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What Is A Bank Run?

By Edited Nov 13, 2013 4 9

The recent and ongoing global financial crisis has resulted in many terms from the financial world making it into the everyday household through media and politicians. In the early years of this millennium most people would never have heard of a CDO, CDS, MBS or Subprime Mortgages.

 

Another term that has been often used in the many reports is the threat of a run on the banks. This raises the question "What is a Bank Run?" In order to answer that question we first need to get a basic understanding of how banks and the monetary system work on a very basic level. So don't worry, I'm not going to overwhelm you with highly technical details that would bore you to insanity.

 

 

How Banks Handle Money

 

Everybody understands that banks are in the money business by accepting deposits from one group of people and making loans out to another group of people. As a save you go to a bank and hand over your money in the trust that they will look after it, and in return you receive interest (depending where you are in the world, interest in 2012 is pretty close to zero). Unless you deposit your money with a bank for a term that cannot be broken, through something that is known as a CD, or Certificate of Deposit, you essentially make a demand deposit.

 

What this means is that you deposit money with the bank and can at any time go to your bank and ask for your money returned to you or moved to another account or another bank. While you have little control over what the bank does with your money once you leave, you still have, in theory, full control over whether your money stays in that bank.

 

Some readers may have heard of Fractional Reserve Banking (FRB), which is the way our monetary system works. Now I don't want to go into a complicated discussion of how FRB increases the money supply or whether it is a good or bad system; that is a debate that probably goes beyond a short article.

 

For the purpose of understanding what a bank run is you only need to comprehend the following. Let's say you deposit $1000 with your bank in a demand deposit account, which allows you to withdraw the money whenever you so choose. The bank uses a portion of that money (about 90%) to make loans to other people and charge them interest on those loans. Thousands of other people do exactly the same thing and the bank essentially only holds a fraction of the deposits quickly available, hence the term Fractional Reserve Banking.

 

All is fine so long as those people that took out the loans continue to make repayments, and those that deposit money do not want to withdraw large amounts in a short space of time.

 

 

What Triggers A Bank Run?

 

In normal economic conditions where there are no increased levels of loan defaults, this system of fractional reserves functions without too many people worrying about it. The problem arises when there is some sort of mass worry, panic or hysteria. The most recent crisis can definitely be described as a panic situation, and as we all lived through it we should have a good idea what the general sentiment was like.

 

For a run on a bank to be triggered some bad, sorry, very bad news has to make it out to the public through the media. Bad news can include, but is not limited to, a major fraud scandal, unforeseen losses on the loans made, a crippling information systems fault or sudden deterioration in the overall economy.

 

These types of situations can then cause a lot of people who have deposits with a bank to arrive at the bank to withdraw or transfer their money. Remember how I just pointed out that in the Fractional Reserve Banking system, banks only hold a portion of customer's deposits readily available, generally about 10%? All it effectively takes for bank to be forced to close its doors is for more than 10% of its deposit customers to demand their money.

 

It is because of this low level of withdrawals needed, that bank runs happen so suddenly and can cripple a bank in a matter of days or even hours. Especially in today's era of Electronic Funds Transfer banks runs can happen with a lot shorter queues outside physical bank branches.

 

 

Some Historic Examples

 

As already mentioned, bank runs are a phenomenon directly linked to Fractional Reserve Banking, so one has to look at the early days of FRB to see the first incidents of such occurring. 17th century England saw some of the first experiments with FRB, when gold smiths took in people's gold and silver, which was money at the time, for safe keeping and gave customers a receipt. When these receipts started being used for exchange of goods, it became very tempting for gold smiths to create more receipts than they had gold in their safes. This quickly back fired when their customers found out about this demanding back their gold.

Bank Run Queue
 

During the Great Depression in the US, hundreds of banks were forced out of business because the economy in general deteriorated so much that people simply didn't trust banks any more. Pictures of queus of people outside banks whose doors were closed are only too common, and the events were also dramatised in the 1946 movie "It's a Wonderful Life".

 

It's a wonderful life(100564)

Some people may remember that during the late 80s and early 90s there was a Savings and Loan crisis in the US, where over 700 saving and loan associations failed in the US. But the most notable events on modern times were during the earl days of the current global financial crisis. Pictures of queues of people outside Britain's Northern Rock bank circulated the world.

 

A very new term that has been doing the rounds in the media is "Bank jog", which has been used to describe the situation in Greece where depositors are withdrawing money from banks at a relatively slow pace compared to bank runs that happen within days or hours. 

 

I hope this article has helped explain and clarify the phenomenon of a bank Run.

 

Image Credits: naotakem, jarape

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Comments

Jun 2, 2012 7:23am
askformore
Very good explanation of what a 'bank run' is. Thumbs up!
Jun 2, 2012 9:27am
DaddyDadChris
I'm glad you liked it
Jun 2, 2012 9:27am
DaddyDadChris
This comment has been deleted.
Jul 25, 2012 3:58pm
techkaush
Great article. I liked it!
Jul 28, 2012 2:19pm
nyclifestyle1
For a run on a bank to be triggered some bad, sorry, very bad news has to make it out to the public through the media. Bad news can include, but is not limited to, a major fraud scandal, unforeseen losses on the loans made, a crippling information systems fault or sudden deterioration in the overall economy. Arturo Montenora
Aug 28, 2012 4:34pm
ajsbooks
Great article, i found it very informative

Thanks
Sep 24, 2012 2:25am
DaddyDadChris
Thanks for the comment and I'm glad you liked it
Sep 20, 2012 6:04am
Pindar
Thanks for the article Chris. I would like to add something about the "bank jog". In Greece all the banks have the last 2 to 3 years slowly but steadily "losing" their deposits, due to the dire and uncertain socio-economic situation. The leak has long exceeded the 10% limit, nowadays it must somewhere between 15 and 20%. However not equivalent amount of loans has been asked back before they expired (I don't think they could do that anyway). So all the banks have long been in deep red.

So how do they not close? Let's thank the charming ECB (European Central Bank) for that, who lends money to the banks with dirt cheap interest - now a mere 0,75%. Our entire economy has defaulted on every level, from the banks, to the companies and local stores, to the government to half of the households, yet they keep injecting us with doses of more loans (not the 0,75% interest ones, these are reserved only for the banks; we pay 4+% interest) - only to postpone the "official" announcement of the inevitable and thus inflate further our debt. We are rewriting the economics text books here..
(I hope I will find the clarity and patience to write something about it)
Sep 24, 2012 2:28am
DaddyDadChris
Hi Pindar, I fully agree with your sentiment. It is beyond me how the elitists in Brussels, elected and unelected, come to the conclusion that a problem of too much debt can be solved with even more debt? To me this is total and utter stupidity.
I would be very interested in an article about current opinion in Greece, as I don't believe politicians and the media tell us the truth.
Nov 12, 2012 8:19am
david021
great article, I like the history lesson included, very informative! this was new to me
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