Definition: Bank Run refers to a situation in which numerous depositors of a bank rush to withdraw their money at the same time. This happens due to the fear that the bank will not be able to repay their deposited sum in full and on time. As a result of this, they start withdrawing it altogether before the situation gets out of hand.
In simple words, when depositors, who worry about the bank’s solvency, start a run and withdraw their money, it is called a bank run.
Due to the mass withdrawal of funds from the bank accounts, the chances of default increase, which ultimately causes more people to withdraw their funds. Eventually, there arises a situation when bank reserves fall short to cover the amount of withdrawals. It destabilizes banks to such a degree that it runs out of cash, leading to bankruptcy.
If you look at the history of the world, there are several bank runs during Great Depression and Financial Crisis in 2008.
Causes of Bank Run
There are three major causes of bank runs which include:
- Lack of confidence in the bank
- Poor corporate governance
- Non-payment of interest on depositors’ funds.
Do you know what runs a banking system smoothly?
Well, it is the trust and faith of the customers which keeps it going. If the trust and faith of the customers somehow decrease, it creates a situation of tension. It forces a bank to enter into a phase of insufficient liquidity.
How Bank Run takes place?
Generally, banks keep a certain proportion of their assets in the form of cash. This implies that the maximum portion of the funds received as deposits is lent to the borrowers or invested in the open market in interest-bearing assets.
Banks often maintain daily reserves to meet the cash demands of customers. But, when a large number of customers, start withdrawing their money or transferring it to another bank as a response to some news or rumour, the situation starts getting worse.
Note: The demand for cash among customers and the risk of default increases in the same ratio.
Hence, the bank is required to increase the cash, to meet the increasing demand of the accountholders. If they fail to meet the demand of the depositors, they will break the contractual debtor-creditor relationship between the bank and the customer respectively. For this the bank sells its assets in haste and that too at a price which is lower than its real price (if held till maturity) in the secondary market.
Due to the huge appetite of the banks to make profits, the banks hold a very small amount of capital which mainly comprises of borrowed money, losses on the sale of securities results in insolvency of the bank. Therefore, it becomes a self-fulfilling prophecy. So, in this way run may make a solvent bank insolvent.
What do the running depositors do with their money?
- Redepositing the money. The depositors may redeposit the money in the bank which they think is better in terms of safety. This is called direct deposit.
- Buying of Treasury Securities: When the depositors think that no bank is safe. Now, the question arises, what do the sellers of the securities do with the money? Well, if the seller deposits the funds in the bank they believe is safe, this is called an indirect deposit.
- Holding the currency outside the banking system: If both the depositor and the seller of the treasury securities are of the view that no bank is safe enough to park their money. They keep their money out of circulation. A run on the individual bank will convert into a system-wide run. And this is the worst of all the situations.
A word from Business Jargons
So, a bank run is a panic among the customers of a bank, that causes sudden mass withdrawals, beyond the actual cash available. It is seen as a grave crisis which bank experience.
Due to the various developments over time like securitization of mortgages and consumer loans, banking portfolios have become liquid. But there are some bank assets like corporate loans, which are still illiquid.