What Is a Bank Run?
A bank run occurs when a large number of customers of a bank or other financial institution withdraw their deposits simultaneously over concerns of the bank's solvency.
As more people withdraw their funds, the probability of default increases, prompting more people to withdraw their deposits. In extreme cases, the bank's reserves may not be sufficient to cover the withdrawals.
Understanding Bank Runs
Bank runs happen when a large number of people start making withdrawals from banks because they fear the institutions will run out of money. A bank run is typically the result of panic rather than true insolvency.
A bank run triggered by fear that pushes a bank into actual insolvency represents a classic example of a self-fulfilling prophecy. The bank does risk default, as individuals keeping withdrawing funds. So what begins as panic can eventually turn into a true default situation.
That's because most banks don't keep that much cash on hand in their branches. In fact, most institutions have a set limit to how much they can store in their vaults each day. These limits are set based on need and for security reasons. The Federal Reserve Bank also sets in-house cash limits for institutions. The money they do have on the books is used to loan out to others or is invested in different investment vehicles.
How Bank Runs Happen
Because banks typically keep only a small percentage of deposits as cash on hand, they must increase their cash position to meet the withdrawal demands of their customers. One method a bank uses to increase cash on hand is to sell off its assets—sometimes at significantly lower prices than if it did not have to sell quickly.
Losses on the sale of assets at lower prices can cause a bank to become insolvent. A bank panic occurs when multiple banks endure runs at the same time.
- A bank run happens when large groups of customers withdraw their money from banks simultaneously based on fears that the institution will become insolvent.
- With more people withdrawing money, banks will use up their cash reserves and ultimately end up defaulting.
- The Federal Deposit Insurance Corporation was established in 1933 in response to a bank run.
Preventing Bank Runs
In response to the turmoil of the 1930s, governments took several steps to diminish the risk of future bank runs. Perhaps the biggest was establishing reserve requirements, which mandate that banks maintain a certain percentage of total deposits on hand as cash.
Additionally, the U.S. Congress established the Federal Deposit Insurance Corporation (FDIC) in 1933. Created in response to the many bank failures that happened in the preceding years, this agency insures bank deposits. Its mission is to maintain stability and public confidence in the U.S. financial system.
But in some cases, banks need to take a more proactive approach if faced with the threat of a bank run. Here's how they may do it.
1. Slow it down. Banks may choose to shut down for a period of time if they are faced with the threat of a bank run. This prevents people from lining up and pulling their money out. Franklin D. Roosevelt did this in 1933 after he assumed office. He declared a bank holiday, calling for inspections to ensure banks' solvency so they could continue operating.
2. Borrow. Banks may borrow from other institutions if they don't have enough cash reserves. Large loans may stop them from going bankrupt.
3. Insure deposits. When people know their deposits are insured by the government, their fear generally subsides. This has been the case since the U.S. established the FDIC.
Central banks typically act as a last resort for lending to individual banks during crises like a bank run.
Bank Run Examples
The stock market crash of 1929 precipitated a spate of bank runs across the country, ultimately culminating in the Great Depression. The succession of bank runs that occurred in late 1929 and early 1930 represented a domino effect of sorts, as news of one bank failure spooked customers of nearby banks, prompting them to withdraw their money. For example, a single bank failure in Nashville led to a host of bank runs across the Southeast.
Other bank runs during the Depression occurred because of rumors started by individual customers. In December 1930, a New Yorker who was advised by the Bank of United States against selling a particular stock left the branch and promptly began telling people the bank was unwilling or unable to sell his shares. Interpreting this as a sign of insolvency, bank customers lined up by the thousands and, within hours, withdrew over $2 million from the bank.