Bank Runs

Definition

A bank run is a situation where a large number of bank customers withdraw their deposits from a financial institution due to a fear that the bank may become insolvent and be unable to meet its obligations. This can lead to the collapse of the bank as it becomes unable to cover the withdrawals, creating a self-fulfilling prophecy of the bank's failure.

5 Must Know Facts For Your Next Test

1. Bank runs can occur when customers lose confidence in a bank's ability to meet its financial obligations, leading to a sudden surge in withdrawal requests.
2. Fractional reserve banking, where banks hold only a portion of their deposits as reserves, can make banks vulnerable to bank runs if too many customers try to withdraw their funds simultaneously.
3. Deposit insurance, such as the Federal Deposit Insurance Corporation (FDIC) in the United States, helps prevent bank runs by assuring customers that their deposits are protected up to a certain amount.
4. Central banks or other institutions can act as a 'lender of last resort' by providing emergency funding to banks experiencing liquidity issues, which can help stop or prevent a bank run.
5. Bank runs can have severe consequences, leading to the collapse of the affected bank and potentially causing wider financial instability and economic disruption.

Review Questions

• Explain how the fractional reserve banking system can contribute to the risk of bank runs.
  • In a fractional reserve banking system, banks only hold a fraction of their total deposits as reserves, lending out the rest. This means that if a large number of customers try to withdraw their funds at once, the bank may not have enough reserves to cover the withdrawals, leading to a bank run. The bank's inability to meet its obligations can then become a self-fulfilling prophecy, as more customers try to withdraw their money out of fear that the bank will fail.
• Describe how deposit insurance and the role of a lender of last resort can help prevent or stop a bank run.
  • Deposit insurance, such as the FDIC in the United States, helps prevent bank runs by assuring customers that their deposits are protected up to a certain amount. This reduces the incentive for customers to withdraw their funds out of fear of losing their money. Additionally, central banks or other institutions can act as a 'lender of last resort' by providing emergency funding to banks experiencing liquidity issues. This can help stop or prevent a bank run by ensuring that the bank has the necessary funds to meet withdrawal requests, restoring customer confidence in the financial institution.
• Analyze the potential consequences of a bank run and its impact on the broader financial system and economy.
  • Bank runs can have severe consequences, leading to the collapse of the affected bank and potentially causing wider financial instability and economic disruption. The failure of a bank can lead to a loss of confidence in the banking system as a whole, triggering a domino effect where customers of other banks also try to withdraw their funds, leading to more bank failures. This can disrupt the flow of credit, investment, and economic activity, potentially causing a broader financial crisis and economic recession. The negative impacts of a bank run can be far-reaching, affecting businesses, consumers, and the overall economic well-being of a community or nation.

Related terms

Fractional Reserve Banking: A banking system where banks only hold a fraction of their total deposits as reserves, lending out the rest, which can lead to bank runs if too many customers try to withdraw their funds at once.

Deposit Insurance: A system where the government guarantees a certain amount of each depositor's funds, which can help prevent bank runs by assuring customers that their money is safe.

Lender of Last Resort: A central bank or other institution that provides emergency funding to banks experiencing liquidity issues, which can help prevent or stop a bank run.