Overview

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. It may occur when, in a fractional-reserve banking system (where banks normally only keep a small proportion of their assets as cash), a large volume of customers seek to withdraw a greater amount of cash from deposit accounts with a financial institution in a short space of time than the institution has cash on-hand, because the customers believe that the 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.

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.

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. 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. 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, and much of the economic damage was caused directly by bank runs. 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.

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, and after a run has started, a temporary suspension of withdrawals.

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.

History

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 secure much-needed political reforms. 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 began a run on the banks under the rallying cry "Stop the Duke, go for gold!". After the cancellation of $25M of deposits, the government yielded and stopped blocking passage of the reform bill.

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. 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.

Theory

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.^([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. 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.

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. Banks can charge much higher interest on their long-term loans than they pay out on demand deposits, allowing them to earn a profit.

Systemic banking crisis

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.

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.

Some measures are more effective than others in containing economic fallout and restoring the banking system after a systemic crisis. 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.

Individual banks

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