble (1717–19), the French Mississippi Company (1717–20), the post-Napoleonic depression (1815–30), and the Great Depression (1929–39).

Bank runs have also been used to blackmail individuals and governments. In 1832, for example, the British government under the Duke of Wellington overturned a majority government on the orders of the king, William IV, to prevent reform (the later Reform Act 1832 (2 & 3 Will. 4. c. 45)). Wellington's actions angered reformers, and they threatened a run on the banks under the rallying cry "Stop the Duke, go for gold!". [8]

Many of the recessions in the United States were caused by banking panics. The Great Depression contained several banking crises consisting of runs on multiple banks from 1929 to 1933; some of these were specific to regions of the U.S. [3] Bank runs were most common in states whose laws allowed banks to operate only a single branch, dramatically increasing risk compared to banks with multiple branches particularly when single-branch banks were located in areas economically dependent on a single industry. [9]

Banking panics began in the Southern United States in November 1930, one year after the stock market crash, triggered by the collapse of a string of banks in Tennessee and Kentucky, which brought down their correspondent networks. In December, New York City experienced massive bank runs that were contained to the many branches of a single bank. Philadelphia was hit a week later by bank runs that affected several banks, but were successfully contained by quick action by the leading city banks and the Federal Reserve Bank. [10] Withdrawals became worse after financial conglomerates in New York and Los Angeles failed in prominently-covered scandals. [11] Much of the US Depression's economic damage was caused directly by bank runs, [5] though Canada had no bank runs during this same era due to different banking regulations. [9]

Money supply decreased substantially between Black Tuesday and the Bank Holiday in March 1933 when there were massive bank runs across the United States. Money supply during the great depression era.png
Money supply decreased substantially between Black Tuesday and the Bank Holiday in March 1933 when there were massive bank runs across the United States.

Milton Friedman and Anna Schwartz argued that steady withdrawals from banks by nervous depositors ("hoarding") were inspired by news of the fall 1930 bank runs and forced banks to liquidate loans, which directly caused a decrease in the money supply, shrinking the economy. [12] Bank runs continued to plague the United States for the next several years. Citywide runs hit Boston (December 1931), Chicago (June 1931 and June 1932), Toledo (June 1931), and St. Louis (January 1933), among others. [13] Institutions put into place during the Depression have prevented runs on U.S. commercial banks since the 1930s, [14] even under conditions such as the U.S. savings and loan crisis of the 1980s and 1990s. [15]

The 2007–2008 financial crisis was centered around market-liquidity failures that were comparable to a bank run. The crisis contained a wave of bank nationalizations, including those associated with Northern Rock of the UK and IndyMac of the U.S. This crisis was caused by low real interest rates stimulating an asset price bubble fuelled by new financial products that were not stress tested and that failed in the downturn. [16]

Theory

A poster for the 1896 Broadway melodrama The War of Wealth depicts a 19th-century bank run in the U.S. War of wealth bank run poster.jpg
A poster for the 1896 Broadway melodrama The War of Wealth depicts a 19th-century bank run in the U.S.

Under fractional-reserve banking, the type of banking currently used in most developed countries, banks retain only a fraction of their demand deposits as cash. The remainder is invested in securities and loans, whose terms are typically longer than the demand deposits, resulting in an asset–liability mismatch. No bank has enough reserves on hand to cope with all deposits being taken out at once. [17] [ better source needed ]

Diamond and Dybvig developed an influential model to explain why bank runs occur and why banks issue deposits that are more liquid than their assets. According to the model, the bank acts as an intermediary between borrowers who prefer long-maturity loans and depositors who prefer liquid accounts. [1] [14] The Diamond–Dybvig model provides an example of an economic game with more than one Nash equilibrium, where it is logical for individual depositors to engage in a bank run once they suspect one might start, even though that run will cause the bank to collapse. [1]

In the model, business investment requires expenditures in the present to obtain returns that take time in coming, for example, spending on machines and buildings now for production in future years. A business or entrepreneur that needs to borrow to finance investment will want to give their investments a long time to generate returns before full repayment, and will prefer long maturity loans, which offer little liquidity to the lender. The same principle applies to individuals and households seeking financing to purchase large-ticket items such as housing or automobiles. The households and firms who have the money to lend to these businesses may have sudden, unpredictable needs for cash, so they are often willing to lend only on the condition of being guaranteed immediate access to their money in the form of liquid demand deposit accounts, that is, accounts with shortest possible maturity. Since borrowers need money and depositors fear to make these loans individually, banks provide a valuable service by aggregating funds from many individual deposits, portioning them into loans for borrowers, and spreading the risks both of default and sudden demands for cash. [1] Banks can charge much higher interest on their long-term loans than they pay out on demand deposits, allowing them to earn a profit.

Depositors clamor to withdraw their savings from a bank in Berlin, 13 July 1931 Bundesarchiv Bild 102-12023, Berlin, Bankenkrach, Andrang bei der Sparkasse.jpg
Depositors clamor to withdraw their savings from a bank in Berlin, 13 July 1931

If only a few depositors withdraw at any given time, this arrangement works well. Barring some major emergency on a scale matching or exceeding the bank's geographical area of operation, depositors' unpredictable needs for cash are unlikely to occur at the same time; that is, by the law of large numbers, banks can expect only a small percentage of accounts withdrawn on any one day because individual expenditure needs are largely uncorrelated. A bank can make loans over a long horizon, while keeping only relatively small amounts of cash on hand to pay any depositors who may demand withdrawals. [1]

However, if many depositors withdraw all at once, the bank itself (as opposed to individual investors) may run short of liquidity, and depositors will rush to withdraw their money, forcing the bank to liquidate many of its assets at a loss, and eventually to fail. If such a bank were to attempt to call in its loans early, businesses might be forced to disrupt their production while individuals might need to sell their homes and/or vehicles, causing further losses to the larger economy. [1] Even so, many, if not most, debtors would be unable to pay the bank in full on demand and would be forced to declare bankruptcy, possibly affecting other creditors in the process.

A bank run can occur even when started by a false story. Even depositors who know the story is false will have an incentive to withdraw, if they suspect other depositors will believe the story. The story becomes a self-fulfilling prophecy. [1] Indeed, Robert K. Merton, who coined the term self-fulfilling prophecy, mentioned bank runs as a prime example of the concept in his book Social Theory and Social Structure . [18] Mervyn King, governor of the Bank of England, once noted that it may not be rational to start a bank run, but it is rational to participate in one once it had started. [19]

Systemic banking crisis

Bank run during the Great Depression in the United States, February 1933 Bank Run in Michigan, USA, February 1933.jpg
Bank run during the Great Depression in the United States, February 1933

A bank run is the sudden withdrawal of deposits of just one bank. A banking panic or bank panic is a financial crisis that occurs when many banks suffer runs at the same time, as a cascading failure. In a systemic banking crisis, all or almost all of the banking capital in a country is wiped out; this can result when regulators ignore systemic risks and spillover effects. [2]

Systemic banking crises are associated with substantial fiscal costs and large output losses. Frequently, emergency liquidity support and blanket guarantees have been used to contain these crises, not always successfully. Although fiscal tightening may help contain market pressures if a crisis is triggered by unsustainable fiscal policies, expansionary fiscal policies are typically used. In crises of liquidity and solvency, central banks can provide liquidity to support illiquid banks. Depositor protection can help restore confidence, although it tends to be costly and does not necessarily speed up economic recovery. Intervention is often delayed in the hope that recovery will occur, and this delay increases the stress on the economy. [2]

Some measures are more effective than others in containing economic fallout and restoring the banking system after a systemic crisis. [2] [20] These include establishing the scale of the problem, targeted debt relief programs to distressed borrowers, corporate restructuring programs, recognizing bank losses, and adequately capitalizing banks. Speed of intervention appears to be crucial; intervention is often delayed in the hope that insolvent banks will recover if given liquidity support and relaxation of regulations, and in the end this delay increases stress on the economy. Programs that are targeted, that specify clear quantifiable rules that limit access to preferred assistance, and that contain meaningful standards for capital regulation, appear to be more successful. According to IMF, government-owned asset management companies (bad banks) are largely ineffective due to political constraints. [2]

A silent run occurs when the implicit fiscal deficit from a government's unbooked loss exposure[ clarification needed ] to zombie banks is large enough to deter depositors of those banks. As more depositors and investors begin to doubt whether a government can support a country's banking system, the silent run on the system can gather steam, causing the zombie banks' funding costs to increase. If a zombie bank sells some assets at market value, its remaining assets contain a larger fraction of unbooked losses; if it rolls over its liabilities at increased interest rates, it squeezes its profits along with the profits of healthier competitors. The longer the silent run goes on, the more benefits are transferred from healthy banks and taxpayers to the zombie banks. [21] The term is also used when many depositors in countries with deposit insurance draw down their balances below the limit for deposit insurance. [22]

The cost of cleaning up after a crisis can be huge. In systemically important banking crises in the world from 1970 to 2007, the average net recapitalization cost to the government was 6% of GDP, fiscal costs associated with crisis management averaged 13% of GDP (16% of GDP if expense recoveries are ignored), and economic output losses averaged about 20% of GDP during the first four years of the crisis. [2]

Prevention and mitigation

2007 run on Northern Rock, a UK bank, during the 2007-2008 financial crisis Northern Rock Queue.jpg
2007 run on Northern Rock, a UK bank, during the 2007–2008 financial crisis
A run on a Bank of East Asia branch in Hong Kong, caused by "malicious rumours" in 2008 Response of malicious rumours of BEA on 24 Sept 2008.jpg
A run on a Bank of East Asia branch in Hong Kong, caused by "malicious rumours" in 2008

Several techniques have been used to help prevent or mitigate bank runs.

Individual banks

Some prevention techniques apply to individual banks, independently of the rest of the economy.

Systemic techniques

Some prevention techniques apply across the whole economy, though they may still allow individual institutions to fail.

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. [27]

Techniques to deal with a banking panic when prevention have failed:

Depictions in fiction

The bank panic of 1933 is the setting of Archibald MacLeish's 1935 play, Panic . Other fictional depictions of bank runs include those in American Madness (1932), It's a Wonderful Life (1946, set in 1932 U.S.), Silver River (1948), Mary Poppins (1964, set in 1910 London), Rollover (1981), Noble House (1988) and The Pope Must Die (1991).

Arthur Hailey's novel The Moneychangers includes a potentially fatal run on a fictitious US bank.

A run on a bank is one of the many causes of the characters' suffering in Upton Sinclair's The Jungle .

In The Simpsons season 6 episode 21 The PTA Disbands has Bart Simpson starting a hush whisper campaign at the Bank of Springfield as a prank to instigate a bank run. The bank run is not shown, instead the bank manager, who bears resemblance to Jimmy Stewart, says the savings are in other people's houses, spoofing It's a Wonderful Life.

See also

Related Research Articles

<span class="mw-page-title-main">Federal Deposit Insurance Corporation</span> US government agency providing deposit insurance

The Federal Deposit Insurance Corporation (FDIC) is a United States government corporation supplying deposit insurance to depositors in American commercial banks and savings banks. The FDIC was created by the Banking Act of 1933, enacted during the Great Depression to restore trust in the American banking system. More than one-third of banks failed in the years before the FDIC's creation, and bank runs were common. The insurance limit was initially US$2,500 per ownership category, and this has been increased several times over the years. Since the enactment of the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010, the FDIC insures deposits in member banks up to $250,000 per ownership category. FDIC insurance is backed by the full faith and credit of the government of the United States, and according to the FDIC, "since its start in 1933 no depositor has ever lost a penny of FDIC-insured funds".

<span class="mw-page-title-main">Fractional-reserve banking</span> System of banking

Fractional-reserve banking is the system of banking in all countries worldwide, under which banks that take deposits from the public keep only part of their deposit liabilities in liquid assets as a reserve, typically lending the remainder to borrowers. Bank reserves are held as cash in the bank or as balances in the bank's account at the central bank. Fractional-reserve banking differs from the hypothetical alternative model, full-reserve banking, in which banks would keep all depositor funds on hand as reserves.

<span class="mw-page-title-main">Full-reserve banking</span> Offering of loans exclusively from time deposits

Full-reserve banking is a system of banking where banks do not lend demand deposits and instead only lend from time deposits. It differs from fractional-reserve banking, in which banks may lend funds on deposit, while fully reserved banks would be required to keep the full amount of each customer's demand deposits in cash, available for immediate withdrawal.

<span class="mw-page-title-main">Lender of last resort</span> Government guarantee to provide liquidity to financial institutions

In public finance, a lender of last resort (LOLR) is the institution in a financial system that acts as the provider of liquidity to a financial institution which finds itself unable to obtain sufficient liquidity in the interbank lending market when other facilities or such sources have been exhausted. It is, in effect, a government guarantee to provide liquidity to financial institutions. Since the beginning of the 20th century, most central banks have been providers of lender of last resort facilities, and their functions usually also include ensuring liquidity in the financial market in general.

A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth but do not necessarily result in significant changes in the real economy.

<span class="mw-page-title-main">Too big to fail</span> Concept in economics

"Too big to fail" (TBTF) is a theory in banking and finance that asserts that certain corporations, particularly financial institutions, are so large and so interconnected that their failure would be disastrous to the greater economic system, and therefore should be supported by government when they face potential failure. The colloquial term "too big to fail" was popularized by U.S. Congressman Stewart McKinney in a 1984 Congressional hearing, discussing the Federal Deposit Insurance Corporation's intervention with Continental Illinois. The term had previously been used occasionally in the press, and similar thinking had motivated earlier bank bailouts.

In finance, an asset–liability mismatch occurs when the financial terms of an institution's assets and liabilities do not correspond. Several types of mismatches are possible. An asset-liability mismatch presents a material risk at institutions with significant debt exposure, such as banks or sovereign governments. A significant mismatch may lead to insolvency or illiquidity, which can cause financial failure. Such risks were among the principal causes of economic crises such as the 1980s Latin American Debt Crisis, the 2007 Subprime Mortgage Crisis, the U.S. Savings and Loan Crisis, and the collapse of Silicon Valley Bank in 2023.

In financial economics, a liquidity crisis is an acute shortage of liquidity. Liquidity may refer to market liquidity, funding liquidity, or accounting liquidity. Additionally, some economists define a market to be liquid if it can absorb "liquidity trades" without large changes in price. This shortage of liquidity could reflect a fall in asset prices below their long run fundamental price, deterioration in external financing conditions, reduction in the number of market participants, or simply difficulty in trading assets.

<span class="mw-page-title-main">Bank failure</span> Insolvency or illiquidity of a bank

A bank failure occurs when a bank is unable to meet its obligations to its depositors or other creditors because it has become insolvent or too illiquid to meet its liabilities. A bank usually fails economically when the market value of its assets declines to a value that is less than the market value of its liabilities. The insolvent bank either borrows from other solvent banks or sells its assets at a lower price than its market value to generate liquid money to pay its depositors on demand. The inability of the solvent banks to lend liquid money to the insolvent bank creates a bank panic among the depositors as more depositors try to take out cash deposits from the bank. As such, the bank is unable to fulfill the demands of all of its depositors on time. A bank may be taken over by the regulating government agency if its shareholders' equity are below the regulatory minimum.

<span class="mw-page-title-main">Diamond–Dybvig model</span> Theoretical description of bank runs and financial crises

The Diamond–Dybvig model is an influential model of bank runs and related financial crises. The model shows how banks' mix of illiquid assets and liquid liabilities may give rise to self-fulfilling panics among depositors. Diamond and Dybvig, along with Ben Bernanke, were the recipients of the 2022 Nobel Prize in Economics for their work on the Diamond-Dybvig model.

<span class="mw-page-title-main">Bank</span> Financial institution which accepts deposits

A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets.

The interbank lending market is a market in which banks lend funds to one another for a specified term. Most interbank loans are for maturities of one week or less, the majority being overnight. Such loans are made at the interbank rate. A sharp decline in transaction volume in this market was a major contributing factor to the collapse of several financial institutions during the financial crisis of 2007–2008.

<span class="mw-page-title-main">Deposit account</span> Bank holding into and from which money can be placed or withdrawn

A deposit account is a bank account maintained by a financial institution in which a customer can deposit and withdraw money. Deposit accounts can be savings accounts, current accounts or any of several other types of accounts explained below.

The Panic of 1930 was a financial crisis that occurred in the United States which led to a severe decline in the money supply during a period of declining economic activity. A series of bank failures from agricultural areas during this time period sparked panic among depositors which led to widespread bank runs across the country.

Financial fragility is the vulnerability of a financial system to a financial crisis. Franklin Allen and Douglas Gale define financial fragility as the degree to which "...small shocks have disproportionately large effects." Roger Lagunoff and Stacey Schreft write, "In macroeconomics, the term "financial fragility" is used...to refer to a financial system's susceptibility to large-scale financial crises caused by small, routine economic shocks."

<span class="mw-page-title-main">2007–2008 financial crisis</span> Worldwide economic crisis

The 2007–2008 financial crisis, or the global financial crisis (GFC), was the most severe worldwide economic crisis since the Great Depression. Predatory lending in the form of subprime mortgages targeting low-income homebuyers, excessive risk-taking by global financial institutions, a continuous buildup of toxic assets within banks, and the bursting of the United States housing bubble culminated in a "perfect storm", which led to the Great Recession.

The 2003 banking crisis of Myanmar was a major bank run in private banking that hit Myanmar (Burma) in February 2003. It started with a decline in the trust for private financial institutions following the collapse of small financial enterprises and proliferating rumors about the liquidity of major private banks. Leading to a bank run on the Asia Wealth Bank, the crisis quickly spread to all major private banks in the country. It led to severe liquidity problems for private banks and scarcity of the kyat. Though exact data is not available, it is believed that the crisis caused major economic hardship for many in Myanmar.

Liquidity regulations are financial regulations designed to ensure that financial institutions have the necessary assets on hand in order to prevent liquidity disruptions due to changing market conditions. This is often related to reserve requirement and capital requirement but focuses on the specific liquidity risk of assets that are held.

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