Many people don’t understand how and why a bank run occurs and what it means. Banks have a duty to safeguard deposits and the economic system, but they do need a great deal of public trust. A bank’s success is not always dependent on its financial strength. A loss of public trust can place significant strain on even a well-funded institution.
We will discuss what a bank run is, why banks fail, and the major reasons behind bank runs, as well as some lessons from banking failures in the past, in this blog.
What is a Bank Run?
A bank run is when there is a mass withdrawal of bank deposits due to fear of the bank’s failure. At first glance, this may seem illogical. Why would all the customers rush to the bank if it was healthy?
The answer lies in how banking works.
Banks don’t store all the dollars that are put into them in the vault. They, on the other hand, use a substantial portion of deposits for loans, government securities, and other relatively safe investment options. This not only helps the bank earn money but also helps in the promotion of economic growth.
Why Do Banks Fail?
Bank failures are never just because of one thing. Rather, the failures typically result from a combination of weaknesses that are gradually created and then are revealed by some accident.
1. Poor Asset Management
The profits of banks depend on their money-lending and investment in financial assets.
When a bank’s loans are not repaid by the borrowers, or investments lose considerable value, the bank’s financial situation is worse.
If the underwriting standards are not up to scratch, if risks are taken too frequently, or if there is a lack of awareness of one particular industry, then these can become hidden threats over time.
A lot of the historic instances of bank failures started with management choices and improper asset and liability management. These seemed to be beneficial in the more prosperous days that were then but turned out to be disastrous during adverse economic times.
2. Liquidity Problems
Liquidity is the speed at which a bank is able to obtain cash. Billions of dollars in assets could not be quickly converted into cash, and a bank would be in trouble, even though it owned such assets.
Now, imagine owning several valuable properties but needing cash immediately. Selling them quickly may not be easy, but you require cash tomorrow morning, what will you need to do? You can have a lot of money, but you don’t have a lot of cash when you want to buy real estate.
It’s the same situation for banks. If withdrawals speed up unexpectedly, it is more important to be liquid than to be profitable over the long term.
3. Interest Rate Risk
A major takeaway from the banking crisis of recent months is that as banks do not exist in a vacuum, older bonds and long-term investments can lose market value because of rising interest rates.
This doesn’t mean that you lose money immediately.
But when a bank has to liquidate them before they come to maturity due to customer withdrawals, then the losses turn into realized losses.
Many banking crises have happened in history, such as the S&L crisis and the Silicon Valley Bank failure, which have been caused by the rapid rise in interest rates.
4. Concentration Risk
Diversification is not only for the protection of the investors, but also for the financial institutions. A bank’s problems occur when it over-depends on the following:
- One industry
- One geographic region
- One customer type
The first type of investments are those that fall under the category of one. When this highly concentrated area of business deals with economic difficulties, the bank’s balance sheet can be impacted as well.
5. Losing Public Trust
Trust is the key to banking. At the time of opening an account, customers are unlikely to look at the balance sheets. They make the presumption that regulators, executives, and financial institutions are acting responsibly.
As soon as trust starts waning, rumors will proliferate, and they’ll spread like wildfire, particularly in the digital age.
In the past, a bank run would take place on the streets in front of the bank branches, but today it’s through the mobile phone.
Also Read: Bank Statement: What It Is, How to Get It, and Its Importance
How Successful Banks Keep Themselves Safe?
Successful banks plan for the times when uncertainty arises. Generally, strong institutions have the following characteristics:
- Adequate capital reserves
- Diverse loan portfolios
- High-quality investments
- Conservative risk management
- Funding for emergency needs.
- Robust liquidity planning
The regulators have also imposed minimum capital and minimum liquidity requirements to withstand economic shocks. Since the global financial crisis, these requirements have become much more stringent.
Regulations can’t remove all the risks, but today’s banking system is far more resilient than it was decades ago.
Lessons from History
A very interesting part of banking is that lessons are learned from each crisis. The theme remains the same despite the changes in circumstances.
1. The Great Depression
The most well-known bank runs were the ones during the Great Depression. Following the 1929 stock market crash, public confidence in financial institutions declined, leading to widespread bank runs and thousands of bank failures.
In those days, there was no deposit insurance, and in a bank failure, depositors frequently lost all their funds. The crisis had a fundamental impact on American banking.
Federal deposit insurance was established, leading to a sudden growth in confidence and to a sharp decrease in the possibility of bank runs taking place.
In some cases, it’s not the technology; it’s a rebuilding of public trust that is the most important innovation.
2. The Savings and Loan Crisis
The late 70s and 80s saw a significant rise in inflation and interest rates. Several savings institutions had taken out long-term fixed-rate mortgages but had taken deposits in the short term.
As the rates started to go up, their business became increasingly impossible.
Eventually, hundreds of institutions of every kind failed. The crisis has made it apparent how dangerous interest rate mismatches can be in the event of economic conditions shifting more rapidly than planned.
3. The Global Financial Crisis of 2008
Housing market risk-taking was the main factor behind the 2008 financial crisis. Banks were laxer in their lending criteria, and investors were complacent about the risks of mortgage-backed securities.
During the downturn in the real estate market, loan delinquencies sharply rose. Confidence disappeared. The financial institutions suffered huge losses, credit markets virtually shut down, and governments across the world sought to stabilize the financial system.
The fallout resulted in broad-ranging reforms to regulation, increased capital requirements, and increased stress testing.
4. Silicon Valley Bank and 2023 Banking Crisis
The crisis at Silicon Valley Bank was a stark reminder of the speed at which a banking crisis can happen today.
Unlike traditional bank runs that involved long lines outside branches, the Silicon Valley Bank crisis unfolded digitally. Billions of dollars went through the system as transfers of money via electronic means without hours.
The bank had bought numerous treasuries, the majority from long-term government bonds, which it had bought when interest rates were at an historically low level.
Those investments declined in market value due to the swift increase in rates. And it would normally be something that would have been dealt with. But withdrawals went faster than the bank could forgo investments, though, at a large discount.
Social media, investor networks, and messaging rapidly and instantly spread the news. Regulators and executives were stunned by the precipitous drop in confidence. This episode highlighted how quickly a financial crisis can escalate in the digital age.
Check Out: Pending Transactions: Meaning, Processing Time, and Bank Balance Impact
How to Identify the Warning Signs?
If you’re not a regular depositor, you do not have to study a bank’s balance sheets every week, but having a basic understanding can be helpful.
The following are some signs to watch out for:
- Consistent financial losses.
- High level of reliance on a single sector.
- Regulatory enforcement actions.
- Declining capital ratios.
- High level of uninsured deposits.
- Continuous negative publicity about management.
All of these do not mean that the component is about to fail. Temporary setbacks are a possibility for healthy banks. But if several warning signs are present, they should be taken seriously.
Do You Need to Worry About Your Money in a Bank Run?
For most people, the answer should be no.
Today, financial institutions have a lot of protections not available in previous crises. Regulators will keep a close eye on financial institutions and new risks, and deposits are covered by deposit insurance up to specified limits.
In addition, governments have forceful reasons not to encourage a mass panic since the stability of the banking sector is critical for the economy as a whole.
That’s not to say that banks are no longer failing. Individual institutions can and may go bankrupt. What’s different about the regulatory structure today is that it is set up so that it minimizes contagion and shields the ordinary depositor from ruinous losses.
The banking system has changed just because of the lessons learned from the previous banking crisis.
Final Thoughts
Bank runs are always a fascinating phenomenon and one that demonstrates something more than finance; it demonstrates human behaviour. Numbers are important, but so is psychology. Before analysts can decipher the facts, a rumour or viral social media post or a loss of confidence can cause billions of dollars to shift.
Rather than being a sign of fragility in the banking system, that is merely the case for the banks themselves. Indeed, history has shown that is not the case. Banks have seen depressions, inflation, recessions, financial bubbles, and technology. Each of these major crises has resulted in changes that have increased the resilience of the system.
Read Next: What is Single Touch Payroll? – Its Benefits, Common Mistakes, and Reporting Process
FAQs
What is a bank run on deposits?
When depositors rush to withdraw their funds from a bank run on deposits occurs. Banks don’t hold all funds in cash because they borrow out a large portion of the money that they receive as deposits. If many people start to withdraw their money at the same time, it might become a liquidity crisis for the bank.
What causes a run on the bank?
Typically, a run on the bank is brought about by a loss of public confidence. If negative news, rumors, poor financial performance, or economic uncertainty cause customers to withdraw their deposits all at once, they could withdraw their funds, and the bank could lose all its money.
Can a bank survive a bank run?
No, not all bank runs lead to a bank failure. Some banks manage to survive a bank run through the use of cash reserves, borrowing from the central bank, or raising more capital. Today’s banking system is also more resilient due to modern regulations, deposit insurance, and tougher liquidity requirements.
Sources
- Bank Run – By Wall Street Prep
- What is a bank run? – By Experian
