Bank Run

Definition

A bank run is a term used to describe a situation where bank customers withdraw all the money in their deposit accounts for fear that the bank insolvency. The more customers withdraw their money out of fear the more the chances of bankruptcy the bank has, maintaining only a small portion of its assets as cash. On the long run, if the bank run becomes uncontrollable that it affects other banks as well, not only would the individual banks experience bankruptcy but an industry-wide panic which can lead to an economic recession.

Understanding Bank Run

A bank run is caused more from customer panic rather than actual bank insolvency which results in pushing the bank into actual bankruptcy, thereby, making the cause of panic a reality. As more customers withdraw their money the panic increases leaving the bank with more chances of bankruptcy as well. In order to contain the panic, the bank would have to place withdrawal limits per account /customer, temporarily suspend all withdrawals, or borrow more cash from other banks or the central bank.

The first case of bank run happened in 1930 which created a ripple of other bank runs in the Southeast. It was caused by a customer who walked into a branch of the Bank of United States to sell off his stock in the bank. The bank had advised him not to sell the stock as it was a good investment. Misunderstanding the bank's counsel, the customer reportedly stated to all who cared to listen that the bank was facing insolvency for refusing to sell his stock. Within a short time, many of the bank’s customers had lined up outside the bank to withdraw their money. A total of $2 million in cash was withdrawn that same day. For security reasons, banks hold only a portion of its total assets, setting vault limits for its smaller branches. The rest of the bank’s assets/deposits/cash are being channeled into investment vehicles or loaned out to other clients for business purposes. As a result of this, it is quite possible for a bank to go short on cash when the withdrawals gradually exceed the vault limit. In 1931 and 1932 the US yet again experienced bank runs.

In response to the bank insolvency panic of the early 1930s, the federal government took necessary steps to control the issue and ensure that bank runs do not occur in the future such as placing a mandate for all banks to maintain a certain percentage of total deposits as cash at hand. The Federal Deposit Insurance Corporation was established in 1933 by the US Congress. The agency is responsible for insuring bank deposits, and to maintain stability and confidence in the financial system of the US.