The bane of Basel III
The bane of Basel III
A bank run occurs when many customers withdraw all their money simultaneously from their deposit accounts with a banking institution for fear that the institution is, or might become, insolvent. The situation takes place in fractional reserve banking systems where banks only maintain a small portion of their assets as cash. As more customers withdraw their money, there is a likelihood of default, and this will trigger more withdrawals to a point where the bank runs out of cash. An uncontrolled bank run can lead to bankruptcy, and when multiple banks are involved, it creates an industry-wide panic that can lead to economic recession.
A bank run occurs due to customer panic rather than actual insolvency on the part of the bank. A bank run that emanates from public fear and that pushes a bank into actual bankruptcy is an example of a self-fulfilling prophecy. As more people withdraw money, the risk of bankruptcy increases and this triggers even more withdrawals. The bank may limit the number of withdrawals per customer or suspend all withdrawals altogether as a way of dealing with the panic. Also, the bank may get more cash from other banks or from the central bank to increase its cash on hand.
The United States stock market crash in 1929 left the public susceptible to rumors of an impending financial crisis. There was a decrease in investment and consumer expenditure, which led to increased unemployment and decline in industrial production. A wave of banking panics worsened the situation, with anxious depositors rushing to withdraw their bank deposits. The simultaneous withdrawals forced banks to liquidate loans and sell their assets to meet the withdrawals.
The first bank run started in Nashville, Tennesse, in 1930 and this triggered a wave of bank runs in the Southeast as customers rushed to withdraw their deposits. Banks hold only a fraction of the deposits, with the rest of the deposits being loaned out to other clients. Due to a cash shortage, banks were forced to liquidate the loans and sell assets at rock-bottom prices to supplement the mass withdrawals. Other bank runs followed in 1931 and 1932. Bank runs were most rampant in states whose laws mandated banks to run only a single branch, and this increased the risk of failure.
The biggest casualty of the banking crisis was the Bank of United States in December 1930. A customer walked in the New York branch of the bank and asked to sell off his stock in the bank. However, the bank advised him against selling the stock since it was a good investment. The customer left the bank and started spreading rumors that the bank had refused to sell his stock and it was facing insolvency. Within hours, the bank customers lined up outside the bank and made withdrawals totaling $2 million in cash.
After assuming office in 1933 as the 32nd President of the United States, Franklin D. Roosevelt declared a national bank holiday. The holiday allowed for federal inspection of all banks to determine if they were solvent enough to continue operations. The president also called on the US Congress to come up with new banking legislation to help the ailing financial institutions.
In 1933, President Roosevelt gave speeches that were broadcast on radio, assuring American citizens that the government would not want to see other incidents of bank failures. He assured the public that the banks would safeguard their deposits once they resumed operations and that it was safer to keep money in the bank than to keep it under the mattress. Roosevelt’s actions and words marked the start of a restoration process where citizens would trust the banks again.
The Banking Act of 1933 led to the formation of the Federal Deposit Insurance Corporation (FDIC). The act gave the body the authority to supervise, regulate, and provide deposit insurance to commercial banks. The body was also responsible for promoting sound banking practices among banks and maintaining public confidence in the financial system. To avoid triggering a bank run, the FDIC performs takeover operations in secret and closed banks re-open in the next business day under new ownership. The body remains active to date.
In a situation where a banking institution faces the threat of insolvency due to a bank run, it may use the following techniques to mitigate the run:
A bank may slow down a bank run by artificially slowing down the process. During the recession in the United States, banks that feared a bank run would have their employees and their relatives make a long queue in front of the tellers and make small and slow deposits or withdrawals. This would help the bank buy time before the closing time. However, this technique may not work in the current technological era of internet banking. The ideal solution would be to have the authorities close the bank for some period to prevent customers from withdrawing all their money.
Where the bank’s cash reserves cannot handle the number of cash withdrawals, the bank may borrow money from other banks or the central bank. If they can be loaned a huge sum of money, this can prevent the bank from going bankrupt. The Central Bank as the lender of last resort has a responsibility to loan out money to struggling banks to prevent their bankruptcy. Also, prominent cash deliveries to the bank can convince the customers that there is no need to make quick withdrawals.
Providing insurance to customer deposits provides a guarantee to participants that, should the bank go under, they will get their money back. Deposit insurance started in the United States after the Great Depression when the Federal Deposit Insurance Corporation (FDIC) was formed. The body restored public confidence in the banking system and ensured that customers get all their money back when a bank becomes insolvent. If a bank collapses, the FDIC allows a bank with high capital reserves to acquire the vulnerable bank, together with its customers. The customers can then access their deposits in the new bank. In the worst cases, the FDIC may auction the collapsed bank’s assets to pay back depositors.
A bank can encourage its customers to make term deposits and earn a percent of interest on the money. Customers can only withdraw their money after the end of an agreed period and not on demand. If term deposits form a huge percentage of a bank’s liabilities, the bank can survive a bank run even if customers withdraw other deposits. Term deposits are usually invested in other profitable ventures that earn the bank some interest.
Thank you for reading CFI’s guide to bank runs. To learn more about the banking industry, CFI offers the following resources.