Should You Be Worried About A “Run on the Bank?”

February 14, 2022

With near-daily alerts of record inflation and an impending bear market, the risk of banking panic feels pressing. The risk of a bank run is directly related to a loss of confidence in a bank or the financial system as a whole. 

Bank runs don’t happen very often, but we remember several of the big ones. Like the series of bank runs compounding the woes of the Great Depression or the Greek Financial Crisis, for example.

What is a run on the bank? What causes one? And what can you do to protect yourself in case the bank comes up short? Here’s an explanation. 

What is a Run on the Bank?

A run on the bank occurs when a significant number of customers withdraw deposits from the bank at the same time out of fear the bank will default. The name originates from when people would literally run as fast as they can to their bank to withdraw funds. 

When a large group of customers withdraws their money all at once, a bank will become less and less able to fulfill the withdrawals. As more people withdraw, the likelihood of default increases, causing more customers to take their money out. If enough customers withdraw funds, the bank will use up its cash reserves and ultimately end up defaulting. 

Customers withdraw their money out of concern for the bank’s solvency—its ability to meet its long-term financial obligations and debts. This is a critical measure of financial stability and health, as it determines whether the bank can continue to manage operations in the future. 

Here’s the catch: bank runs are often the result of customer fear rather than a true threat of insolvency. In other words, by panicking, customers create a true default situation.

How Can a Bank Run Out of Money?

Banks don’t keep very much cash on hand. In fact, most branches have in-house cash limits for how much they can store in their vaults per day, as regulated by the Federal Reserve. This is for security reasons. 

Also, banks earn revenue by leveraging cash for loans or other investment vehicles. Only a small percentage of a bank’s cash position is kept on hand. If a bank were to keep more cash in reserves, it would be vulnerable to security threats (i.e. a robbery) and would earn little to no revenue.  

The Federal Reserve requires banks to maintain a certain amount of liquidity to avoid excessive lending in the event of defaults, but otherwise, a bank only keeps a small percentage of liquidity on hand. After all, most of the time, customers won’t cash out their entire account at once. 

In the event that a bank sees an increase in withdrawal demands, it has to increase its cash position to meet demand. One option for banks in this situation is to quickly sell off assets to generate liquidity, often at a far lower sale price than the bank could have achieved if it weren’t in a hurry.

This is how a bank run creates true insolvency—if a bank has to scramble to meet demand and accumulates major losses on asset sales, it may run out of assets to liquidate. A bank panic happens when multiple banks run out of liquidity simultaneously.

Bank Run vs. Silent Bank Run

While a bank run is usually depicted as a long line of customers frantically waiting to withdraw their money, that likely isn’t the case anymore. These days, because of online banking, banks are more likely to see a silent bank run.

A silent bank run works exactly like a regular bank run, but customers don’t physically enter the bank. Instead, customers use digital withdrawal methods like wire transfers, ACH transfers, and similar techniques.

Unfortunately, a silent bank run is worse than a traditional bank run, at least in the eyes of the bank. Traditional barriers, such as long lines, can somewhat slow the pace of a bank run, which gives the bank marginally more time to play catch-up. There are no such barriers in a silent bank run, and unlike a traditional bank run, customers don’t have to wait for working hours.

Impact of a Run on the Bank

Here’s the bad news: bank runs are the result of fear, and ironically, customer behavior turns all of those fears into a self-fulfilling prophecy. Bank runs create negative feedback loops that can cause a more systemic financial crisis. 

Again, because U.S. banks rely on fractional reserve banking, not all customer withdrawals are available on hand. That’s fine most of the time since customers don’t generally need all of their money at once. But when a large number of customers want to liquidate their accounts, the bank won’t have enough to meet demand and has to sell assets to increase its cash position.

That makes matters worse for the bank since it has to sell those assets at a loss. Because bank runs often happen during times of economic crisis, the losses can be significant, and it may take quite a while for the bank to recover its losses. If the bank becomes completely insolvent, it may result in a bank failure.

Will Your Money Be Safe in a Run on the Bank?

Under FDIC deposit insurance, most banking customers in the U.S. who use a participating bank receive full or partial protection even if the bank fails. In most cases, protection is limited to a $250,000 maximum per depositor, per institution, and per ownership category.

If a bank fails, an open bank will assume the failed bank’s deposits, allowing customers to continue accessing their accounts. The only change is the name (or the app). 

Granted, this isn’t perfect protection. If customers across multiple banks create bank runs and the issue is severe, there may not be a bank that can take on deposits of a failed bank. But this would only be a serious concern in the event of a total financial collapse. 

Invest to Hedge Against Economic Downturns

A run on a bank is frightening, even if you understand that the run is just the result of fear. That’s why it’s essential to protect your wealth across multiple investments rather than just relying on your cash accounts. Real assets such as fine art and real estate are seen as potential recession hedges due to their low correlation to traditional markets. 

On the Masterworks platform, members can purchase shares in securitized blue-chip artwork from artists with a history of strong returns. Fill out your membership application today to learn more.

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