Most of us don’t keep our money under our mattress. We keep it in the bank, where we trust it will be safe until we need it.
This trust is the reason banks stay in business. If enough people lose that faith, it can trigger a chain of events known as a bank run.
A bank run occurs when a large group of customers loses faith in their bank and try to withdraw their funds at the same time. When a bank doesn’t have the funds to cover these withdrawals, it runs the risk of failing.
What Causes Bank Runs
Simply put: panic.
When customers worry that their bank will go bankrupt, they want to get their money out quickly. But the bank doesn’t have a big safe with Scrooge McDuck’s cash rate. Banks lend most of the money customers save to borrowers or invest interest-bearing assets.
Banks only keep small amounts of cash. Usually, this cash is enough to cover a typical daily customer withdrawal. But if too many customers withdraw money at once, the bank may not have enough funds to cover them.
The famous scene from the classic Christmas movie “It’s a Wonderful Life” shows this concept in action. (Except in real life, bankers rarely hand out cash from their own pockets.)
How Banks Can Overcome Runs
If a bank experiences a run, it has several options. Can:
- Sell assets to generate the needed cash.
- Limit the amount or number of withdrawals a customer can make or pause withdrawals altogether.
- Borrow money from another bank or the Federal Reserve.
If the bank sells some of its assets and they are not as much in value as when the bank bought them, it results in a loss. Banks can go bankrupt (unable to pay their debts) and fail.
Ironically, the fear of customers becomes a self-fulfilling prophecy, even if the bank is really healthy from the start.
Walking Historic Bank
There have been several significant bank runs in US history. These are some of the most famous.
Panic of 1907
The Knickerbocker Trust, one of New York’s largest banks, collapsed in 1907 due to bad investment speculation.
Hoping to corner the copper market, two small brokerage firms bought a large number of shares in United Copper Co. They plan to increase the price and resell it for a huge profit. Instead, prices plunged, bankrupting brokers and shaking Americans’ faith in the banking system.
Because the Knickerbocker Trust had connections to brokers, it was the first bank to be hit by panic and failure. What started as a bank run in New York City quickly spread across the nation, triggering a series of runs known as the Panic of 1907.
The panic and recession that followed led to the passing of the Federal Reserve Act in 1913. This act created the Federal Reserve, the central bank of the United States. The Fed oversees and regulates the banking industry, sets monetary policy, and provides economic stability.
The Great Depression Banking Panic (1930 – 1931)
The stock market crash of 1929 severely damaged public confidence in financial institutions. The relatively new Federal Reserve responded by cutting the nation’s money supply, reducing bank liquidity. As a result of the bank panics of 1930 and 1931, thousands of banks went bankrupt, and much of America’s savings went with it.
In response, Congress passed the Emergency Banking Act of 1933, which gave the president executive powers to act without the approval of the Federal Reserve in a financial crisis. President Franklin Roosevelt declared a bank holiday that closed banks and the Federal Reserve for a week.
This gave Congress time to create the Federal Deposit Insurance Corporation, which protects customer deposits in the event of a bank run. The FDIC creates a safety net for customers and increases public confidence in the banking system, reducing the likelihood of it running in the future.
The Great Recession (2007 – 2009)
As in the Panic of 1907, the Great Recession resulted from risky speculation, this time in the form of subprime lending.
Banks bundle mortgages into investment assets called mortgage-backed securities, which can generate steady returns if markets do well. Spurred on by this, banks began issuing mortgages to borrowers with lower credit ratings than they would normally approve (subprime credit) — risky bets that came with potentially higher returns.
When the housing bubble burst, many of these subprime borrowers defaulted, leaving banks to cover losses on the remaining loan amount and forfeit the interest they would otherwise have collected. Banks large and small went bankrupt, including Washington Mutual, the largest bank failure in US history.
“Bailout” was the word back then. To keep the financial industry from collapsing, Congress passed the Emergency Economic Stabilization Act and the Troubled Asset Assistance Program in 2008. These acts allowed the US Department of the Treasury to buy ill-fated mortgage-backed securities from banks and buy bank shares to shore up faltering institutions. .
FTX Collapse (2022)
The recent boom of FTX can be thought of as a new breed: running virtual banks. The cryptocurrency exchange collapsed within the span of days when people found out that it had lent customer funds to investment firm Alameda Research (which is owned by the founder of FTX). Worried about the trustworthiness of FTX and the safety of their funds, users withdrew an estimated $8 billion, and FTX’s value took a nosedive.
One of the main criticisms of cryptocurrencies is the lack of regulation and a way out for crypto holders who lose money on their investments. Until the government addresses this issue, we may see more going like FTX.
Final Word
Traditional bank collapses are now less likely thanks to the controls and regulations created after the Panic of 1907. But they can still happen (see: The Great Recession).
If a bank run occurs, the government can assist the bank by:
- Save the banks
- Allowing other banks to acquire it
- Increase federal cash reserve requirements
The good news for customers is that FDIC insurance covers you. So even if your bank is in trouble, your money is safe — unless it’s in cryptocurrency. Then, you’re out of luck unless the government rolls out new regulations.
