Bank runs have been the talk of the town for the past week after the Silicon Valley Bank had to declare bankruptcy about a week ago.
After the stock market crash and financial crisis of 2008, people and governments are taking bank failures quite seriously.
Since I work at a bank, I’ve answered quite a few questions about the subject lately and decided I’ll share the basics with you here.
What is a Bank Run?
A bank run is a vicious cycle where customers withdraw their deposits from their bank at the same time because they’re afraid that the bank will run out of money.
The cycle begins when more and more people are getting scared and too many customers begin to withdraw money from the bank. If this cycle continues to escalate, the bank may actually run out of cash reserves, default on its payments, and reach actual insolvency.
In other words, a bank run is a situation where a lot of depositors withdraw their money from the bank at the same time. If this continues and the bank fails to deliver, the bank will become insolvent.
Why do Bank Runs Occur?
The thing with banks is that they don’t actually have all their customers’ money at hand, they have only a fraction of their deposits as cash reserves. What this means is that the banks can cover some number of withdrawals at the same time, but not all of them.
The number one reason why bank failures happen is panic. When people go into panic mode, they start to doubt whether the bank can cover their money or not.
It’s not about whether the bank is solvent or not, it’s about what depositors think about the bank’s solvency. If they all decide the bank is insolvent and try to withdraw all their money at once, the bank will become insolvent.
So, in a way, our banking system is a game of trust.
Once the trust is broken and a bank run occurs, preventing further cash withdrawals and containing the run from spreading to other banks can be difficult.
How Can a Bank Run be Prevented?
Because a bank run can trigger a greater financial crisis, governments around the world have taken precautionary actions through banking regulations.
The most important ways to prevent bank runs are reserve requirements and bank deposits insurance. Reserve or capital requirements mean that banks are required to have a certain percentage of their deposits in cash, which at the moment is 10%.
The idea is that banks maintain some amount of cash at their disposal to maintain trust and prevent massive withdrawals.
Deposit insurance, on the other hand, is insurance by the government that if the bank does default on its payments, the government will pay you. In the U.S., this is handled by the FDIC (Federal Deposit Insurance Corporation).
The amount they pay depends on a country’s banking system. In the U.S. it’s $250,000 per banking institution.
In Finland, for example, the government guarantees to pay €100,000 per institution.
Should You Be Worried?
What makes bank failures problematic is that the depositors themselves decide whether a bank run happens or not. It’s a sort of self-fulfilling prophecy.
So, if no one is worried, there would be no need to worry. Our financial system is a system that’s built on trust. Unfortunately, we humans like to resort to panic every now and then, which complicates things a little bit.
Luckily, there’s really not much reason to be concerned since the government will back you up even if your bank would fail.
If you have loads of cash (above $250,000 in the U.S.), you can split your money between other financial institutions to ensure you’re fully protected by the government.
To summarize, if you have a moderate amount of deposits, there’s no need to worry about bank failures.
