table of contents
When the conviction of a bank’s insolvency spreads among its customers, there is a bank run and a massive withdrawal of money from the bank.
▪ Fear for your money – bank run
In economic terms, this year has started as if God had took Hitchcock’s advice – first an earthquake, then work up to a climax. But instead of an earthquake, we had problems in the banking sector and the collapse of several banks – Silvergate, Silicon Valley Bank, Credit Suisse and First Republic Bank.
Silicon Valley Bank and Silvergate attracted the most attention, as these banks’ troubles left customers fearful of their money and eager to withdraw their funds. Unfortunately, these banks did not have enough money to withdraw their customers’ funds, so they went bankrupt. There was a so-called bank run and you may have heard or read the term in the news. In this episode, we wanted to explain what exactly a bank run is.
▪ What are the banks doing?
Banking is basically in two types of business – taking money as a deposit and making loans.
People put their money in banks because it makes their money safer and easier to manage – it’s easier to check how much money we have, transfer money, open a deposit or invest in the stock market by transferring money to a brokerage account. At the same time, whenever a person or organization needs it, they can withdraw their money.
It is worth noting that having a bank deposit gives you the right to withdraw cash. A person who has money in the bank has the right to withdraw cash at any time, and the bank is obliged to withdraw this cash. When the depositor withdraws money, the amount of funds deposited with the bank decreases and the amount of cash the person has in the wallet increases. The deposit is not just a number that is displayed on the computer screen. It is also the ownership of cash.
Banks mainly earn on interest on loans granted. It is worth stopping at what a loan is and how it affects the bank’s situation. When the bank grants a loan, it creates a deposit – it adds the appropriate amount of funds to the borrower’s account. Granting a loan does not mean that the bank takes some of the previously accumulated money and lends it to the borrower. Giving credit means that banks create funds, and economists will say that by lending, the bank created money.
The term funds was used for a reason. Different forms of money are used in the economy – the two main forms we will focus on today are cash and deposits. These two forms are not the same! When we pay in cash, we are handing over physical money. But when we pay by bank transfer, using card, or otherwise via a bank, then the matter is a bit different. On our bank account, the size of the deposit decreases, that is, the amount of cash that we can withdraw from the bank decreases. On the other hand, the size of our contractor’s deposit increases, that is, the amount of cash that the contractor has accumulated on his bank account increases. For this reason, the amount of cash that the contractor has the right to withdraw from his bank also increased.
▪ Bank reserves
In this section, for the sake of simplicity, we will omit the issue of central bank reserves and assume that bank reserves consist only of cash.
Banks not only receive money in the form of deposits or repayment of loan installments. They also have to meet their obligations. For the purpose of settling liabilities, banks accumulate reserves, that is, a certain amount of cash in which it can repay it’s liabilities. Customer cash deposits are also used as reserves by which the bank settles liabilities – this means that if it is necessary to transfer reserves to another bank, our example bank will reach for the cash that has been accumulated in it.
What obligations does the bank have? These are, for example, cash withdrawals to customers or payments to customers of other banks. As soon as cash is withdrawn by the depositor, the amount of cash held in the vault decreases. The same is true when a person who has an account in a bank buys something from a person who has an account in another bank. When we buy, for example, a computer and pay for it with a card, and the seller of the computer has an account in another bank, then the amount of deposits in our bank decreases and the amount of deposits in the sellers’ bank increases. What happens as a result of this? The sellers’ bank has the right to demand that our bank provide it with the appropriate amount of cash that the seller has the right to withdraw.
▪ Fractional reserve
Banks operate on the basis of fractional reserve, that is, the amount of deposits in the bank is greater than the amount of cash that the bank holds. Why?
This is primarily due to the fact that the bank, when granting a loan, creates deposits. But this deposit is the right to withdraw cash. This means that when the bank grants a loan, it creates obligations that it will have to pay in the future.
To understand this better, we will now take the example of Bank A, which initially has no assets or capital of its own. The customers of bank A brought 1 million dollars in cash and deposited it in this bank. This means that the bank has 1 million dollars in cash assets and 1 million dollars in liabilities. At this point, the bank is able to pay all its liabilities because it holds as much cash as people are allowed to withdraw.
After some time, a person comes to bank A who wants to take out a loan of 100,000 dollars. The management of bank A thinks “why not” and decides to grant this loan. At this point, bank A opened an account for the borrower and entered into the system that there was 100,000 dollars in the borrower’s account. How did this loan affect the bank’s situation?
Both the bank’s assets and liabilities increased by 100,000. On the assets side, the amount of credit granted increased. But on the liabilities side, the bank’s liabilities increased. After granting this loan, people collectively have the right to withdraw 1,100,000 dollars in cash from bank A, although the bank’s cash holdings have not changed. The more credit the bank grants, the more cash from the bank individuals, companies or other banks have the right to withdraw.
This means that bank A is not able to pay cash to all those who have the right to demand it from this bank, at the same time. This is the essence of fractional reserve – more people are entitled to the cash held in the bank than their bank actually holds. The use of fractional reserves is the norm for banks. The bankers have noticed that despite the outflows and inflows of reserves, they always have a certain amount of cash, so they decide to increase their lending. Since they always have some reserves that they do not use to settle their liabilities, they can issue some more credit and earn interest.
▪ Bank run
If everyone who has the right to withdraw cash wanted to do it at the same time, the bank would get into trouble. It would then have to somehow acquire the appropriate amount of reserves, which is so difficult and expensive that it is usually impossible. A situation in which people rush to withdraw cash at once is a nightmare for the bank and means its collapse.
This situation of people withdrawing money at once from the bank is what a bank run is. As people do not worry about their money kept in the bank on a daily basis, only credible information about serious problems of the bank provokes people to take actions that are dangerous for the bank.
When the conviction of a bank’s insolvency spreads among its customers, there is a bank run and a massive withdrawal of money from the bank.
An important aspect of a bank run is its massiveness. When one person is concerned that they will not be able to recover the money held in the bank, it does not matter much to the bank. Well, it’s lost one client. But if, for example, 40 or 50 percent of customers come to this conclusion and start withdrawing their funds from the bank, then the bank will have a problem because it will have to raise huge amounts of cash somehow.
Bank runs also tend to spread to other banks. As soon as a large bank fails due to a bank run, the customers of other banks also start to worry about their money. If such a big bank collapsed, maybe mine is in trouble, but I don’t know it yet?
▪ Is government doing anything about this?
Bank runs are a known phenomenon and we also know their consequences. Among other things, due to the occurrence of these panics, countries around the world establish institutions that aim to control bank panics so that they do not spread to other banks and fight the negative consequences of banks’ problems with settling liabilities. In the USA, such an institution is, for example, The Federal Deposit Insurance Corporation, abbreviated as FDIC.
First of all, FDIC deals with guaranteeing deposits. This means that money deposited in a bank account is insured by FDIC and in the event of a bank failure and a problem with the client’s recovery of money, FDIC will provide funds from which the money will be paid out. However, the amount of funds that the FDIC pays out to a single customer of a failing bank is limited – the FDIC will pay us money worth up to at least 250,000 dollars. If we accumulated more in a failing bank, there is no guarantee that we will recover the money.
