Bank Run

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.

History

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!”.

Notable Incidents

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.[1] 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,[3] 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.

Theory

A famous model on bank runs was developed by Diamond and Dybvig.

In Fiction

• In The Count of Monte Cristo the protagonist Edmond Dantes, in disguise as the fabulously wealthy Count of Monte Cristo, takes revenge on Danglars by withdrawing huge sums of money under a letter of credit from another bank which gives “unlimited credit”. This, combined with rumours of insolvency, leads to the bank’s collapse and disgrace for its founder Danglars.
• In James Clavell’s novel, Tai-Pan, a bank run nearly bankrupts the protagonist, Dirk Struan, and forms the basis of many events in the book.
• In the Tom Swift series, the eponymous hero uses his technology to stop a run on the bank.
• In the 1964 movie Mary Poppins, the Banks children accidentally cause a bank run at their father’s bank.
• In one of the pivotal scenes of the movie, It’s a Wonderful Life, the hero George Bailey saves his building and loan association from a run by using the money from his wedding trousseau to supply cash to his panicked depositors.
• In Arthur Hailey’s 1975 novel The Money Changers, the hero narrowly prevents a bank run from bankrupting his bank after the revelation of a major fraud.
• In the episode “The PTA Disbands” of The Simpsons, Bart Simpson causes a bank run by inserting rumours about the bank’s insolvency. This causes a Jimmy Stewart-like bank manager to say “I don’t have your money here. It’s at Bill’s house and Fred’s house!” referring to the bank run on It’s a Wonderful Life.
• In The Jungle, by Upton Sinclair, rumours of a bank run cause the character Marija to withdraw her savings. Later, it turns out that “the cause of the panic had been the attempt of a policeman to arrest a drunken man in a saloon next door, which had drawn a crowd at the hour the people were on their way to work, and so started the ‘run’.”
• In Sneakers, the main character Martin Bishop and his antagonist Cosmo discuss how information control can be used to produce bank runs: Posit: People think a bank might be financially shaky. — Consequence: People start to withdraw their money. — Result: Pretty soon it is financially shaky.

Prevention

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).

• Deposit insurance systems (such as the Canadian Deposit Insurance Corporation in Canada or the Federal Deposit Insurance Corporation in the United States) insure each depositor up to a certain amount, therefore the depositors’ savings are protected even if the bank fails. This removes the incentive to withdraw your deposits simply because others are withdrawing theirs. (Note, though, that this works only if consumers trust the insurance system. When the Maryland, US state savings and loan system collapsed in 1985, the underfunded insurance system took more than a year to refund deposits to account-holders at the institutions that failed.)
• Central banks act as a lender of last resort. To prevent a bank run, the Central Bank guarantees that it will make short-term, high-interest loans to banks, to ensure that, if they remain economically viable, they will always have enough liquidity to honour their deposits. However, in the case of Northern Rock it was the announcement that the Bank of England was providing this facility to Northern Rock that triggered the bank run.
• Reserve ratios and Tier 1 capital thresholds both limit the proportion of deposits which a bank can loan out. These methods help ensure that a bank does not have an unsustainably low level of reserves.

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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