AÂ bank-run occurs when a large number of depositors queue outside a bank, and ask for their money back. Normally, customers and depositors hear rumors about the bad state of their bank, and decide that it is a good idea to take their money out of the bank.
When a large number of people start withdrawing their money from the bank, the bank starts facing a liquidity crunch, and usually starts discouraging people from withdrawing their money.
When the bank discourages withdrawals – it lends credence to the rumors, and more and more people start to queue up. This increases the bank’s problems – a vicious cycle is triggered, and it eventually becomes a self-fulfilling prophecy.
Why does the bank discourage withdrawals?
It is common to call the depositors of the bank, its customers. However, if you have a savings account in a bank, and collect interest on it – how are you the customer? The bank doesn’t make any money off of you.
The bank makes its money by lending. So the money that you deposited to the bank has been lent out to corporates, entrepreneurs, sub-prime mortgage holders, and other people who need to pay off their credit card debt etc.
At any point in time – the bank may have less than 10% of its total deposits. In fact, if every person in a country decides to withdraw their money from the bank at the same time – nothing can stop the financial sector from getting destroyed.
There simply isn’t enough cash in the system to face such a situation.Â And that is the reason banks discourage withdrawals.
How can Bank Runs be prevented?
Theoretically, the risk of a bank-run can only be eliminated completely if the maturity of the deposits are matched 100% to maturity of loans made out by the bank. In such a case, all the banks loans will mature at the same time, as their withdrawals become due. However, this is realistically not possible.
The two steps that are usually taken during during a bank run are:
1. The Government provides Liquidity to the Bank: If the bank-run is triggered just because of a rumour, and the bank is fundamentally healthy, then the Government should provide a bridge – loan to the bank to tide over the crisis. Once, the panic is settled and people are assured that their money is safe, the deposits will find their way back to the bank and everyone will be happy.
2. The Government Insures the Depositors: The second step is for the government to assure the investors that their deposits are protected, and in case – the bank defaults – the depositors will still be paid their money back. This will work like the FDIC in US.
Since, bank-runs areÂ a case of a crisis in confidence, the solutions lies in restoring the confidence of depositors, and assuring them that their money will be paid back.
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