Bank runs gained notoriety around the time of the Great Depression when some consumers lost their life’s savings. Shortly after that, the government formed the Federal Deposit Insurance Corporation (FDIC), an independent agency that protects consumer bank deposits in the event of similar financial catastrophes that lead to bank failures. While that means that the risk consumers take with their deposits is now dramatically less than it used to be, understanding bank runs can help you avoid making panic withdrawals that can hurt banks and the larger economy.
Bank Runs Can Cause Asset Sell-offs and Losses
Since U.S. banks use what is known as fractional reserve banking, not all customer deposits are available at banks in cash for immediate withdrawal. Instead, banks keep only a fraction of customer deposits in cash stocked in vaults and automatic teller machines (ATMs). Some is held in reserves, and some is used in loans or other types of investments. In general, most customers don’t need their money at the same time. When a large number of customers try to withdraw their money at the same time, the demand for deposits can overwhelm a bank. To meet its obligations, a bank may even be forced to sell off long-term assets. If a bank is forced to generate cash by selling investments, it may have to incur considerable losses since the height of a financial crisis is generally a bad time for the bank to redeem assets for cash.
Bank Runs Can Lead to Bank Failures
Bank runs are based on worries about bank insolvency that are ultimately rooted in the fear of losing money. Customers think (often rightly) that if a bank goes belly up, they’ll lose all of their money in the bank. This concern is understandable; your hard-earned savings seem to be at risk, so you make a desperate rush for the exit. Unfortunately, even rumors that a bank can’t give people their money can act as self-fulfilling prophecies. A bank might be on somewhat shaky ground but far from failure. However, if everyone believes that the bank is or will be insolvent and pulls funds out at the same time as a result, the bank suddenly becomes much weaker. When a bank cannot satisfy customer demands for withdrawals—or if there’s even a rumor that the bank will be unable to do so—the situation worsens. Customers fear being the “last one to the exit” and may try to withdraw as much as possible, leaving a bank unable to give customers their money. In a worst-case scenario, a bank may become insolvent, leading to complete failure. If a bank wasn’t going to fail before, the likelihood of insolvency increases during and after a panic. A bank run can happen with one particular financial institution, or it can happen on a national level, leading to an economic decline. If investors or account holders believe that the banking system or financial system of a given country is about to collapse, they may even attempt to move funds to foreign banks.
The FDIC Protects Banks and Consumers From Runs
The establishment of nationwide insurance on bank deposits through the FDIC has had the effect of reassuring consumers about their deposits and making runs and subsequent bank failures less common. However, most depositors in the U.S. will not lose money even if runs do occur and their bank fails. In fact, they might not be inconvenienced in any meaningful way. Through FDIC insurance, customers at participating banks may get full or partial protection from monetary losses if a bank fails. Federally insured credit unions enjoy similar coverage through the National Credit Union Share Insurance Fund (NCUSIF). In either case, protection is generally limited to $250,000 per depositor, per institution, per ownership category. In the case when an open bank assumes the deposits of a failed bank, covered customers of the failed bank can continue to write checks, deposit money, and make electronic transfers as if nothing happened. At some point, they may notice that the name and logo on their statements change, but their account balance would be the same as it would have been had the bank remained open.
The Bottom Line
Bank runs are a scary prospect that can lead to bank losses and failures along with economic decline. But the availability of deposit insurance means that they’re less likely today and are generally not warranted unless depositors are not fully covered by the FDIC or NCUSIF or a total collapse of the financial system is imminent and you’re concerned that your money will become worthless. You can minimize the panic that drives bank runs and even do your part to prop up the economy by keeping your money in FDIC- or NCUSIF-insured accounts up to the limit and avoiding herd behavior.
