Unfortunately a bank run was often a self-fulfilling process. The practice of fractional-reserve banking meant that banks had enough reserves on hand to satisfy only a portion of withdrawal demands (usually less than 10 percent). A bank literally "ran of out of cash" with an excessive amount of withdrawals, forcing the bank to shut down. The fear of a bank failure often caused the bank to fail.

The Balance of Fractional-Reserve Banking

Fractional-reserve banking makes it possible for a bank to profitably function as a financial intermediary (matching up borrowers and lenders) while at the same time keeping deposits (and a significant portion of the economy's money supply) safe and liquid. However, pursuing both activities is a delicate balancing act.

Should a bank keep too many reserves, deposits are safe but it cannot generate as much revenue as a financial intermediary. Should it keep too few reserves, then a bank can generate more financial intermediary revenue, but deposits are not as safe. Tilting too far in one direction or the other is likely to force a bank to close down.

Tipping the Balance

• Bad Management: At the top of the list is bad decisions by bank managers. In particular, because a bank generates more profit acting as a financial intermediary than as a safekeeper of deposits, it is prone to keep too few reserves. If so, it might not be able to satisfy the demands of normal deposit withdrawals, which can then create a bank-run inducing worry among customers.


• Bad Economy: Even a prudently managed bank can be subject to a bank run if the local economy turns sour. In particular, if an economic contraction causes lost jobs and reduced incomes, then bank customers are likely to deposit less and withdraw more from their accounts. If this happens in a short time period, such as what might happen from a local factory suddenly closing down, then bank reserves might be depleted, once again creating bank-run inducing concerns among customers.


• Bad Neighbors: A well-managed bank can also have its fractional-reserve bank tipped due to problems at neighboring banks. The customers of one bank might become concerned about the safety of their deposits, should another bank in the local community fail. Like a row of dominoes, the failure of one bank can induce runs on other banks.

Economy-Wide Bank Panics

Such events were typically termed bank panics. In fact, the common term for business-cycle contractions during this era was bank panic rather than the modern terms recession or contraction. Some of the more notable bank panics occurred in 1873, 1893, 1907, and 1932. The bank panic in 1907 led to the creation of the Federal Reserve System. The bank panic in 1932 was during the depths of the Great Depression and led to the creation of the Federal Deposit Insurance Corporation.

Deposit Insurance to the Rescue

After numerous bank runs, bank panics, and economic downturns leading up to the Great Depression of the 1930s, the federal government established the Federal Deposit Insurance Corporation (FDIC) to alleviate bank-run-inducing concerns among deposits. The FDIC was created in 1933 as a direct response to the bank panic of 1932.