Bank Run Definition – How does it happen? – Explanation

Bank Run: The bank is stormed – definition & examples

What sounds like the title of a crime thriller with bank robbery is the colloquial English term for a rush of customers to the bank counters. A bank run is spoken of when investors want to withdraw their savings en masse within a very short time. Since a bank only holds a portion of its customers’ deposits in liquid form, this can lead to the insolvency of the institution in extreme cases.

In times of crisis, many customers suddenly withdraw cash. But how does such behavior occur?

Reasons that can trigger a bank run

Basically, a bank run occurs when there is a high level of uncertainty. The result: a collective fear for one’s own money. In our economic system, this is largely due to the banks.

The reasons for widespread uncertainty are primarily:

The bank is in crisis: Uncertainty already occurs when rumors of a crisis begin to circulate. The investor sees his risk increase the longer he leaves his deposits with the bank.
The human “herd instinct” or “peer pressure”: News of a recent mass withdrawal of deposits can trigger a rush. Many trust that there must be a reason for this without knowing it themselves.
Hyperinflation as a fear driver: The extreme Inflation fuels the awareness that consumers will be able to buy less for their money tomorrow.

The mechanism and impact of a bank run

Banks have a limited ability to pay out deposits placed with them in the short term. Financial management calculates, not least on the basis of experience, what part of their customers would like to have at their disposal on a regular basis. In order for an institution to operate profitably, the remainder of the capital, less a safety margin, is invested.

In this context, the term “maturity transformation” plays an important role. This is the technique of accepting short- and medium-term funds and investing them in larger tranc profit-oriented. To this end, banks invest funds over various maturities in order to have a continuous supply of liquidity.

Simplified by an example:

A private investor invests 100,000 euros in fixed-term deposits in tranches of 10,000 euros each. He chooses ten different maturities in order to have an amount of 10,000 euros (plus interest) at his disposal every year. If, contrary to expectations, the entire amount is needed in the 5th year, this amount is not available.

The maturity transformation leads to liquidity bottlenecks in the event of a mass run on deposits, which in the worst case could lead to the bank’s insolvency. The problem has intensified in recent years as banks no longer make a profit by holding liquid funds. As a result of the ongoing low-interest phase, the opposite is the case: banks have to pay penalty interest for money they park at the ECB in the short term.

Examples from the past

The images of queues in front of ATMs in Athens and other Greek cities are still present in many people’s minds.

Especially during economic crises, there is a risk of bank runs, as history shows. These include:

Great Depression in October 1929, following the New York stock market crash
Financial crisis as of 2007
Argentina crisis 1998-2002

In Germany, the bank run on the Cologne-based Herstatt Bank in 1974 attracted a great deal of attention and raised awareness throughout the banking industry. As a consequence the deposit guarantee scheme of German banks, to which most institutions are now affiliated.

One of the major events in the EU area was the run on the British bank Northern Rock. The bank ran into liquidity bottlenecks as a result of a one-sided refinancing strategy.

Far-reaching consequences and measures to prevent them

The above-average withdrawal of cash leads a bank to a Reduction in central bank money (Cash is central bank money). Transfers from one bank to another put less strain on the banking system. If the bank runs out of central bank money, customers can no longer withdraw cash. The dramatic consequence: even banks with high profits can become insolvent and thus face the end.

Protection of confidence can protect against a bank run

When Herstatt Bank went bankrupt, the industry had a vested interest in boosting confidence in banks. This gave rise to the German banks’ deposit protection scheme. Customers of institutions that are members of the protection fund are guaranteed to get their money back within the conditions in the event of insolvency.

Similarly, the financial crisis led politicians to seek to strengthen Germany as a banking center. in 2007, the government therefore issued a deposit guarantee to reassure savers. Uniform deposit guarantees now apply throughout the EU, guaranteeing repayment of savings up to a total amount of 100,000 euros. The guarantors are the respective countries.

Another instrument is the recognition of more Securities on the part of the central bank. More collateral deposited with the central bank means that banks can borrow more money when needed.

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