Bank Runs

Definition

A bank run occurs when a large number of bank customers simultaneously withdraw their deposits because they believe the bank may be unable to meet its obligations. This can lead to the bank's inability to function and potential collapse, as it does not have enough liquid assets to meet the sudden demand for withdrawals.

5 Must Know Facts For Your Next Test

1. Bank runs can be triggered by rumors or concerns about a bank's solvency, leading to a self-fulfilling prophecy as more depositors withdraw their funds.
2. Bank runs can have a contagion effect, where the failure of one bank can lead to runs on other banks, causing a systemic crisis in the banking system.
3. Fractional reserve banking, where banks hold only a fraction of their deposits as reserves, makes the banking system vulnerable to bank runs.
4. Deposit insurance, such as the Federal Deposit Insurance Corporation (FDIC) in the United States, helps prevent bank runs by assuring depositors that their money is safe up to a certain limit.
5. Central banks often act as 'lenders of last resort' during bank runs, providing emergency liquidity to banks to help them meet withdrawal demands and prevent the collapse of the banking system.

Review Questions

• Explain how the concept of fractional reserve banking contributes to the risk of bank runs.
  • In a fractional reserve banking system, banks only hold a fraction of their total deposits as reserves, and lend out the rest. This means that if too many depositors try to withdraw their money at once, the bank may not have enough liquid assets to meet the demand. This vulnerability to sudden withdrawals is a key factor that can trigger bank runs, as depositors lose confidence in the bank's ability to repay their deposits.
• Describe the role of deposit insurance in preventing and mitigating bank runs.
  • Deposit insurance, such as the FDIC in the United States, is designed to prevent bank runs by assuring depositors that their money is safe up to a certain limit, even if the bank fails. By providing this guarantee, deposit insurance helps maintain confidence in the banking system and reduces the incentive for depositors to withdraw their funds en masse during times of uncertainty. This, in turn, can help prevent the self-fulfilling prophecy of a bank run and the potential collapse of the banking system.
• Analyze the potential systemic effects of a bank run and the role of central banks in addressing this issue.
  • Bank runs can have a contagion effect, where the failure of one bank can lead to runs on other banks, causing a systemic crisis in the banking system. This can have far-reaching consequences for the broader economy, as the disruption of the financial system can lead to a reduction in credit availability, economic activity, and overall financial stability. Central banks often act as 'lenders of last resort' during bank runs, providing emergency liquidity to banks to help them meet withdrawal demands and prevent the collapse of the banking system. This intervention is crucial in maintaining confidence in the banking system and mitigating the systemic risks posed by bank runs.

Related terms

Liquidity: The ability of a bank to meet its short-term obligations, such as depositor withdrawals, by converting its assets into cash or cash equivalents.

Fractional Reserve Banking: A banking system where banks only hold a fraction of their total deposits as reserves, and lend out the rest, which can lead to bank runs if too many depositors try to withdraw their money at once.

Deposit Insurance: A government-backed insurance program that protects bank deposits up to a certain amount, designed to prevent bank runs by reassuring depositors that their money is safe.