Bank run Totally Explained

Everything about Bank Run totally explained

A bank run (also known as a run on the bank) is a type of financial crisis. It is a panic which occurs when a large number of customers of a bank withdraw their deposits because they fear it is, or might become, insolvent. This action can destabilize the bank to the point where it becomes insolvent. Banks retain only a fraction of their deposits as cash (see fractional-reserve banking): the remainder is invested in securities and loans. No bank has enough reserves on hand to cope with more than the fraction of deposits being taken out at once. As a result, the bank faces bankruptcy, and will 'call in' the loans it has offered. This can cause the bank's debtors to face bankruptcy themselves, if the loan is invested in a plant or other items that can't easily be sold.
If many or most banks suffer runs at the same time, then the resulting chain of bankruptcies can cause a long economic recession.
As a bank run progresses, it generates its own momentum. As more people withdraw their deposits, the likelihood of default increases, so other individuals have more incentive to withdraw their own deposits. A bank run is a kind of positive feedback loop which has much in common with the reflexive processes described by George Soros, amongst others. Another example of a reflexive process is economic bubble.

Theory

Diamond and Dybvig developed a widely used model to explain why bank runs occur and why banks issue deposits that are more liquid than their assets. This model starts with illiquid assets such as store inventories, which can't be sold immediately without taking a substantial loss. Investors holding illiquid assets sometimes need access to liquid assets (for example to fund an entrepreneurial project that must be started quickly), but are hampered by not being able to predict when these opportunities arise. A bank can invest in a set of illiquid assets; the deposits in the bank become a more liquid asset that allows investors to share the risk of losses due to early liquidation. If only a few depositors withdraw at any given time, this works well; if not, the bank (as opposed to the original investors) may have liquidity problems, and depositors will rush to withdraw their deposits, forcing the bank to liquidate its assets at a loss, and eventually to fail. When such a bank calls in its loans early, this forces borrowers to disrupt their production, causing further economic problems.
A bank run can occur even when started by a false story. Even depositors who know the story is false will have an incentive to withdraw, if they think other depositors will believe the story.

Collective prevention

Some prevention techniques apply across the whole economy, though they may still allow individual institutions to fail. These techniques create moral hazards, since they reduce incentives for banks to avoid making risky loans; the goal is for the benefits of collective prevention to outweigh the costs of excessive risk-taking.

Central banks act as a lender of last resort. To prevent a bank run, the central bank guarantees that it'll make short-term loans to banks, to ensure that, if they remain economically viable, that'll always have enough liquidity to honor their deposits. Much of the Depression's economic damage was caused directly by bank runs, and institutions put into place after the Depression have prevented runs on U.S. commercial banks since the 1930s.

Recent incidents

In 2001, during the Argentine economic crisis (1999-2002), a bank run and corralito was experienced in Argentina. There are various theories into the cause. This contributed towards the bank runs in neighbouring Uruguay during the 2002 Uruguay banking crisis.
   From 9 November to 12 November 2006, Nepal Bangladesh Bank Limited (NB bank) in Nepal suffered a bank run. On 8 November 2006, a Nepalese newspaper reported that NB Bank's 13 billion Nepalese rupees was at severe risk due to misuse of deposits by bank management. This news caused a run on the bank. Depositors withdrew around 3 billion Nepalese rupees during the three days of the run. However, after the takeover of bank management by the central bank of Nepal, the run ended.
In early August 2007, the American firm, Countrywide Financial suffered a bank run as a consequence of the subprime mortgage crisis.
   On 13 September 2007, the British bank Northern Rock arranged an emergency loan facility from the Bank of England, which it claimed was the result of short-term liquidity problems. The bank's defenders claimed its cash shortage was the result of over-exposure to the failing US sub-prime mortgage market, while its critics argued that it was the result of NR's own careless lending practices. A run began the following day, Friday, with reports of its internet banking site being overloaded, and long queues outside branches that day, Saturday morning and the following Monday. News reports on 17 September stated that an estimated £2 billion GBP of retail deposits had been withdrawn by customers since the bank had applied for emergency funds.
   On Tuesday, 11 March 2008, a bank run began on the securities and banking firm Bear Stearns. Credit officers of rival firms began to say that Bear Stearns wouldn't be able to make good on its obligations. Within two days, Bear Stearns's capital base of $17 billion had dwindled to $2 billion in cash, and Bear Stearns told government officials that it saw little option other than to file for bankruptcy the next day. By 07:00 Friday, the Federal Reserve decided to lend Bear Stearns money, the first time since the Great Depression that it had lent to a nonbank. Stocks sank, and that day JPMorgan Chase began an effort to buy Bear Stearns as part of a government-sponsored bailout. The deal was arranged by Sunday in an effort to calm markets before markets opened Monday.

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