A bank run is a kind of panic when people rush to withdraw funds kept in a bank because they believe that the institution may stop functioning in the nearest future. This can lead to a real default, because more and more people withdraw money, thus causing the domino effect and destabilizing the bank. As a result, the institution runs out of cash and faces bankruptcy. However, there are other reasons for a bank run except just the human factor.
What Is a Bank Run?
It is a rush of customers to a bank to withdraw their deposits as soon as possible. If several banks or even the entire banking sector is affected, it is called a bank panic.
Typically, emerging doubts about the institution's ability to survive are the trigger for the run. Since a bank holds only a fraction of its assets in cash and the bulk of it is invested in long term assets, the bank run itself can easily end in bankruptcy.
The maturity transformation of a bank works if only a small part of the savers uses the possibility of withdrawing deposits at short notice. However, in the case of rumors about problems or imminent imbalances, the investors will withdraw their deposits on a massive scale. The risk that only suspicions can trigger an onslaught of savers on their money, is due to the fact that the deposits will be paid according to the principle of "first come, first served."
Reasons for a Bank Run
There are several possible reasons for a run:
Hyperinflation: Those who first withdraw their money can buy the most goods for the same amount of money.
Crisis of the bank: As the institution faces the insolvency threat, the investors have fear for their deposits. The longer they leave their deposits in the bank, the more grows their risk. The counter-storm itself can then lead to the actual bankruptcy.
Herd behavior: Investors observe a potentially random mass withdrawal and blindly embrace it, confident that this must have a definite cause.
In all these cases, it is an optimal strategy for the investor to participate in the run as early as possible, as this is the highest probability of getting their money. However, this situation is unstable and can lead to the collapse of the bank and the loss of deposits.
Bank Run Examples
The greatest bank run series in history took place during the Great Depression, specifically between 1929 (triggered by the stock market crash) and 1933. The runs were the reason for the most part of the US Depression's economic damage. The first panics started in the Upper South in November 1930, one year after the stock market crash. In December, New York City was hit by massive bank runs. A week later, Philadelphia also experienced runs that affected several banks.
Other runs during the Depression occurred because of rumors spread by individual customers. In December 1930, a New Yorker who was advised by the Bank of the United States against selling a specific stock left the branch and started telling people that the institution was not able to sell his shares. Having interpreted this as a sign of insolvency, thousands of customers withdrew over $2 million within hours.
The global financial crisis of 2007 was revolving around market liquidity failures that could be compared with a bank run. 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 thus failed.
Bank Run Prevention
There are several measures that can keep the investors confident of their funds and thus prevent the bank run situation.
If an investor can rely on the repayment of their deposit, regardless of whether the other savers withdraw their deposits early or not, there is no rational need to withdraw the deposit prematurely. Therefore, deposit insurance schemes can prevent a run, as they guarantee the liquidity of the bank, especially in its crisis. In this case, investors are guaranteed the security of not losing their deposits by issuing securities or by being able to transfer the assets to another institution. There are both government and private insurance programs. A private institution must have sufficient collateral while the state refinances itself by collecting taxes.
Suspension of Repayment
To prevent a bank run, the institution can announce that it will suspend payments after a certain threshold. This threshold is contractually agreed and made public. So, only investors who really need the money will have the right to withdraw it. Everyone else has to worry about their payouts, as it remains unclear when the threshold is reached, and the investors must be clear that any further withdrawal will carry greater risk.
However, this only works optimally if the proportion of savers who want to withdraw early is approximately known. Otherwise, the problem is to set the threshold. If it is too low, investors will mistrust the bank and not invest. If it is too high, then the institution has to provide a disproportionate amount of money, with which it can make little or no profit.
The problem of the bank run arises from the fact that the institution cannot make any noteworthy profit by just storing money. It, therefore, strives to exploit its assets profitably by making profitable investments or lending money and getting loan interest. Long term investments typically bring a higher profit than short term ones. In a bank run, the institution cannot convert the long term investments back into cash.
A bank run refers to a massive withdrawal of funds by bank customers caused by rumors about the possible insolvency of the bank. Sometimes such runs can happen for no reason at all, only resulting from a domino effect of the fund's withdrawal. Other reasons are hyperinflation and the bank crisis. The greatest runs occurred during the stock market crash and the Great Depression, between 1929 and 1933.