Bank Runs

A Bank Run is a financial panic attack. It happens when a large number of a bank's customers, gripped by the fear that the bank is on the brink of collapse, rush to withdraw their deposits all at once. This isn't just a few people closing their accounts; it's a stampede for the exits. The core of the panic lies in the fundamental nature of banking itself. Under the fractional reserve banking system, banks don't keep all your money locked in a vault. They keep a small fraction on hand for daily withdrawals and lend out the rest to earn interest on loans and investments. This model works perfectly well in normal times, but it creates a critical vulnerability. If too many depositors demand their money back simultaneously, the bank simply won't have enough cash. This fear can become a devastating self-fulfilling prophecy, where the run itself can push a previously healthy bank into actual insolvency, as famously seen during the Great Depression and more recently with the collapse of Silicon Valley Bank in 2023.

A bank run unfolds like a fire, starting with a spark, fueled by the bank's own structure, and quickly growing into an uncontrollable inferno.

The initial trigger is always a loss of public confidence. This can be sparked by many things:

• Bad News: Reports that the bank has made poor investments or is suffering heavy losses. For example, a bank holding lots of long-term government bonds will see the value of those assets fall when interest rates rise sharply.
• Rumors: In the age of social media, rumors of a bank's instability—true or not—can spread like wildfire and trigger a digital bank run in hours, not days.
• Contagion: The failure of another, similar bank can make people worry about their own, even if it's perfectly healthy. Seeing long queues (physical or digital) of others withdrawing money is often enough to convince even skeptical depositors to join in, just in case.

The banking system itself provides the fuel. As mentioned, banks lend out most of the money they take in as deposits. Their assets are mostly illiquid—things like 30-year mortgages and business loans that can't be turned into cash instantly. Their liabilities, however, are your deposits, which are liquid—you can demand them back at any time. When a run begins, the bank quickly depletes its cash reserves. To meet further withdrawal demands, it must start selling its assets.

This is where the situation turns critical. A bank desperate for cash must sell its assets in a “fire sale,” meaning it sells them quickly for whatever price it can get, which is often far below their true value. These massive losses wreck the bank's balance sheet, turning the fear of insolvency into the reality of insolvency. This news then leaks out, confirming everyone's worst fears and intensifying the run. This vicious cycle seals the bank's fate, proving that in banking, perception can create reality.

Even if you don't have all your money in one bank, understanding bank runs is critical for protecting and growing your wealth.

A single bank run is bad, but the real danger is contagion. When one bank fails, it can ignite a chain reaction, causing depositors to lose faith in the entire banking system. This can lead to a full-blown systemic crisis, where credit freezes up, businesses can't get loans, and the economy grinds to a halt. The 2008 Global Financial Crisis is a powerful example. For an investor, this means a major bank failure can drag down the entire stock market, hurting your entire portfolio, not just your shares in financial companies. It's a reminder that the health of the banking system is the bedrock of the modern economy.

If you're considering investing in a bank's stock, you are essentially betting on its stability. A value investor must look beyond simple earnings and analyze a bank's resilience to panic. Key things to examine include:

• Capital Strength: Look at the bank's Capital Adequacy Ratio (CAR). This measures its capital (the bank's own money, not depositors') against its risk-weighted assets. A higher ratio means a bigger cushion to absorb unexpected losses.
• Liquidity: How much cash and easily-sellable assets does the bank have to meet short-term withdrawals? This is a measure of its liquidity position.
• Deposit Base: Are the bank's deposits “sticky” or “hot”? A bank with millions of small, insured retail accounts is far more stable than one that relies on a few huge, uninsured corporate accounts that can be withdrawn in an instant.

Fortunately, governments and central banks learned bitter lessons from past crises. Today, powerful safeguards are in place to prevent bank runs.

• Deposit Insurance: This is the most important protection for the average person. In the United States, the Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000 per depositor, per bank. In the European Union, Deposit Guarantee Schemes (DGS) offer protection up to €100,000. This insurance removes the primary incentive to run, as your money is safe up to the limit even if the bank fails.
• Lender of Last Resort: A central bank, like the US Federal Reserve or the European Central Bank, can act as a “lender of last resort.” It can provide emergency loans to banks that are solvent but facing a short-term liquidity crunch, stopping a run before it can spiral out of control.