A bank run is when many customers of a particular bank withdraw their deposits at the same time, in fear that the bank might fail. Bank runs can occur when there is a fear of economic instability, or when rumours begin to spread about the bank’s financial health. Bank runs can lead to further economic instability and can ultimately cause a bank to fail.
Runs on the liquidity of a bank are dangerous for society because they may cause a chain reaction in which people lose trust in the banking system, causing a financial crisis. This is especially hazardous in times where physical presence is not always needed to transfer large sums and online and direct transactions are common. The assertion is that when people lose confidence in the banking system, they may withdraw their money from banks, resulting in a lack of funds for banks to lend. This can lead to a “credit crunch” in which businesses cannot access the funds needed to operate, leading to a contraction of economic activity and a recession. A bank run can also cause a decrease in the value of the currency, an increase in inflation, and a decrease in foreign investment.
Regulators may attempt to predict a bank run by monitoring the number of deposits and their value that are withdrawn from the bank, tracking customer complaints, monitoring the bank’s financial performance, and conducting stress tests to evaluate the bank’s ability to withstand a potential run. The Diamond-Dybvig model is a useful tool to assist regulators in their efforts. When things go wrong, regulators may put in place measures to help prevent a bank run, such as capital requirements, liquidity requirements, and deposit insurance. These measures help to ensure that customers have confidence in the bank and that their deposits are secure.
Financial regulators stop a bank run by placing the troubled financial institution under external or statutory administration whilst imposing a moratorium on outgoing payments. While a consolidation, resolution or termination of the bank is examined, deposit insurance may be triggered. This external guarantee allows bank account holders and depositors to be repaid even if the bank fails. Several tools to mitigate risk are available in the initial stage of the administration. These include but are not limited to a mandatory capital injection and increase of liquidity, a sale of a (part) of the business, asset separation or winding up via a bail-in scenario.