Bank run

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A bank run (also known as a run on the bank) is a type of financial crisis. It is a panic which occurs when a large number of customers of a bank withdraw their deposits because they fear it is, or might become, insolvent. This action can destabilize the bank to the point where it becomes insolvent. Banks retain only a fraction of their deposits as cash (see fractional-reserve banking): the remainder is invested in securities and loans. No bank has enough reserves on hand to cope with more than the fraction of deposits being taken out at once. As a result, the bank faces bankruptcy, and will 'call in' the loans it has offered. This can cause the bank's debtors to face bankruptcy themselves, if the loan is invested in a plant or other items that cannot easily be sold.

A banking panic or bank panic occurs if many banks suffer runs at the same time. The resulting chain of bankruptcies can cause a long economic recession.

As a bank run progresses, it generates its own momentum. As more people withdraw their deposits, the likelihood of default increases, so other individuals have more incentive to withdraw their own deposits. A bank run is a kind of positive feedback loop which has much in common with the reflexive processes described by George Soros, amongst others. Another example of a reflexive process is economic bubble.

Contents 1 Theory 2 Prevention 2.1 Individual banks 2.2 Collective prevention 3 History 3.1 Recent incidents 4 References

[edit] Theory

Main article: Diamond-Dybvig model

Diamond and Dybvig^[1] developed a widely used model to explain why bank runs occur and why banks issue deposits that are more liquid than their assets. This model starts with illiquid assets such as store inventories, which cannot be sold immediately without taking a substantial loss. Investors holding illiquid assets sometimes need access to liquid assets (for example to fund an entrepreneurial project that must be started quickly), but are hampered by not being able to predict when these opportunities arise. A bank can invest in a set of illiquid assets; the deposits in the bank become a more liquid asset that allows investors to share the risk of losses due to early liquidation. If only a few depositors withdraw at any given time, this works well; if not, the bank (as opposed to the original investors) may have liquidity problems, and depositors will rush to withdraw their deposits, forcing the bank to liquidate its assets at a loss, and eventually to fail. When such a bank calls in its loans early, this forces borrowers to disrupt their production, causing further economic problems.^[2]

A bank run can occur even when started by a false story. Even depositors who know the story is false will have an incentive to withdraw, if they think other depositors will believe the story. The story becomes a self-fulfilling prophecy.^[2]

[edit] Prevention

Several techniques can be used to help prevent bank runs.

[edit] Individual banks

Some prevention techniques apply to individual banks, independently of the rest of the economy.

• A bank can take deposits from depositors who do not observe common information that might spark a run. For example, in the days before deposit insurance, it made sense for a bank to have a large lobby and fast service, to prevent a line of depositors from extending out into the street, causing passers-by to infer that a bank run is occuring.^[2]

• A bank can temporarily suspend withdrawals to stop a run. In many cases the threat of suspension prevents the run, which means the threat need not be carried out.^[2]

• Bank regulation or other constraints can impose a reserve ratio requirement, which limits the proportion of deposits which a bank can lend out, making it less likely for a bank run to start.^[3] This practice sets a limit on the fraction in fractional-reserve banking; in the extreme and hypothetical case, full-reserve banking requires a reserve ratio of 100%.

[edit] Collective prevention

Some prevention techniques apply across the whole economy, though they may still allow individual institutions to fail. These techniques create moral hazard, since they reduce incentives for banks to avoid making risky loans; the goal is for the benefits of collective prevention to outweigh the costs of excessive risk-taking.^[4]

• Central banks act as a lender of last resort. To prevent a bank run, the central bank guarantees that it will make short-term loans to banks, to ensure that, if they remain economically viable, they will always have enough liquidity to honor their deposits.^[2]

• Deposit insurance systems (the Federal Deposit Insurance Corporation in the United States) insure each depositor up to a certain amount, so that depositors' savings are protected even if the bank fails. This removes the incentive to withdraw one's deposits simply because others are withdrawing theirs.^[2]

[edit] History

Bank runs first appeared as part of cycles of credit expansion and its subsequent contraction. In the 16th century onwards, English goldsmiths issuing promissory notes suffered severe failures due to bad harvests plummeting parts of the country into famine and unrest. Other examples are the Dutch Tulip manias (1634-1637), the British South Sea Bubble (1717-1719), the French Mississippi Company (1717-1720), the "Post Napoleonic Depression" (1815-1830) and the Great Depression (1929-1939).

Bank runs have also been used to blackmail individuals or governments; for example in 1830 when the British Government under the Duke of Wellington overturned a majority government under the orders of the king, George IV, to prevent reform (the later 1832 Reform Act), he angered reformers and so a run on the banks was threatened under the rallying cry "To stop the Duke go for gold!".

Many of the recessions in the United States were caused by banking panics. The Great Depression contained several banking crises consisting of runs on multiple banks from 1929 to 1933; some of these were specific to regions of the U.S.^[5] Much of the Depression's economic damage was caused directly by bank runs,^[6] and institutions put into place after the Depression have prevented runs on U.S. commercial banks since the 1930s,^[1] even under conditions such as the U.S. savings and loan crisis of the 1980s and 1990s.^[7] The Depression's bank runs left a lasting mark on the American psyche, exhibited in sometimes disturbing images such as the bleak scenes where the fictional hero George Bailey contemplates suicide in the movie It's a Wonderful Life.^[8]

[edit] Recent incidents

In 2001, during the Argentine economic crisis (1999-2002), a bank run and corralito was experienced in Argentina. There are various theories into the cause.^[9] This contributed towards the bank runs in neighbouring Uruguay during the 2002 Uruguay banking crisis.

From 9 November to 12 November 2006, Nepal Bangladesh Bank Limited (NB bank) in Nepal suffered a bank run. On 8 November 2006, a Nepalese newspaper reported that NB Bank's 13 billion Nepalese rupees was at severe risk due to misuse of deposits by bank management. This news caused a run on the bank. Depositors withdrew around 3 billion Nepalese rupees during the three days of the run. However, after the takeover of bank management by the central bank of Nepal, the run ended.^{[citation needed]}

In early August 2007, the American firm, Countrywide Financial suffered a bank run as a consequence of the subprime mortgage crisis.^[10]

On 13 September 2007, the British bank Northern Rock arranged an emergency loan facility from the Bank of England, which it claimed was the result of short-term liquidity problems. The bank's defenders claimed its cash shortage was the result of over-exposure to the failing US sub-prime mortgage market, while its critics argued that it was the result of NR's own careless lending practices. A run began the following day, Friday, with reports of its internet banking site being overloaded,^[11] and long queues outside branches that day, Saturday morning and the following Monday.^[12] News reports on 17 September stated that an estimated £2 billion GBP of retail deposits had been withdrawn by customers since the bank had applied for emergency funds. ^[13]

On Tuesday, 11 March 2008, a bank run began on the securities and banking firm Bear Stearns. While Bear Stearns was not an ordinary deposit-taking bank, it had financed huge long-term investments by selling short-maturity bonds (Asset Backed Commercial Paper), making it vulnerable to panic on the part of its bondholders. Credit officers of rival firms began to say that Bear Stearns would not be able to make good on its obligations. Within two days, Bear Stearns's capital base of $17 billion had dwindled to $2 billion in cash, and Bear Stearns told government officials that it saw little option other than to file for bankruptcy the next day. By 07:00 Friday, the Federal Reserve decided to lend Bear Stearns money, the first time since the Great Depression that it had lent to a nonbank. Stocks sank, and that day JPMorgan Chase began an effort to buy Bear Stearns as part of a government-sponsored bailout. The deal was arranged by Sunday in an effort to calm markets before markets opened Monday.^[14]

[edit] References