What Is a Bank Run?

Banking

In the vast world of banking and finance, few events are as potentially disastrous and historically notorious as a “bank run.” The word carries connotations of an old-fashioned burglary heist executed by men in bandanas. But, in reality, the term is far more mundane.

A bank run describes a scenario where many customers of a bank attempt to withdraw their money simultaneously due to fears of the bank’s imminent insolvency. What causes these panic-inducing events, and how can they impact the average person’s pocketbook and the wider economy?

concerned bank customers

This guide explores the concept of a bank run, unpacking its causes and consequences. Finally, we’ll look at the measures taken by banks and the federal government to prevent bank runs. Whether you’re a seasoned investor or just beginning your financial journey, understanding bank runs is crucial to navigating the complex landscape of personal finance.

What is a bank run?

A “bank run” refers to a situation where a large number of customers of a bank or a similar financial institution withdraw their money at the same time, due to fears that the institution will become insolvent.

With a banking system built on the premise of fractional reserve banking—where only a small percentage of bank deposits are backed by actual cash reserves—bank runs can result in a self-perpetuating cycle of fear and cash withdrawals, leaving a bank short of cash and hastening its demise.

The Nuts and Bolts of the Banking System

At the heart of the U.S. financial systems lie commercial banks. Understanding how commercial banks operate can help you grasp the concept – and significance – of a bank run.

Commercial banks operate on a system called fractional reserve banking. In essence, when you deposit money into a bank, it doesn’t simply sit there. The bank holds only a small percentage, known as reserves, and uses the rest to issue loans or make other investments. This is how banks generate income: by lending your money to others and charging interest on those loans.

This system functions seamlessly under normal conditions. On any given day, only a small fraction of a bank’s total depositors withdraw their funds. Most of the depositors’ money stays within the bank’s vaults, helping to generate profits. It’s a system built on trust, where everyone’s money is safe as long as everyone doesn’t demand it back at once.

However, this trust is also the system’s Achilles heel. If too many customers—spooked by real or imagined financial troubles—decide to withdraw their funds simultaneously, the bank faces a bank run. Banks can’t fulfil the demands of all depositors due to the fractional nature of their cash reserves, which leads to a crisis of confidence and, in some instances, bank failures.

Reasons Behind Bank Runs

Bank runs are generally triggered more by fear and panic than the actual financial instability of a bank. The banking system relies heavily on the confidence of depositors. If that confidence wavers, it can have serious repercussions.

For instance, rumors about a bank’s risky loans or poor financial health can spark a wave of fear among depositors, leading them to rush to withdraw their deposits. This sudden surge in withdrawals can result in a bank run, even if the bank was financially sound to begin with. The bank might be forced to sell assets or make other emergency moves to meet the depositors’ demands, thereby further stoking fears and potentially leading to the bank’s demise.

Similarly, the financial system’s interconnectedness means problems at one bank can quickly spread. If a bank in the same market—or even a different market—experiences difficulties, customers might fear for their own bank’s stability and start to withdraw their money. This shows how easily a bank run could potentially be triggered, highlighting the delicate balance on which the banking system operates.

The Domino Effect of Bank Runs

Bank runs, once initiated, often unfold in a rapid, self-perpetuating cycle that can be challenging to halt. As the initial wave of worried depositors withdraw their money, the bank’s available cash reserves start dwindling, increasing the bank’s liabilities.

As the word spreads, more customers may join the rush to withdraw their funds, fearing that they will be left empty-handed. This escalating cycle of withdrawals often leads the bank to exhaust its available cash, triggering a liquidity crisis.

To meet the unexpected demand for cash, the bank might be forced into emergency measures. It may have to liquidate loans—often at less than their full value—or sell other assets quickly, often at a significant loss. These actions can potentially harm the bank’s financial position even further, fueling the panic instead of quelling it.

An illustrative example of this was the Washington Mutual bank failure during the global financial crisis. As panic among depositors escalated, the bank saw a rapid outflow of funds—more than $16 billion within a ten-day span—which further aggravated the bank’s financial position. The bank was eventually seized by federal regulators, marking the second-largest bank failure in U.S. history.

A Glimpse into Historic Bank Runs

History provides numerous instances of bank runs that have had significant impacts on economies, the most notable of which happened during the Great Depression and the global financial crisis of 2007-2008.

The Great Depression, which began with the stock market crash in 1929, saw a wave of bank runs across the country. Fear and uncertainty gripped depositors, who attempted to withdraw their money en masse.

Their lack of trust in the banks’ ability to return their funds led to multiple bank runs. As a result, many banks, unable to meet the sudden demand for cash, collapsed. These bank failures caused a significant contraction in the money supply, exacerbating the economic downturn.

The global financial crisis of 2007-2008 bore witness to a new kind of bank run—a silent one. In this scenario, bank runs unfolded largely out of the public eye, as depositors quietly withdrew their money electronically rather than lining up outside bank branches.

A classic example of this was Northern Rock in the UK, which experienced the first run on a British bank in over 150 years. In the U.S., Washington Mutual also fell victim to a silent bank run, leading to the largest bank failure in U.S. history.

In both cases, depositors began to withdraw their funds due to concerns about the banks’ exposure to the subprime mortgage market, even though both banks were solvent at the time. The subsequent runs on these banks, however, led to their downfall, illustrating the devastating power of bank runs and the essential role of depositor confidence in the banking system.

The Impact of Bank Runs

The effects of bank runs can be severe and wide-ranging, affecting both individual depositors and the broader economy. For individual customers, a bank run that leads to a bank failure can mean the loss of their deposited funds. Imagine waking up one day to find that the bank where you’ve kept your life’s savings has gone under—that’s the very real risk posed by bank runs.

Fortunately, FDIC insurance protects your deposits up to $250,000 per depositor, per account type. But funds may not always be available immediately in this situation.

It’s not just individuals who stand to lose. Bank runs can ripple out to destabilize the entire financial system. If one bank fails, it can trigger a chain reaction that impacts other banks and large financial institutions, known as systemic risk.

Fear can spread from one bank to others, causing more bank runs. The subsequent wave of bank failures can lead to a decrease in lending and the availability of credit, causing the economy to contract or even plunge into a financial crisis.

Lessons from Past Bank Runs

Bank runs have taught us the importance of a robust and regulated financial system. From the establishment of the Federal Reserve System in 1913 to the creation of the FDIC in the 1930s, financial institutions and government bodies have evolved their practices to mitigate the risk of bank runs. The evolution of banking regulations reflects these lessons learned from many banks’ failures during times of crisis.

Moreover, the rise of online and mobile banking has allowed for a new kind of bank run—a silent bank run. In these cases, depositors don’t physically line up to withdraw money. They simply transfer funds electronically, leading to a less visible but potentially just as damaging bank run. It’s an example of how the financial landscape continues to change, necessitating ongoing vigilance and adaptation.

Preventive Measures Against Bank Runs

Given the potential devastation caused by bank runs, a range of measures have been put in place to prevent them. Banking regulations and oversight by central banks are at the heart of these preventative strategies.

Central banks, like the Federal Reserve Bank in the U.S., often step in during times of crisis to provide stability and confidence. They act as a “lender of last resort”‘ for banks under threat from a bank run, providing them with necessary liquidity to meet the demands of depositors and alleviate panic.

In addition, deposit insurance systems, such as the Federal Deposit Insurance Corporation (FDIC) in the U.S., have been established to provide an extra layer of protection. Created in response to the many bank failures during the Great Depression, the FDIC insures bank accounts up to a certain limit.

This insurance provides financial protection to depositors, ensuring they won’t lose all their money even if their bank fails. The existence of such a system reassures depositors and reduces the likelihood of bank runs, contributing to the overall stability of the banking system.

Steps to Take During a Bank Run

In light of the recent news surrounding First Republic Bank, Silicon Valley Bank, and Signature Bank, it’s become even more important for depositors to be aware and prepared. When a bank run is underway, understanding your bank’s financial health and the protections in place for your deposits is critical.

While most banks offer high yield savings accounts insured by the FDIC, it’s always prudent to verify that your deposits are indeed protected. This insurance safeguards your deposits up to $250,000 per depositor, per account type, per institution in the event of a bank failure. Joint accounts have up to $500,000 in protection.

If you’re concerned about the possibility of a bank run following these recent events, you might want to diversify your holdings. Rather than having all your savings in one bank, consider spreading your funds across different types of accounts and different financial institutions.

Credit unions are excellent alternative options for depositing your money. Just as banks in the U.S. have FDIC coverage, credit unions are protected by the National Credit Union Share Insurance Fund (NCUSIF). Many credit unions offer no-fee checking and savings accounts and high interest rates for savings, along with exemplary customer service.

Despite the alarming news of recent bank failures, remember that bank runs, while dramatic, are relatively rare events, particularly in stable, well-regulated financial systems. However, the recent news is a sobering reminder that being aware of your bank’s financial health, ensuring your deposits are insured, and diversifying your holdings are crucial steps in protecting your finances.

Bottom Line

Bank runs, while a crucial aspect of financial history, are less common in modern times due to stronger financial regulations and deposit insurance. However, understanding how a bank run occurs and how it can impact the financial system is vital.

When you learn how bank runs work, you’ll better grasp the importance of a stable banking system, consumer confidence, and, above all, the need for financial literacy. In times of economic uncertainty, understanding these concepts can provide you with the knowledge and peace of mind to make informed decisions about your money.

Dawn Allcot
Meet the author

Dawn Allot is a full-time freelance writer and content marketing expert specializing in personal finance, real estate, and technology. In addition to her work at Crediful, Dawn regularly writes for LoopNet, Solvable, and The Balance.