In times of crisis, people like a sense of
certainty.
After all, haven’t we all been burned before
for trusting in the wrong institutions?
And for a lot of people, nothing feels more
certain than a big, comforting pile of cold,
hard cash.
However, problems start to arise when a lot
of people have this same idea at once.
This raises the question: Can a bank literally
run out of cash if everyone withdraws their
money at the same time?
And while this may seem like a silly question,
the answer is actually a resounding “Yes.”
It’s called a Bank Run – they’ve happened
before, and it’s possible they might happen
again.
First, let’s take a look at the basics.
During periods of financial instability – take,
for example, the Great Depression of the 1930s
and the global financial crash of 2008 – a
so-called “Bank Panic” begins.
During those panics, customers of a commercial
bank believe that the bank may close and lose
their money as a result.
This then becomes a self-fulfilling prophecy,
as depositors begin a mass-withdrawal of their
savings, leading to a so-called “run on
the bank.”
The vicious cycle continues – Banks lose
financial liquidity, savers pull out their
deposits, news of this reduces confidence
in the bank’s stability, and more savers
pull out their deposits as a result.
The end result is typically the bank entering
a total nosedive.
Eventually, the bank becomes totally insolvent
and their cash reserves run dry.
They end up imposing restrictions on withdrawals,
and at that point, the jig is essentially
up.
You’re probably wondering: How on Earth
does this happen?
The two main priorities of a commercial bank
are to handle deposits and withdrawals from
customers, so shouldn’t there be safeguards
for this kind of thing?
Well, the problem with Bank Runs is that they’re
pretty much tailored to take advantage of
vulnerabilities inherent in the system.
There are regulations on how much physical
cash your local bank branch can keep on its
premises, for both their expected daily usage
of said cash and security reasons.
In other words, if a bank’s vault is carrying
way more cash than it needs on an average
day, and that bank is robbed, that’s an
extremely expensive robbery right there.
The Federal Reserve also imposes limits on
the amount of in-house cash a bank can carry,
and even this cash isn’t all entirely devoted
to customer savings withdrawals.
This is called fractional reserve banking
– as each bank only keeps a fraction of
its overall cash reserves for daily use.
Banks also need this cash to provide money
for small in-house loans, as well as for investment
projects.
When the bank’s customer base is pulling
out money like crazy, they need to siphon
extra cash from other areas in order to keep
up with withdrawal demand.
This is known as increasing their cash position.
In order to increase their cash position fast
so they can keep up with demand, banks in
the process of a bank run will often sell
off their assets at significantly lower than
asking price.
The selling off of assets goes public, which
feeds into public panic, and more withdrawals.
Banks will be haemorrhaging money throughout
this process just to stay above water.
These financial catastrophes are a mix of
economics and mob psychology, as increasing
public instability manifests directly in the
instability of the bank.
Seeing as bank runs typically happen in times
of crisis, selling off long-term investment
assets will fetch an even lower price than
usual, plunging the financial institutions
even further into the hole.
While one might think it would be easy to
nip a bank run in the bud by quelling the
fears of the consumer base and assuring them
that a panicked withdrawal will only worsen
the situation, talking sense into the public
is often easier said than done.
The lead-up to a bank run can almost feel
like a Mexican Standoff – just like nobody
in a standoff situation wants to be the first
to put down their gun, customers fear being
the “last one to exit” and losing their
hard-earned savings if the bank does eventually
fail.
The cruel irony is that fear that a bank will
fail is often one of the greatest contributors
in its failure.
Currently, during today’s times of economic
instability, there have been whispers of restricted
cash withdrawals on savings in some United
States and European banks.
Bank runs are almost always at least a slight
risk during times of panic – right now,
we’re seeing a microcosm of the same psychology
that drives bank runs in toilet paper buyouts.
You can apply the exact same cyclical formula:
People fear toilet paper shortages and therefore
buy more toilet paper.
People buying more toilet paper fans the flames
of shortage fears, and the panic buying continues,
leading to real shortages.
It’s an extremely basic pattern that feels
almost engraved into human society.
Let’s take a look at a few more historical
bank runs to see if the pattern holds true.
The period of time that brought Bank Runs
into the national conversation was the Great
Depression of the 1930s.
It all started with the stock market crash
of Thursday, October 24th, 1929, which reached
its grim peak on October 28th, also known
as Black Tuesday.
The United States had just experienced the
Roaring Twenties – one of the greatest periods
of economic prosperity in history – but
that was all about to come crashing down.
The market and the general public had been
massively overconfident due to the prior trend
of market growth, overpricing the stock and
artificially inflating the market as a result.
This led to what economists called an “asset
bubble.”
And the thing about bubbles is, no matter
how attractive they seem, or for how long,
they always burst.
And that’s exactly what happened.
Bank credit also rose rapidly, and they were
handing out loans like candy.
The public weren’t afraid of debt because
the market had been so stable, for so long.
The general public were buying on margin,
which means – in a very simplified sense
– they were making down payments on stock
with money borrowed from the bank.
Meanwhile, industrial and agricultural overproduction
was hurting share prices, and a sudden 1%
interest hike from the Federal Reserve Bank
of New York added to the pile of factors in
this economic chemical reaction.
The resulting explosion effectively collapsed
the entire US economy, kicking economic growth
to the curb and sending the Gross Domestic
Profit into freefall.
This brings us full circle, back to Bank Runs.
The public were terrified by the sudden shock
of the economy that’d been doing so well
abruptly disintegrating around them.
As a result, they wanted the comfort of having
cold, hard cash in their hands and under their
mattresses.
Americans flocked to banks and withdrew cash
en masse, exacerbating what was already a
complete, economic dumpster fire.
Financial newspapers at the time were releasing
headlines like “Huge Selling Wave Creates
Near-Panic as Stocks Collapse” and “Prices
of Stocks Crash in Heavy Liquidation “ , fuelling
the panic further.
The American public lost faith in the banking
system, pulling out their funds and forcing
the banks to sell off their assets in order
to keep up with demand.
It was a textbook series of bank runs, leading
to bank failures and an inability to invest
in businesses that lead to widespread economic
stagnation across the nation.
Bank runs are never the sole cause of an economic
collapse, but they’re almost always a component
of economic downturn.
By necessity, they’re something that occurs
after a period of economic instability has
already begun, and then goes on to make the
whole situation even worse.
Which brings us to a much more recent example
of economic catastrophe: The 2008 stock market
crash.
Unless you’re a keen economics enthusiast,
or you’ve seen or read The Big Short, you
probably need a quick refresher on what exactly
happened there.
Dubbed the worst financial crisis since the
Great Depression, the stock market crash was
caused by the huge and dangerously unstable
subprime mortgage market – wherein millions
of people with obscenely terrible credit were
given mortgages that lenders often knew they
couldn’t ever really pay back, creating
a housing bubble.
You may have gathered by this point that there
are major similarities in pretty much all
the economic disasters of the 20th and 21st
centuries, and you wouldn’t be wrong.
Just like we said earlier, economics and human
psychology are intrinsically tied together,
and tend to run in endlessly repeating cycles.
Much like the Great Depression, the devastating
economic collapse precipitated by the 2008
stock market crash set fire to the tinderbox
of an already financially-paranoid public.
The collapse of the Lehman Brothers Bank suddenly
reminded the world that the financial institutions
around them weren’t infallible forces of
nature.
Banks could go down, and if they went down,
they could take all of your savings with it.
As a result, the bank runs began, and people
across the globe started once again making
mass withdrawals.
Banks like the Northern Rock Bank in the UK
were devastated by the sudden influx of terrified
consumers who wanted their money where they
could see it, soon being pushed into insolvency
by people who just didn’t trust the system
anymore.
And honestly, who could blame them?
Bank runs are the financial expression of
pure public panic, occurring only in times
when customers simply don’t trust banks
to keep their money safe.
By now, we imagine you’re probably feeling
a little paranoid yourself – is it possible
that, in the next few weeks, the banks we’ve
been entrusting all our savings to will just
collapse under the weight of their customers
worst fears?
Well, thankfully, it’s really not that simple.
After the devastating effects of two different
rounds of bank runs, central banks like the
Federal Reserve have put in protections and
regulations to keep banking institutions and
their customers from falling victim to bank
runs.
The Fed ensures that bank customers are given
deposit insurance – the purpose of which
is making sure that, even if a bank does indeed
go under, customers are ensured that they’ll
get their savings back.
This isn’t a new development, either – the
Federal Deposit Insurance Corporation, or
FDIC, was first formed in 1933 as a response
to the ravages of the Great Depression.
In fact, it was the existence of this deposit
insurance scheme that prevented the bank runs
during the 2008 financial crisis from being
a heck of a lot worse.
In the event of a bank failure, the FDIC can
help transition the customer savings accounts
into a different bank.
Or even, in worst case scenarios, auction
off the assets of the collapsed bank as collateral
to pay off the customers for their lost savings.
The banks themselves also have some methods
for counteracting the potentially devastating
effects of a bank run.
One method is slowing down the process by
artificially lengthening withdrawal queues
in order to hold back the tide and cling onto
some stability.
The bank may also borrow money in order to
put themselves in a better cash position,
rather than immediately resorting to siphoning
out investment and loan money or selling off
assets at a reduced price.
They can receive a loan from other commercial
banks or from the Federal Reserve in these
kinds of exceptional circumstances.
Another innovative method commercial banks
use to prevent the threat of bank runs is
the introduction of term deposits.
These are a particular kind of savings account
where the customer forgoes their right to
withdraw their deposit at any time in exchange
for holdings at a fixed interest rate.
This means that the bank ultimately retains
unilateral control over when the deposit can
be removed – up until the agreed-upon term
date – making bank runs for these kinds
of deposits effectively impossible.
These days, while bank runs will continue
to be a risk for as long as human beings are
panicky and erratic, measures put in place
to mitigate them mean they won’t be nearly
as devastating as in prior instances.
Banks are more familiar with the threat, and
insurance measures put in place by the FDIC
ensures that the average joe won’t be left
penniless as a result of other customers’
fear and impulsivity.
But in any situation where mob mentality causes
problems, it’s important to be part of the
change: Don’t panic and pull your money
out at the slightest sign of instability,
because if you do, you’re just another part
of the cycle.
Thanks for watching this episode of The Infographics
Show!
If you want to sound really smart at parties
and meetings with your knowledge of finance
and economics, we’ve got you covered.
Why not check out “What If The Stock Market
Crashed Tomorrow” and “Insurance Explained
– How Do Insurance Companies Make Money
and How Do They Work.”
In the meantime, invest wisely, and remember
to save for the future!
