Bank Runs

What happens when everyone lines up at the bank's door to withdraw some money? What are the reasons that push people to withdraw their funds from banks? Does the bank always give you your money back? What happens when banks can't give the money back to deposits? You will be able to answer all these questions once you read our article on Bank Runs.

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Contents
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    How Do Banks Work?

    To understand what a bank run means, you have to know how the bank functions and how it makes a profit. Whenever you go to a bank to deposit money, the bank keeps a fraction of that money in its reserves and uses the rest to make loans for other clients they have. A bank pays you interest on your deposit for allowing them to use your money to make loans to other clients. The bank then charges a higher interest when it lends the money to other individuals or businesses. The difference between the interest that the bank pays on your deposit and the interest it charges on loans provides the profit for the bank. The higher the difference, the more profit the bank takes home.

    Now banks, especially giant banks, have millions of people depositing their money in their deposit accounts.

    Bank Run Definition

    So, what actually is a bank run? Let's consider the definition of a bank run.

    Bank runs occur when many individuals start to withdraw their funds from financial institutions due to fear that the bank might fail.

    Usually, that happens because individuals are concerned about the ability of the financial institutions to give their deposits back. A bank run is most often the product of panic rather than actual bankruptcy, as is the case with most defaults.

    Bank Runs A bank run on American Union Bank New York City StudySmarterFig 1. - A bank run on American Union Bank, New York City

    One typical occasion where you would see a bank run as the one in Figure 1 is when you have rumors spreading that a bank is in financial problems. This then prompts fear and uncertainty amongst those who have deposited money in that bank, causing everyone to go and withdraw money as soon as possible. Individuals continue to withdraw cash from the bank, putting the bank in danger of default; consequently, what starts off as fear may quickly escalate into an actual bank failure. Although the bank might have had the funds to cover some initial withdrawals, when most people begin to withdraw, banks can no longer meet those demands.

    This is because most banks do not maintain a large amount of cash on their reserves. Most financial institutions must keep only a portion of the deposits in their reserves. Banks have to use the other part to make loans; otherwise, their business model would fail. The Federal Reserve establishes the reserve requirement.

    The money they do have on hand is either lent out or invested in a variety of various investment vehicles, depending on the situation. In order to fulfill the withdrawal requests of their clients, banks must raise their cash reserves, which is problematic given that they generally hold just a tiny fraction of their deposits as cash on hand.

    The sale of assets is one technique of increasing cash on hand, although it is often done at a much lower price than it would have gotten if it did not have to sell so rapidly. When a bank suffers losses on the sale of assets at reduced prices and it does not have enough money to repay the people who are coming to withdraw their deposits, it may be forced to declare bankruptcy.

    All these factors then create a perfect recipe for bank runs. When numerous bank runs occur simultaneously, this is referred to as a bank panic.

    Preventing Bank Runs: Deposits, Insurance, and Liquidity

    There are a number of tools that governments use to prevent bank runs. The government requires banks to keep a portion of their deposits as reserves and have the deposits insured by agencies such as the Federal Deposit Insurance Corporation (FDIC). Additionally, banks are required to maintain liquidity - in other words, banks need to have a certain amount of cash or easily-convertible-to-cash assets on hand.

    Deposits refer to the money individuals put in a bank on which they earn interest. The bank then uses these deposits to make other loans. It is the demand to withdraw these funds all at once that then leads to bank runs.

    Liquidity refers to the amount of cash or easily-convertible-to-cash assets banks have on their hands that they can use to cover their deposits.

    As a result of the upheaval of the 1930s, governments adopted a number of actions to reduce the likelihood of bank runs occurring again. Perhaps the most significant was the establishment of reserve requirements, which demand that banks maintain a specific proportion of total deposits on hand in cash. There are also the capital requirements of banks to keep more capital than the number of deposits they have at hand.

    Deposit insurance is a guarantee by the government to pay the deposits back in the event that the bank is not able to do so.

    The Federal Deposit Insurance Corporation (FDIC) was founded by the United States Congress in 1933. This institution, established in reaction to the many bank failures that occurred in the prior years, guarantees bank deposits up to a limit of $250,000 per account. It aims to ensure stability and public trust in the financial system of the United States by guaranteeing depositors their money back.

    However, when banks face an increased likelihood of a bank run, here are some of what they can do. Confronted with the prospect of a bank run, institutions may need to adopt a more aggressive strategy. Here's how they may go about it.

    Temporarily shut down operations

    When banks are confronted with bank runs, they may shut down their operations for a period of time. People will not be able to line up and withdraw their money due to this. Franklin D. Roosevelt did this shortly after taking office in 1933. He announced a bank holiday and ordered inspections to guarantee that banks' stability was not jeopardized, allowing them to continue functioning.

    Borrow money

    In the event that a bank risks having everyone lined up to get their money back, banks may use the discount window. The discount window refers to the ability of banks to borrow from the Federal Reserve at an interest rate known as the discount rate. Additionally, banks may also borrow from other financial institutions. They may be able to avoid bankruptcy by taking out large loans.

    Term deposits

    Term deposits are another way banks can prevent having their deposits drained in a matter of days. They can do this by paying interest on deposits for a determined period of time. Depositors can't withdraw their money until the date of maturity. If most of the deposits on a bank have a maturity date, it is easier for a bank to cover the withdrawal demands.

    Bank Runs Examples

    In the past, several episodes of bank runs have happened during crisis times. Below are a few examples from the Great Depression, the 2008 financial crisis, and more recently Russia in the wake of Ukraine War-related sanctions.

    Bank runs during Great Depression1

    When the stock market failed in the US in 1929, which is believed to have initiated the Great Depression, most individuals in the US economy became increasingly sensitive to rumors that a financial disaster was approaching. This was a period when you had a significant decline in investment and consumer spending, unemployment numbers skyrocketed, and the overall output dropped.

    Panic amongst individuals exacerbated the crisis, and nervous depositors were racing to withdraw their money from their bank accounts to avoid losing their savings.

    The first bank run occurred in Nashville, Tennessee, in 1930, and this sparked a wave of bank runs across the Southeast as clients hurried to take their money from their banks.

    As banks were using most of their deposits to fund loans to other customers, they didn't have enough cash to make up for the withdrawals. Banks were obliged to liquidate debts and sell assets at rock-bottom prices as a result of a cash deficit to replenish the massive withdrawals of cash.

    In 1931 and 1932, there were more bank runs. Bank runs were widespread in areas where banking regulations required banks to operate just one branch, increasing the likelihood of a bank's demise.

    The Bank of the United States, which went bankrupt in December 1930, was the most significant victim of the financial crisis. A client came into the bank's New York office and sought to have his stock in the bank sold off for a reasonable price. The bank encouraged him not to sell the shares since it was a decent investment after all. The client left the bank and began circulating reports that the bank had refused to sell his shares and that the bank was on the verge of going out of business. Customers of the bank formed a queue outside the bank and made cash withdrawals totaling $2 million within hours of the business opening.

    Bank runs in the US during the 2008 financial crisis2

    Besides the bank runs experienced during the Great Depression, the US experienced another bank run during the 2008 financial crisis. Washington Mutual was one of the largest financial institutions in the US that were involved in a bank run during the 2008 financial crisis. Depositors withdrew 9 percent of total deposits in nine days. Other large financial institutions that failed during this period, such as Lehman Brothers, did not experience a bank run because they were not commercial banks that took deposits, but they failed because of credit and liquidity crises. Basically, their creditors could not pay back as they made lots of risky loans, and as the number of creditors defaulting was on the rise, these banks failed.

    Bank Runs in Russia

    The war in Ukraine led to numerous sanctions imposed on Russia by Western governments and created much uncertainty. Driven by fears that banks would not be able to give the money back, Russians started lining up to withdraw their funds, which is considered to have initiated a bank run amongst Russian banks. To prevent further escalation, the central bank decided to provide liquidity to banks. However, as the West also sanctions the central bank, it remains to be seen whether that is sustainable.3

    Bank Runs - Key takeaways

    • Bank runs occur when many individuals start to withdraw their funds from financial institutions due to fear that the bank might fail.
    • Deposits refer to the money individuals put in a bank on which they earn interest. The bank then uses these deposits to make other loans. It is the demand to withdraw these funds that then leads to bank runs.
    • Liquidity refers to the amount of cash or easily-convertible-to-cash assets banks have on their hands that they can use to cover their deposits, which provide liability for the bank.
    • Deposit insurance is a guarantee by the government to pay the deposits back in the event that the bank cannot do so. Most of the banks in the US are part of FDIC - the Federal Deposit Insurance Corporation. The FDIC guarantees depositors their money back up to a limit of $250,000 per account.
    • Some of the ways to prevent bank runs include: temporarily shutting down operations, borrowing money, term deposits, and deposit insurance.

    References

    1. Federal Reserve, "The Great Depression", https://www.federalreservehistory.org/essays/great-depression
    2. Federal Reserve Board, "Old-Fashioned Deposit Runs." https://www.federalreserve.gov/econresdata/feds/2015/files/2015111pap.pdf
    3. CNBC, "Long lines at Russia’s ATMs as bank run begins — with more pain to come.", https://www.cnbc.com/2022/02/28/long-lines-at-russias-atms-as-bank-run-begins-ruble-hit-by-sanctions.html
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    Frequently Asked Questions about Bank Runs

    What is a bank run?

    Bank runs occur when many individuals start to withdraw their funds from financial institutions due to fear that the bank might fail.

    What happens during a bank run?

    People line up in front of the bank to withdraw their funds from deposits.

    What are the effects of a bank run?

    It can lead to bank failures and can be contagious and affect other banks.

    When was the largest bank run in the US?

    During the Great Depression.

    How to prevent bank runs?

    Some of the ways to prevent bank runs include: temporarily shutting down operations, borrowing money, setting maturity for deposits (term deposits), insurance on deposits

    Test your knowledge with multiple choice flashcards

    Whenever you go to a bank to deposit money, the bank keeps a fraction of that money in its ______ and uses the rest to make _____

     A bank pays you ______ on your deposit for allowing them to use your money to make loans to other clients.

    The bank charges you ______ interest for your deposit and ______ interest for others making loans.

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