Business, Legal & Accounting Glossary
A bank run (also known as a run on the bank) is a type of financial crisis. It is a panic which occurs when a large number of customers of a bank fear it is insolvent and withdraw their deposits.
A run on the bank begins when the public begins to suspect that a bank may become insolvent. As a result, individuals begin to withdraw their savings. This action can destabilize the bank to the point where it may, in fact, become insolvent. Banks retain only a fraction of their deposits as cash (see fractional-reserve banking): the remainder is invested in securities and loans. As a result, no bank has enough reserves on hand to cope with more than the fraction of deposits being taken out at once. As a result, the bank faces bankruptcy, and will ‘call-in’ the loans it has offered. This can cause the bank’s debtors to face bankruptcy themselves if the loan is invested in a plant or other items that cannot easily be sold.
If many or most banks suffer runs at the same time, then the resulting chain of bankruptcies can cause a long economic recession.
As a bank run progresses, it generates its own momentum. As more people withdraw their deposits, the likelihood of default increases, so other individuals have more incentive to withdraw their own deposits. For this reason, a bank run has much in common with the reflexive processes described by George Soros, amongst others. Another example of a reflexive process is an economic bubble.
Bank runs first appeared as part of cycles of credit expansion and its subsequent contraction. In 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 (1634-1637), the British South Sea Bubble (1717-1719), the French Mississippi Company (1717-1720), the “Post Napoleonic Depression” (1815-1830) and the Great Depression (1929-1939).
Bank runs have also been used to blackmail individuals or governments; for example, in 1830 when the British Government under the Duke of Wellington overturned a majority government under the orders of the king, George IV, to prevent reform (the later 1832 Reform Act), he angered reformers and so a run on the banks was threatened under the rallying cry “To stop the Duke go for gold!”.
In 2001, during the Argentine economic crisis (1999-2002), a bank run and corralito was experienced in Argentina. There are various theories into the cause. This contributed towards the bank runs in neighbouring Uruguay during the 2002 Uruguay banking crisis.
From 9 November to 12 November 2006, Nepal Bangladesh Bank Limited (NB bank) in Nepal suffered a bank run. On 8 November 2006, a Nepalese newspaper reported that NB Bank’s 13 billion Nepalese rupees was at severe risk due to misuse of deposits by bank management. This news caused a run on the bank. Depositors withdrew around 3 billion Nepalese rupees during the three days of the run. However, after the takeover of bank management by the central bank of Nepal, the run ended.
In early August 2007, the American firm, Countrywide Financial suffered a bank run as a consequence of the subprime mortgage crisis.
On 13 September 2007, the British bank Northern Rock arranged an emergency loan facility from the Bank of England, which it claimed was the result of short-term liquidity problems. The bank’s defenders claimed its cash shortage was the result of over-exposure to the failing US sub-prime mortgage market, while its critics argued that it was the result of NR’s own careless lending practices. A run began the following day, Friday, with reports of its internet banking site being overloaded, and long queues outside branches that day, Saturday morning and the following Monday. News reports on 17 September stated that an estimated £2 billion GBP of retail deposits had been withdrawn by customers since the bank had applied for emergency funds.
A famous model on bank runs was developed by Diamond and Dybvig.
Modern economies use several methods to prevent bank runs across the whole economy, while still allowing individual institutions to fail. (A system where no bank was ever allowed to fail would cause a moral hazard, and result in poor management of banks).
According to the World Economic Forum’s Global Competitiveness Report, Canada and Australia are tied for the soundest banking systems in the world.
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This glossary post was last updated: 18th April, 2020 | 18 Views.