Any modern economy requires a functioning banking sector. Apart from the critical role of processing the incredible number of payments and transfers taking place at any point in time, banks help enable economic growth through maturity transformation and the money multiplier, two concepts that are critical to the business of a bank but which cannot be done without introducing a key risk that has led to the downfall of many banks, liquidity risk.
A bank’s primary role is to accept funds or deposits, pool the money and lend it out to those who require funds. Thus, banks act as intermediaries between depositors and borrowers and turn excess short-term savings into long term funding, enabling businesses and individuals to borrow money for long periods of time. Although this creates a valuable source of relatively inexpensive long-term funding for the economy, if a large part of the deposit base attempt to withdraw their deposits within a short period of time the bank will not be able to honour all the requests.
The second concept that allows banks to stimulate the economy is known as the money multiplier, best illustrate with an example. Let’s assume all banks lend out 90% of deposits, when a bank gets a deposit of €100, the bank can lend out €90. The €90 goes back into the economy to be used and €90 ends up being deposited somewhere in the banking sector, enabling new loans of €81 which again ends up being deposited somewhere, and thus the cycle continues. Through the money multiplier a deposit can create loans with a total value multiple times the original deposit value, meaning a lot more money flows through the economy than actually exists.
The result is that the banking system is built on trust, without which the entire system will collapse. With banks being businesses motivated by profit, they can be incentivised to take more risk than is necessarily desired by society. Governments, through regulators, must play an important role in maintaining confidence in the banking sector.
Bank runs are almost as old as banks themselves and, since the 1930’s, bank runs have become much rarer due to government interventions like insuring deposits, however they still occur. Although the fundamental reasons for bank runs are the same the way in which they happen are vastly different and gone are the days of queuing outside a bank in the hopes of recovering your deposit.
A famous case from 1930 is the bank run on New York Bank of United States (NYBUS), which is said to have started the Great Depression. The NYBUS was a large commercial bank in the early 20th century with a significant presence in New York City. In December 1930, the public gathered outside a branch in the Bronx seeking to withdraw their money and thus starting a bank run. The New York Times newspaper reported that the bank run was started by a false rumour spread by a merchant who claimed that the bank refused to sell his stock. The rumours of financial instability and possible default on loans spread quickly which led to panic.
Once this happens it is a classic case of the prisoner’s dilemma, collectively the best course of action is to remain calm, but individually the rationale decision is to get your money out as soon as you can. Depositors were afraid they would lose their savings and rushed to the bank to withdraw their deposits. It is estimated that the bank held $200 million in deposits at the time of the bank run and a large portion of that was withdrawn. The NYBUS’s failure led to loss of confidence in the banking sector thus leading to many more bank runs and collapses across the US. This is a clear example of how loss of confidence in a bank can lead to a bank run. The eventual fallout of the collapse of numerous banks in the US led to both the US and Europe creating deposit insurance schemes. Following the creation of the deposit insurance schemes, bank runs became a lot less frequent and severe.
Bear Sterns was not a traditional deposit taking bank and thus is a great example of the changing `nature of bank runs in modern society. Bear Sterns was an investment bank which was heavily involved in securitisation. In the months leading up to the bank run, Bear Sterns had suffered significant losses due to its exposure to subprime mortgages and related securities. The bank’s stock price had also fallen sharply causing concern amongst investors and depositors. In March 2008, rumours began circulating regarding the bank’s liquidity problems and it potentially having to file for bankruptcy. A bank run ensued, and investors and depositors withdrew their funds. The bank ended up losing $17 billion in a matter of four days forcing the Federal Reserve to step in and organise a rescue by having JPMorgan Chase acquire Bear Sterns for a fraction of the bank’s previous value.
Silicon Valley Bank is the largest run on a bank that the world has ever seen. In a single day, customers withdrew $42 billion from their SVB accounts. SVB was a bank which specialised in banking services for start-up technology companies. The original unmanaged risk that led to the SVB bank run (discussed in detail in our previous blog) was interest rate risk, and the Federal Reserve’s aggressive rate hikes to combat inflation significantly reduces the value of SVB’s assets.
With about $210 billion in assets before the collapse, SVB was not classified as systemically important (as defined in the Dodd-Frank Act where the threshold is $250 billion, increased from $50 billion in 2018) meaning it could be allowed to fail without significant consequences to the wider banking sector, which might have been the case a decade or two ago. However, we have now seen that, in today’s interconnected world, news (credible or not) spreads faster than ever and once reports started spreading that prominent investors advised the businesses they invested in to move their money out of SVB, more people did the same. Only this time the “run” was as simple as logging into an app and making a transfer, someone seeing a Tweet can therefore move their money within seconds. There are reports of people moving money out of SVB while attending a conference as news spread through the audience. Relative calm was returned on 12 March after it was announced that The Federal Deposit Insurance Corporation (FDIC) will fully protect all SVB deposits, not just up to the $250,000 limit.
Now that there has been some time for the dust to settle the question is what will change in the wake of the SVB collapse. Given the importance of confidence in the banking sector, we have seen that during a crisis the definition of “systemically important” is expanded beyond how it might be defined when applying regulation in normal times. If SVB was subject to the more stringent regulation of a systemically important bank the root cause of the collapse would have probably been picked up much earlier.
Another potential way the panic could have been prevented is to increase the limit of deposit insurance or protection (currently €100,000 in the Netherlands and $250,000 in the USA). Given that the initial panic was rooted in a lack of trust and fear that deposits will be lost, the mere presence of higher limit could instil sufficient trust in enough deposit holders to prevent the panic in the first place. If the limit will likely be increased during a crisis anyway, making it explicit will not only mean more deposit holders would have no incentive to join a bank run, contributions to an industry funded guarantee scheme can be calculated accordingly.