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A situation in which a relatively large number of a bank's customers attempt to withdraw their deposits in a relatively short period of time, usually within a day or two. While common throughout the 1800s and early 1900s, government deposit insurance has largely eliminated banks runs in the modern economy. Historically a bank run was prompted by fears that the bank was on the verge of collapse, causing deposits to become worthless. Ironically a bank run often caused the bank to fail. Bank runs were often infectious, leading to economy-wide bank panics and business-cycle contractions. A bank run occurs when the customers of a bank become increasingly concerned about the safety of their deposits. Such concerns historically arose (before government deposit insurance) because the failure of a bank meant the loss of deposits. Customers could literally lose their entire life savings if a bank went out of business. To avoid this, customers attempted to withdraw deposits BEFORE the bank failed.
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 BankingThe possibility of a bank run was the direct consequence of fractional-reserve banking. With fractional-reserve banking banks back up only a fraction of outstanding deposits with reserves that are used to meet the demands for deposit withdrawals.
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 BalanceThe a bank run that upsets the fractional-reserve balance can occur for a number of reasons.
- 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 PanicsFrom the mid-1800s through the early 1900s, bank runs were a relatively common event. Like a row of toppling dominoes or a cascading avalanche of snow, the failure of one bank often induced a series of runs on other banks. When a significant number of banks in the economy failed due to such runs, a significant amount of the economy's money supply also vanished. With less money, the economy entered a business-cycle downturn.
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 RescueBank runs were common in the early history of the U.S. economy because a failed bank meant the lost of customer deposits. In many cases, customers literally lost all of their financial wealth, their entire life savings. To avoid this, customers were induced to withdraw deposits at the slightest hint of bank problems. The risk was simply too great not to act. Of course, a bank run resulted when a significant number of customers did act.
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.
The purpose of the FDIC is to insure the deposits at commercial banks. Should a bank failure, then the FDIC stands ready to pay off deposits up to a maximum level (currently $100,000). The assurance that customers are not likely to lose their life savings has gone a long way to prevent bank runs, bank panics, and related financial problems. Bank runs have been virtually nonexistent in modern times, and factors other than bank panics have triggered recent business-cycle contractions.
BANK RUN, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: March 3, 2024].
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