Bank Run - Keep an Eye on Your Money

 

Watch out for that Bank Run!

A bank run by definition is a large number of a bank or other financial institution’s customers withdrawing their assets simultaneously.  This is due to concerns over the solvency of the financial institution. As the number of customers who withdraw their money increases, the probability of default also increases.  This will, in turn, propel more people to withdraw their funds. In severe cases, the bank’s reserves may not be adequate to cover the withdrawals.  The financial institution could fail if this were to happen.

Causes of a Bank Run

Generally, bank runs are spurned by panic rather than true insolvency of the financial institution. Yet, since these financial institutions risk default as more customers withdraw their assets, what initially started as a panic can turn into a legitimate default crisis. Bank runs triggered by uncertainty and/or fear that result in a bank becoming truly insolvent serve as an example of a self-fulfilling prophecy.

Factors That Result in a Bank Run

Most banks usually retain a small percentage of their deposits as cash on hand.  When customers’ withdrawal demand exceeds the available assets, they must increase their cash reserves to meet those demands.

To increase cash on hand, a financial institution will often sell off its assets.  This could result in significant losses. As a result, these losses from selling the assets at lower prices can also force a bank into insolvency. If multiple banks encounter runs simultaneously, this is a situation referred to as a bank panic.

Will a Bank Run Truly Lead to Insolvency?

It is important to note that the danger associated with bank runs has often been exaggerated. First and foremost, a bank run is unlikely to result in insolvency. This is because depositors worried about their bank’s solvency might begin a run on the financial institution they are concerned about and switch their funds to other banks. If concerns about the bank’s solvency are unfounded, other financial institutions in the area will likely benefit from recycling funds. Moreover, a large portion of the assets lost during the bank run will be filtered back to the institution experiencing the run. This occurs by other financial institutions making loans to the bank in question.  Or they may purchase the institution’s assets at non-liquidation prices. Therefore, in all likelihood, a bank run will not result in a solvent institution becoming insolvent.

On the other hand, if customers’ fears prove to be justified and the bank truly is at risk of insolvency.  Then other financial institutions will steer clear of the insolvent bank. Thus, the bank will not be able to re-establish its liquidity and it will fail. However, the bank run itself did not prompt the insolvency, but rather, it is a symptom of an existing problem.

Examples of Bank Runs

One of the most infamous bank runs in U.S. history resulted from the Stock Market Crash of 1929. In the wake of this cataclysmic event, a bank panic occurred across the nation.  This ultimately lead to the Great Depression. As widespread fear and panic consumed the country, multiple bank runs occurred in late 1929 and early 1930.  These resulted in a chain reaction or domino effect. During this period, the news of one bank failure prompted customers of nearby and surrounding financial institutions to withdraw their funds. This chain of events continued across the United States.

Also during the Depression, bank runs occurred due to speculation from individual customers. One example of this form took place in New York in December 1930. A customer tried to sell off some of his stock at the Bank of United States.  He was discouraged from selling the stock left the branch.  He then immediately spread the word that the bank was unable or unwilling to sell his shares. Many customers viewed this event as a sign of insolvency. As a result, thousands of bank customers filled the streets and withdrew more than $2 million from the institution within hours.

The Great Greek Runs

A modern-day example also exists in the recent Greek bank runs. During the Summer of 2015, the amount of money withdrawn from Greek banks was unprecedented. This event took place as a result of fear over the Greek government’s debt repayment deadline with the International Monetary Fund. Moreover, the Greek powers-that-be had not negotiated a new bailout deal with its international creditors. As a result of the missed debt repayment deadline and no new bailout deal in place, the European Central Bank refused to increase its Emergency Liquidity Assistance to Greek financial institutions. Ultimately, Greek Prime Minister Alexis Tsipras was able to negotiate a new bailout deal for the nation.  This, after accepting a tough reform package and stringent economic guidelines. As a result, Greek financial institutions reopened after being shut down for three weeks. However, a weekly withdrawal limit remained in effect on depositors.

Bank Run Prevention

After The Great Depression safeguards were implemented to reduce the risk of future bank runs. The primary action was to establish reserve requirements, which mandate that financial institutions maintain a minimum threshold percentage of their total deposits as cash on hand.

The second safeguard involved the creation of the Federal Deposit Insurance Corporation (FDIC) by the U.S. Congress in 1933. The purpose of this agency is to insure banking deposits. Meanwhile, the FDIC’s mission is to maintain public confidence and stability in the U.S. financial system.

Conclusion

With uncertainty among the U.S. and global banking sectors, it is important that everyone understands about bank runs and their potential impact. After all, knowledge is power and educating the masses about this topic is key to preventing it.