Bank run

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

2007 run on Northern Rock, a UK bank

A bank run (also known as a run on the bank) occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent. As a bank run progresses, it generates its own momentum, in a kind of self-fulfilling prophecy (or positive feedback): as more people withdraw their deposits, the likelihood of default increases, and this encourages further withdrawals. This can destabilize the bank to the point where it faces bankruptcy.^[1]

A banking panic or bank panic is a financial crisis that occurs when many banks suffer runs at the same time. 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.^[3] Much of the Great Depression's economic damage was caused directly by bank runs.^[4] 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 can help to prevent bank runs. They include temporary suspension of withdrawals, 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 governmental bank regulation.^[5] 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.^[6]

Theory

Under fractional-reserve banking, the type of banking currently used in 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 more than a fraction of deposits being taken out at once.

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][7]

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.

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.^[8]

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]

Systemic banking crises

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][9] 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. Government-owned asset management companies are largely ineffective due to political constraints.^[2]

A silent run occurs when the implicit fiscal deficit from a government's unbooked loss exposure 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.^[10]

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

Several techniques can be used to help prevent bank runs.

Individual banks

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

• A bank can take deposits from depositors who do not observe common 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 a line of depositors from extending out into the street, causing passers-by to infer that a bank run is occurring.^[1]

• 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.^[1]

• Bank regulation or other constraints can impose 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.^[5] This practice sets a limit on the fraction in fractional-reserve banking.

• Full-reserve banking is the hypothetical case where the reserve ratio is set to 100%. Under this approach, the risk of bank runs would be eliminated,^[11] and banks would match maturities of deposits and loans to avoid vulnerability to runs.^[12]

Collective prevention

Some prevention techniques apply across the whole economy, though they may still allow individual institutions to fail. These techniques create moral hazard, since they reduce incentives for banks to avoid making risky loans; the goal is for the benefits of collective prevention to outweigh the costs of excessive risk-taking.^[13]

• 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.^[1]

• 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.^[1] However, depositors may still be motivated by fears they may lack immediate access to deposits during a bank reorganization.^[6]

History

The run on the Montreal City and District Savings Bank. The Mayor addressing the crowd. Printed in 1872 in the Canadian Illustrated News.

Bank runs first appeared as part of cycles of credit expansion and its subsequent contraction. In 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 (1634–1637), the British South Sea Bubble (1717–1719), the French Mississippi Company (1717–1720), the post-Napoleonic depression (1815–1830) and the Great Depression (1929–1939).

Bank runs have also been used to blackmail individuals or governments; for example in 1830 when the British Government under the Duke of Wellington overturned a majority government under the orders of the king, George IV, to prevent reform (the later 1832 Reform Act), he angered reformers and so a run on the banks was threatened under the rallying cry "To stop the Duke go for gold!".

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] Banking panics began in October 1930, one year after the stock market crash, triggered by the collapse of correspondent networks; the bank runs became worse after financial conglomerates in New York and Los Angeles failed in prominently-covered scandals.^[14] Much of the Depression's economic damage was caused directly by bank runs,^[4] and institutions put into place after the Depression have prevented runs on U.S. commercial banks since the 1930s,^[7] even under conditions such as the U.S. savings and loan crisis of the 1980s and 1990s.^[15] The Depression's bank runs left a lasting mark on the American psyche, exhibited in sometimes disturbing images such as the bleak scenes where the fictional hero George Bailey contemplates suicide in the movie It's a Wonderful Life.^[16]

The global financial crisis that began in 2007 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 fueled by new financial products that were not stress tested and that failed in the downturn.^[17]

References