Bank run
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Image:War of wealth bank run poster.jpg A bank run is a type of financial crisis. It is a panic which occurs when a large number of customers of a bank fear it is insolvent and withdraw their deposits.
A run on the bank begins when the public begins to suspect that a bank may become insolvent. As a result, individuals begin to withdraw their savings. This action can destabilise the bank to the point where it may in fact become insolvent. Banks only retain a fraction of their deposits as cash (see fractional-reserve banking): the remainder is issued as loans. As a result, no bank has enough reserves on hand to cope with everyone taking their savings 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 plant or other items that cannot easily be sold.
If many or most banks suffer runs at the same time, then 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 savings, the likelihood of default increases, so other individuals have more incentive to withdraw their own deposits. For this reason, a bank run has much in common with the reflexive processes described by George Soros, amongst others. Another example of a reflexive process is economic bubble.
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 'Dutch Tulip Manias' (1634-1637), 'Compagnie d'Occident Bubble' (1717-1719), 'Post Napoleonic Depression' (1815-1830) and the Great Depression (1929-1939).
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 [1].
Prevention
Modern economies use several methods to prevent bank runs across the whole economy, while still allowing individual institutions to fail. (A system where no bank was ever allowed to fail would cause a moral hazard, and result in poor management of banks).
- Deposit insurance systems (such as the Federal Deposit Insurance Corporation in the United States) insure each depositer up to a certain amount, therefore the depositers' savings are protected even if the bank fails. This removes the incentive to withdraw your deposits simply because others are withdrawing theirs. (Note, though, that this only works if consumers trust the insurance system. When the Maryland, US state savings and loan system collapsed in 1985, the underfunded insurance system took more than a year to refund deposits to account-holders at the institutions that failed.)
- Central banks act as a lender of last resort. To prevent a bank run, the Central Bank guarantees that it will make short-term, high-interest loans to banks, to ensure that, if they remain economically viable, they will always have enough liquidity to honour their deposits.
- Reserve ratios and Tier 1 capital thresholds both limit the proportion of deposits which a bank can loan out. These methods help ensure that a bank does not have an unsustainably low level of reserves.