What is a “Run on the Bank” and How is it Prevented?
A run on the bank, also known as a bank run, happens when a large number of customers pull their deposits from a financial institution because they feel the institution will cease to operate in the near future. Alternatively, it occurs when, in a fractional-reserve banking system (where banks typically only hold a tiny fraction of their resources in cash), a large number of customers withdraw money from deposit accounts with a banking institution simultaneously because they genuinely think the banking firm is or may become, defunct; the cash is either retained or transferred into other investments, such as bonds, rare metals, or precious gems.
Origins of Bank Runs
When they shift money from one bank to another, this is referred to as a capital flight in finance. With each passing minute, a bank run has its own impetus: as more individuals remove money from the bank, the chance of default rises, causing even more people to withdraw more money. This may cause the bank to become unstable to the point where it runs out of funds and is forced to declare bankruptcy. In order to prevent a bank run, an institution may, among other things, restrict the amount of cash that each client may withdraw, prohibit withdrawals entirely, or quickly purchase extra currency from other institutions or from the central bank.
A banking panic, also known as a bank run, is a financial crisis that happens when a large number of banks experience runs simultaneously, as individuals rush to convert their endangered deposits into cash or flee the country’s banking system entirely. A systemic banking crisis is defined as one in which all or nearly all of the national banking assets are completely or nearly completely wiped out. Due to the collapse of the domestic banking system, a sequence of bankruptcies might ensue, culminating in a prolonged economic crisis, as local firms and consumers are deprived of access to finance. According to Ben Bernanke, previous chairman of the Federal Reserve System in the United States, the Great Depression Crisis was triggered by the Federal Reserve System, and bank runs were very much accountable for most of the financial harm. When a systemic financial disaster happens, the costs of resolving it may be enormous, with fiscal expenses averaging 13 percent of GDP and economic production losses averaging 20 percent of GDP for the most significant crises between 1970 and 2007.
History of Bank Runs
Bank runs originally developed as a result of credit growth followed by credit contraction, which occurred in cycles of credit fluctuation. Due to poor harvests, English goldsmiths who issued promissory notes had major failures from the 16th century forward, plunging large areas of the kingdom into starvation and civil turmoil.
Bank runs have sometimes been used as a kind of blackmail against people or governments in the past. Among other things, the British administration under the Duke of Wellington overthrew a majority government on the instructions of King William IV in order to thwart change in the United Kingdom). When the Duke of Wellington’s activities enraged revolutionaries, they plotted a bank run underneath the campaign slogan “Stop the Duke, go for the gold!”
How can bank runs be prevented?
To understand why bank runs arise and why banks offer deposits that are more liquid than their resources, an innovative model was devised that is still used today. As described in the model, the bank functions as a middleman between consumers who desire long-term loans and depositors who desire short-term accounts or cash. A typical case of an economic game possessing multiple Nash equilibriums is the Diamond-Dybvig model, in which it is reasonable for individuals to join in a bank run if they think one is about to begin, even if doing so would lead the bank to fail.
Various approaches have been employed in an attempt to either avoid or lessen the impact of bank runs. Among the measures taken have been a greater reserve requirement (which requires banks to keep a larger portion of their resources in money), government bailouts of financial institutions, increased monitoring and enforcement of financial institutions and central banks acting as lenders of a last-ditch effort, the safety of deposit insurance structures like the United States Federal Deposit Insurance Corporation, and, after a run has begun, the temporary ban of transactions from financial institutions. Even with deposit protection, depositors may still be driven by the fear that they would not have rapid access to their funds during a bank restructuring, as shown by the case of Bank of America.
The following are some of the approaches that have been developed to aid in the prevention or mitigation of bank run situations:
Banks that operate on an individual basis
- Some preventative strategies are applicable to specific banks alone and are not applicable to the rest of the economy as a whole.
- Banks, with their strong construction and traditional attire, frequently give the impression of being stable institutions.
- A bank may attempt to conceal knowledge that might lead to a run on the bank. It did make sense for a bank to have a spacious lobby and efficient delivery in the days before deposit insurance to avoid the building of a line of depositors that extended out into the street, which may lead onlookers to believe that there was a bank run.
- A bank may attempt to slow down the bank run by intentionally slowing down the process, although this is unlikely. Getting a large number of friends and relatives of bank workers to wait in line and conduct a huge number of tiny, sluggish transactions is one method of evading detection.
- Participants inside a bank run may be persuaded that they do not need to withdraw their deposits as soon as they are scheduled to be delivered in large quantities.
Banks that are systemic
- Some preventative measures are applied throughout the whole economy, even if they do not prevent specific organizations from going bankrupt.
- Deposit insurance systems guarantee each depositor up to a specified amount, ensuring that depositors’ funds are secured even if the bank goes out of business or is unable to continue operations. Thus, there is no longer any motivation to withdraw one’s savings just because others are withdrawing theirs. Depositors, on the other hand, may still be driven by concerns that they will not have rapid access to their funds during a bank restructuring. A run on the bank is avoided by keeping takeover activities covert and reopening branches under new control the next business day, as the Federal Deposit Insurance Corporation (FDIC) does. It is possible for government deposit insurance schemes to be rendered ineffective if the government itself is considered to be low on cash reserves.
- It is less likely that a bank will go bankrupt as a result of capital requirements. As a result of the Basel III agreement, bank capital standards have been strengthened, and new regulatory criteria for bank liquidity and bank leverage have been established.