A run on a bank or a bank run is a situation in which a large number of depositors withdraw their money from a bank because of a perceived risk. A series of bank runs transpiring in a particular geographic market or several markets is a more serious situation that involves multiple banks. Runs are a complex event arising from different factors but some historical instances had causes that can be pinpointed. The effects of a bank run can be limited to the affected bank or widespread and involve the entire banking system and economy.
Explaining and Understanding the Causes and Effects of a Bank Run
Causes of a Bank Run
The likelihood of people keeping or withdrawing their cash in banks is determined by their level of confidence. This means that the cause of a bank run is the loss of public confidence due to perceived or real issues affecting a particular bank, the entire banking system, or the greater financial system. There are more specific reasons or factors that lead to the erosion of public confidence. Take note of the following:
1. Financial Standing of a Bank
Silicon Valley Bank collapsed in March 2023 due to a bank run. Its customers grew concerned over the unfavorable investments of the bank and news that it sold the bonds it held at an unfavorable premium. A failed attempt at stock issuance aimed at raising capital to meet its financial obligations trigger widespread panic. The bank run and eventual collapse essentially stemmed from its poor financial decisions and negative financial standing.
The financial health of a particular bank is essential to maintaining the confidence of its depositors. Remember that banks need to generate revenues to fund their operations and provide their depositors with interest in their deposits. Those that follow the fractional reserve mechanism use different revenue-generating activities to maximize their earnings.
Some of these activities have risks and failed ones would result in incurred losses. Significant losses would then render a bank unable to finance its operations and obligations to its depositors. These losses often get widespread attention because the financial statements and other information about the financial health of a bank are available to the public.
A bank with a poor financial standing as determined by its liquidity would then experience capital flight. This is a situation in which its depositors pull out their money to deposit in other banks or invest in other vehicles. This exact situation happened to Silicon Valley Bank. Its depositors withdrew their cash as part of their attempt to save themselves from a possible banking failure and find other more reliable banks.
2. Rumors and Speculations
Some bank customers would pull out their cash stashed in banks even if there is no evidence that the bank is in trouble. This is driven by unfavorable rumors arising from official or unofficial news and excessive but unfounded speculations. A rumor spreading like a wildfire triggers an emotional response that further leads to herd behavior.
There are several examples in the past in which rumors resulted in a bank run. For instance, in 2014, there was circulating news that Jiangsu Sheyang Rural Commercial Bank, a small rural bank in Yancheng in China, refused a withdrawal request. This news was unfounded but it was enough to drive hundreds of customers to the bank and request for withdrawals and account closures despite assurances from regulators and the central bank.
A rumor creates room for speculation that can further lead to a self-fulfilling prophecy. Take note that an increase in withdrawal requests increases the likelihood of a banking failure. This will trigger more withdrawals. The bank would then reach a point where it will run out of cash and become insolvent. An actual bank failure would then occur.
3. Economic Instability and Recession
The Great Depression which started in 1929 and endured until 1939 triggered several instances of a bank run that affect thousands of banks across the. For example, in the United States, bank runs started in the latter months of 1930 and continued to worsen in 1931 and 1932. A bank holiday was declared in 1933 in which all banks were ordered to cease operations.
Several banks also experienced runs during the 2007-2008 Financial Crisis. These included securities and banking firm Bear Stearns, savings and loan association Washington Mutual, and diversified financial services firm Wachovia. The same occurred in several Eurozone countries during the European Debt Crisis. The first significant run was in Greece in 2010 which saw billions of euros in withdrawals. Ireland, Portugal, and Spain also experienced bank runs.
The initial years of an economic crisis or periods of unstable economic conditions and even during a recession often trigger a bank run because people are more prone to safeguard their cash to have them on hand in case of unemployment or other financial hardships. The same crisis also affects the level of confidence of depositors in the banking system.
4. Unfavorable Government Policies
Another cause of a bank run centers on changes in government policies or the imposition of new regulations relevant to the banking system and the overall financial system. Remember that most governments intervene in the affairs of their respective economies in several degrees through legislation and their executions. The monetary policy of a particular country and its central bank has a strong influence on its entire banking system and the greater financial system.
The bank runs that occurred in Iceland during the 2008-2011 Icelandic Financial Crisis is an example of a bank run stemming from an economic crisis but the actual cause of the problem can be traced back further to bank deregulation in 2001. The absence of deregulation encouraged Icelandic banks to take more risks without oversight and transparency.
Note that three of the largest banks in Iceland collapsed after a run on deposits. These included Kaupthing Bank, Landsbanki, and Glitnir. The lack of transparency across the Icelandic banking system combined with the global financial crisis that started in the U.S. resulted in people losing confidence in Icelandic banks due to its global exposure.
A bail-in is another example of how government policies or regulations can cause a bank run. This happened in Cyprus in 2012. A bail-in is a process where a government forces creditors to take losses on their investments in a failing bank. The fractional reserve banking system observed in most countries has also been blamed as a mechanism for setting the stage for serious bank runs because it allows banks to keep a small fraction of cash in reserve.
Effects of a Bank Run
The exact effect of a bank run varies. Some instances had a limited impact while others have wider and lasting consequences. It is important to note that these effects or impacts are determined by the size of the involved bank, the duration of the run, the response of the bank and intervention of the government, the number of affected banks, and if there are contagion effects or the level of exposure of other institutions. Take note of the following:
1. Imposition of a Bank Holiday: A government can declare a bank holiday during the initial phase of a bank run or if there are indicators that massive runs will occur. This would result in a bank or several banks ceasing their operations temporarily until certain conditions are met or if the situation has been assessed and resolved. Take note that the U.S. government declared a bank holiday in 1933 during the Great Depression. The goal was to determine the solvency of American banks and prevent further runs.
2. Limited Banking Failure: There are instances of runs that had limited impact. This means that only the involved banks had suffered losses and ended in a banking failure or collapse due to a liquidity crisis stemming from the depletion of their cash reserves. A notable example is the collapse of Silicon Valley Bank. Some feared that it would trigger a wave of bank runs that would lead to a widespread failure across the U.S. banking system but the situation had remained contained and controlled.
3. Wider Banking System Failure: It is also possible for a run affecting a large bank to cause a wave of runs affecting other banks. This is due to the loss of public confidence in the banking system stemming from either a perceived or real risk. It is important to note that the larger the bank the wider its reputation. A large bank also tends to be more involved in the banking system and the greater financial system. This transpired during the Great Depression and the 2007-2008 Financial Crisis.
4. Contagion and Systemic Risk: A widespread bank run can create a contagion effect in which fear and panic spread beyond to banking system and other financial institutions and the greater financial system. A notable example of this is the 2007-2008 Financial Crisis that started with the failure of banks in the U.S. and spread across different financial markets around the world. Take note that one of the origins of the 2008-2011 Icelandic Financial Crisis is the crisis that started in the U.S.
5. Increase in Borrowing Cost: The access to credit of individuals and institutions will be affected if bank runs result in widespread banking failure and systemic failure in other financial markets. The bank runs in Europe during the European Debt Crisis increased the borrowing cost of several European countries. Businesses were also affected. The increased cost made it more difficult for them to either finance their debt obligations or raise funds for continuing and expanding their operations.
6. Economic Crisis and Recession: Another more serious impact or effect of a bank run is an economic crisis and even a recession. Remember that the collapse of a large bank can result in the collapse of other banks. This will result further in the failure of an entire banking system that can affect other financial institutions and financial markets. Banks have a central role in lending activities. A reduction in these activities can constrain business activities, consumer spending, and other investment activities.