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Bank run

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Subject: Systemic risk, Great Depression, Fractional-reserve banking, Financial crisis of 2007–08, Bank of United States
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Bank run

Depositors clamor to withdraw their savings from a bank in Berlin, 13 July 1931

A bank run (also known as a run on the bank) occurs when, in a fractional-reserve banking system (where banks normally only keep a small proportion of their assets as cash), a large number of customers withdraw cash from deposit accounts with a financial institution at the same time because they believe that the financial institution is, or might become, insolvent; and keep the cash or transfer into other assets, such as government bonds, precious metals or stones. When they transfer funds to another institution it may be characterised as a capital flight. As a bank run progresses, it generates its own momentum: as more people withdraw cash, the likelihood of default increases, and triggering further withdrawals. This can destabilize the bank to the point where it runs out of cash and thus faces sudden bankruptcy.[1] To combat a bank run, a bank may limit how much cash each customer may withdraw, suspend withdrawals altogether, or promptly acquire more cash from other banks or from the central bank, besides other measures.

A banking panic or bank panic is a financial crisis that occurs when many banks suffer runs at the same time, as people suddenly try to convert their threatened deposits into cash or try to get out of their domestic banking system altogether. A systemic banking crisis is one where all or almost all of the banking capital in a country is wiped out.[2] The resulting chain of bankruptcies can cause a long economic recession as domestic businesses and consumers are starved of capital as the domestic banking system shuts down.[3] According to former U.S. Federal Reserve chairman Ben Bernanke, the Great Depression was caused by the Federal Reserve System,[4] and much of the economic damage was caused directly by bank runs.[5] The cost of cleaning up a systemic banking crisis can be huge, with fiscal costs averaging 13% of GDP and economic output losses averaging 20% of GDP for important crises from 1970 to 2007.[2]

Several techniques have been used to try to prevent bank runs or mitigate their effects. They have included a higher

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External links

  • Kaufman, George G. (2008). "Bank Runs". In  

Further reading

  1. ^ a b c d e f g h i j k l Diamond DW (2007). "Banks and liquidity creation: a simple exposition of the Diamond-Dybvig model" (PDF). Fed Res Bank Richmond Econ Q 93 (2): 189–200. 
  2. ^ a b c d e f g Laeven L, Valencia F (2008). "Systemic banking crises: a new database" (PDF). IMF WP/08/224. International Monetary Fund. Retrieved 2008-09-29. 
  3. ^ a b Wicker E (1996). The Banking Panics of the Great Depression. Cambridge University Press.  
  4. ^ http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021108/
  5. ^ a b  
  6. ^ a b Heffernan S (2003). "The causes of bank failures". In Mullineux AW, Murinde V. Handbook of international banking. Edward Elgar. pp. 366–402.  
  7. ^ a b Reckard ES, Hsu T (2008-09-26). "U.S. engineers sale of WaMu to JPMorgan". Los Angeles Times. Retrieved 2008-09-26. 
  8. ^ Gross, David M. (2014). 99 Tactics of Successful Tax Resistance Campaigns. Picket Line Press. p. 176.  
  9. ^ Robert L. Fuller, "Phantom of Fear" The Banking Panic of 1933 (2011) 16–22
  10. ^ Richardson G (2007). "The collapse of the United States banking system during the Great Depression, 1929 to 1933, new archival evidence" (PDF). Australas Account Bus Finance J 1 (1): 39–50. 
  11. ^ Milton Friedman and Anna J. Schwartz, A Monetary History of the United States (1993 ed.) 301–05, 342–46, 351–52
  12. ^ Fuller (2011) 28–31, 66–67, 97–98.
  13. ^ a b Diamond DW, Dybvig PH (1983). "Bank runs, deposit insurance, and liquidity" (PDF). J Pol Econ 91 (3): 401–19.   Reprinted (2000) Fed Res Bank Mn Q Rev 24 (1), 14–23.
  14. ^ Cooper R, Ross TW (2002). "Bank runs: deposit insurance and capital requirements". Int Econ Rev 43 (1): 55–72.  
  15. ^ Maland CJ (1998). "Capra and the abyss: self-interest versus the common good in Depression America". In Sklar R, Zagarrio V. Frank Capra: Authorship and the Studio System. Temple University Press. pp. 95–129.  
  16. ^ Barrell R, Davis EP (2008). "The evolution of the financial crisis of 2007–8". Natl Inst Econ Rev 206 (1): 5–14.  
  17. ^  
  18. ^ "The only way to stop a eurozone bank run". Financial Times. 
  19. ^ Lietaer B, Ulanowicz R, Goerner S (2008). "Options for managing a systemic bank crisis". S.A.P.I.EN.S 1 (2). 
  20. ^ Kane EJ (2000). "Capital movements, banking insolvency, and silent runs in the Asian financial crisis". Pac-Basin Finance J 8 (2): 153–75.  
  21. ^ Rothacker, Rick. $5 billion withdrawn in one day in silent run. The Charlotte Observer, 2008-10-11
  22. ^ a b c d Zoe Chase (2012-06-11). "Three Ways To Stop A Bank Run". NPR. 
  23. ^ a b Chana Joffe-Walt (2009-03-26). "Anatomy Of A Bank Takeover". NPR. 
  24. ^ Allen WR (1993). "Irving Fisher and the 100 percent reserve proposal". J Law Econ 36 (2): 703–17.  
  25. ^ Fernandez R, Schumacher L (eds.) (1997). "Does Argentina provide a case for narrow banking?" (PDF). In Bery SK, Garcia VF (eds.). Preventing Banking Sector Distress and Crises in Latin America. World Bank Discussion Paper No. 360,. pp. 21–46.  
  26. ^ Brusco S, Castiglionesi F (2007). "Liquidity coinsurance, moral hazard, and financial contagion". J Finance 62 (5): 2275–302.  

References

A run on a bank is one of the many causes of the characters' suffering in Upton Sinclair's The Jungle.

Arthur Hailey's novel The Moneychangers includes a potentially fatal run on a fictitious US bank.

The bank panic of 1933 is the setting of Archibald MacLeish's 1935 play, Panic. In addition to the plot of It's a Wonderful Life (1946), other fictional depictions of bank runs include those in American Madness (1932), Mary Poppins (1964) and Noble House (1988).

Depictions in fiction

  • Declaring an emergency bank holiday
  • Government or central bank announcements of increased lines of credit, loans, or bailouts for vulnerable banks

Techniques to deal with a banking panic when prevention have failed:

The role of the lender of last resort, and the existence of deposit insurance, both create moral hazard, since they reduce banks' incentive to avoid making risky loans. They are nonetheless standard practice, as the benefits of collective prevention are commonly believed to outweigh the costs of excessive risk-taking.[26]

  • [22] Government deposit insurance programs can be ineffective if the government itself is perceived to be running short of cash.[23] To avoid such fears triggering a run, the U.S. FDIC keeps its takeover operations secret, and re-opens branches under new ownership on the next business day.[7]
  • Bank capital requirements reduces the possibility that a bank becomes insolvent. The Basel III agreement strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage.
    • Full-reserve banking is the hypothetical case where the reserve ratio is set to 100%, and funds deposited are not lent out by the bank as long as the depositor retains the legal right to withdraw the funds on demand. Under this approach, banks would be forced to match maturities of loans and deposits, thus greatly reducing the risk of bank runs.[24][25]
    • A less severe alternative to full-reserve banking is 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, as more reserves will be available to satisfy the demands of depositors.[6] This practice sets a limit on the fraction in fractional-reserve banking.
  • Transparency may help prevent crises spreading through the banking system. In the context of the recent crisis, the extreme complexity of certain types of assets made it difficult for market participants to assess which financial institutions would survive, which amplified the crisis by making most institutions very reluctant to lend to one another.
  • 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.[1] Walter Bagehot's book Lombard Street provides influential early analysis of the role of the lender of last resort.

Some prevention techniques apply across the whole economy, though they may still allow individual institutions to fail.

Systemic techniques

  • Banks often project an appearance of stability, with solid architecture and conservative dress.[22]
  • A bank may try to hide 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 the formation of a line of depositors extending out into the street which might cause passers-by to infer a bank run.[1]
  • A bank may try to slow down the bank run by artificially slowing the process. One technique is to get a large number of friends and family of bank employees to stand in line and make a large number of small, slow transactions.[22]
  • Scheduling prominent deliveries of cash can convince participants in a bank run that there is no need to withdraw deposits hastily.[22]
  • Banks can encourage customers to make term deposits that cannot be withdrawn on demand. If term deposits form a high enough percentage of a bank's liabilities its vulnerability to bank runs will be reduced considerably. The drawback is that banks have to pay a higher interest rate on term deposits.
  • A bank can temporarily suspend withdrawals to stop a run; this is called suspension of convertibility. In many cases the threat of suspension prevents the run, which means the threat need not be carried out.[1]
  • Emergency acquisition of a vulnerable bank by another instititution with stronger capital reserves. This technique is commonly used by the U.S. Federal Deposit Insurance Corporation to dispose of insolvent banks, rather than paying depositors directly from its own funds.[23]
  • If there is no immediate prospective buyer for a failing institution, a regulator or deposit insurer may set up a bridge bank which operates temporarily until the business can be liquidated or sold.
  • To clean up after a bank failure, the government may set up a "bad bank", which is a new government-run asset management corporation that buys individual nonperforming assets from one or more private banks, reducing the proportion of junk bonds in their asset pools, and then acts as the creditor in the insolvency cases that follow. This, however, creates a moral hazard problem, essentially subsidizing bankruptcy: temporarily underperforming debtors can be forced to file for bankruptcy in order to make them eligible to be sold to the bad bank.

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

Individual banks

Several techniques have been used to help prevent or mitigate bank runs.

A run on a Bank of East Asia branch in Hong Kong, caused by "malicious rumours" in 2008.

Prevention and mitigation

The cost of cleaning up after a crisis can be huge. In systemically important banking crises in the world from 1970 to 2007, the average net recapitalization cost to the government was 6% of GDP, fiscal costs associated with crisis management averaged 13% of GDP (16% of GDP if expense recoveries are ignored), and economic output losses averaged about 20% of GDP during the first four years of the crisis.[2]

A silent run occurs when the implicit fiscal deficit from a government's unbooked loss exposure to zombie banks is large enough to deter depositors of those banks. As more depositors and investors begin to doubt whether a government can support a country's banking system, the silent run on the system can gather steam, causing the zombie banks' funding costs to increase. If a zombie bank sells some assets at market value, its remaining assets contain a larger fraction of unbooked losses; if it rolls over its liabilities at increased interest rates, it squeezes its profits along with the profits of healthier competitors. The longer the silent run goes on, the more benefits are transferred from healthy banks and taxpayers to the zombie banks.[20] The term is also used when a large number of depositors in countries with deposit insurance draw down their balances below the limit for deposit insurance.[21]

Some measures are more effective than others in containing economic fallout and restoring the banking system after a systemic crisis.[2][19] These include establishing the scale of the problem, targeted debt relief programs to distressed borrowers, corporate restructuring programs, recognizing bank losses, and adequately capitalizing banks. Speed of intervention appears to be crucial; intervention is often delayed in the hope that insolvent banks will recover if given liquidity support and relaxation of regulations, and in the end this delay increases stress on the economy. Programs that are targeted, that specify clear quantifiable rules that limit access to preferred assistance, and that contain meaningful standards for capital regulation, appear to be more successful. According to IMF, government-owned asset management companies (bad banks) are largely ineffective due to political constraints.[2]

Systemic banking crises are associated with substantial fiscal costs and large output losses. Frequently, emergency liquidity support and blanket guarantees have been used to contain these crises, not always successfully. Although fiscal tightening may help contain market pressures if a crisis is triggered by unsustainable fiscal policies, expansionary fiscal policies are typically used. In crises of liquidity and solvency, central banks can provide liquidity to support illiquid banks. Depositor protection can help restore confidence, although it tends to be costly and does not necessarily speed up economic recovery. Intervention is often delayed in the hope that recovery will occur, and this delay increases the stress on the economy.[2]

A bank run is the sudden withdrawal of deposits of just one bank. A banking panic or bank panic is a financial crisis that occurs when many banks suffer runs at the same time, as a cascading failure. In a systemic banking crisis, all or almost all of the banking capital in a country is wiped out; this can result when regulators ignore systemic risks and spillover effects.[2]

Bank run during the Great Depression in the United States, 1933.

Systemic banking crises

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 suspect other depositors will believe the story. The story becomes a self-fulfilling prophecy.[1] Indeed, Robert K. Merton, who coined the term self-fulfilling prophecy, mentioned bank runs as a prime example of the concept in his book Social Theory and Social Structure.[17] Mervyn King, governor of the Bank of England, once noted that it may not be rational to start a bank run, but it is rational to participate in one once it had started.[18]

However, if many depositors withdraw all at once, the bank itself (as opposed to individual investors) may run short of liquidity, and depositors will rush to withdraw their money, forcing the bank to liquidate many of its assets at a loss, and eventually to fail. If such a bank were to attempt to call in its loans early, businesses might be forced to disrupt their production while individuals might need to sell their homes and/or vehicles, causing further losses to the larger economy.[1] Even so, many if not most debtors would be unable to pay the bank in full on demand and would be forced to declare bankruptcy, possibly affecting other creditors in the process.

If only a few depositors withdraw at any given time, this arrangement works well. Barring some major emergency on a scale matching or exceeding the bank's geographical area of operation, depositors' unpredictable needs for cash are unlikely to occur at the same time; that is, by the law of large numbers, banks can expect only a small percentage of accounts withdrawn on any one day because individual expenditure needs are largely uncorrelated. A bank can make loans over a long horizon, while keeping only relatively small amounts of cash on hand to pay any depositors who may demand withdrawals.[1]

In the model, business investment requires expenditures in the present to obtain returns that take time in coming, for example, spending on machines and buildings now for production in future years. A business or entrepreneur that needs to borrow to finance investment will want to give their investments a long time to generate returns before full repayment, and will prefer long maturity loans, which offer little liquidity to the lender. The same principle applies to individuals and households seeking financing to purchase large-ticket items such as housing or automobiles. The households and firms who have the money to lend to these businesses may have sudden, unpredictable needs for cash, so they are often willing to lend only on the condition of being guaranteed immediate access to their money in the form of liquid demand deposit accounts, that is, accounts with shortest possible maturity. Since borrowers need money and depositors fear to make these loans individually, banks provide a valuable service by aggregating funds from many individual deposits, portioning them into loans for borrowers, and spreading the risks both of default and sudden demands for cash.[1] Banks can charge much higher interest on their long-term loans than they pay out on demand deposits, allowing them to earn a profit.

Diamond and Dybvig developed an influential model to explain why bank runs occur and why banks issue deposits that are more liquid than their assets. According to the model, the bank acts as an intermediary between borrowers who prefer long-maturity loans and depositors who prefer liquid accounts.[1][13] The Diamond-Dybvig model provides an example of an economic game with more than one Nash equilibrium, where it is logical for individual depositors to engage in a bank run once they suspect one might start, even though that run will cause the bank to collapse.[1]

Under fractional-reserve banking, the type of banking currently used in most developed countries, banks retain only a fraction of their demand deposits as cash. The remainder is invested in securities and loans, whose terms are typically longer than the demand deposits, resulting in an asset–liability mismatch. No bank has enough reserves on hand to cope with all deposits being taken out at once.

A poster for the 1896 Broadway melodrama The War of Wealth depicts a 19th-century bank run in the U.S.

Theory

The global financial crisis that began in 2007 was centered around market-liquidity failures that were comparable to a bank run. The crisis contained a wave of bank nationalizations, including those associated with Northern Rock of the UK and IndyMac of the U.S. This crisis was caused by low real interest rates stimulating an asset price bubble fuelled by new financial products that were not stress tested and that failed in the downturn.[16]

Many of the George Bailey struggles to keep his Building & Loan open with a crowd of customers demanding their deposits.

Bank runs have also been used to blackmail individuals or governments. In 1832, for example, the British government under the Duke of Wellington overturned a majority government on the orders of the king, William IV, to prevent reform (the later 1832 Reform Act). Wellesley's actions angered reformers, and they threatened a run on the banks under the rallying cry "Stop the Duke, go for gold!".[8]

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).

The run on the Montreal City and District Savings Bank. The Mayor addressing the crowd. Printed in 1872 in the Canadian Illustrated News.

History

Contents

  • History 1
  • Theory 2
  • Systemic banking crises 3
  • Prevention and mitigation 4
    • Individual banks 4.1
    • Systemic techniques 4.2
  • Depictions in fiction 5
  • References 6
  • Further reading 7
  • External links 8

[7]

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