Background
The financial markets have been rocked by the collapse of five banks across the United States and Europe during the last few weeks. Although not all banks have failed, their near-simultaneous troubles have led to regulators across the globe hurrying to take measures to prevent further crises, due to fears of a repeat of the 2008 financial crisis. Three of the banks were operating in niche sectors like tech and crypto companies, whose sectorial slowdowns have had a direct impact on these banks. The timeline began with Silvergate Bank, a crypto-industry-friendly bank, providing banking services to blockchain and cryptocurrency research and trading firms, winding down on March 8. Then, within two days, on March 10, the Silicon Valley Bank, a California-based financial institution linked to the start-up and venture capital space, is taken over by Californian financial regulators after it faces a run on its funds, racing to withdraw nearly USD 42 billion. And within another two days, New York-based Signature Bank, another crypto-friendly bank, is also taken over by state regulators, becoming the third casualty within a week. In the following weeks, Europe’s Hapoalim on March 16, and Credit Suisse on March 20, also became victims of bank runs, with the latter being acquired by its larger peer, UBS. In times of recession, when interest rates are at their all-time high to control inflation, banks are having a tough period leading them into the financial trap of bank run. Let us understand bank runs in a little more detail in this article. But firstly, for beginners, let us understand how banks operate and make money.
How do banks make money?
Banks make money by taking deposits from customers and paying them interest rates, usually lower than what they earn by lending or investing the deposited funds. Banks can lend out the money or invest it in bonds that yield a return higher than the interest paid to depositors. The difference between the interest paid to depositors and the interest earned from loans and investments is the bank’s profit. Banks keep some money in liquid investments to make payments to depositors as and when they ask for their money. However, this is usually only a small percentage of the total deposits because all the depositors are not coming to ask for their money at the same time. Apart from the net interest earned, the bank also earns from other ancillary sources such as fees for its services and commissions from selling insurance policies and other financial products. Certain banks also involve themselves in trading activities dealing in securities, currencies, and other financial instruments. Banks also earn money by lending to other banks or financial institutions. They charge interest on these loans, and the rates can vary depending on the perceived creditworthiness of the borrower.
What is a bank run?
A bank run occurs when a large number of customers withdraw their deposits from a bank, often out of fear that the bank may become insolvent and unable to repay its depositors. This can lead to a self-fulfilling prophecy, as the withdrawals may cause the bank to run out of cash and trigger further panic among depositors. Bank runs can be sparked by a variety of factors, such as rumours about the bank’s financial health, news of a major economic or political crisis, or a sudden drop in the value of the bank’s assets. In some cases, bank runs may be exacerbated by a lack of confidence in the banking system as a whole, leading to a contagion effect where depositors rush to withdraw their money from other banks as well. Bank runs can damage the stability of the financial system, as they cause banks to become insolvent. Moreover, if too many banks experience runs at the same time, it can lead to a systemic banking crisis and even a broader economic depression.
What causes bank runs?
Usually, bank runs are triggered by negative rumours or speculation about a bank’s financial health. These rumours can quickly spread and cause depositors to panic and withdraw their funds. Social media and news outlets can amplify these rumours and exacerbate the situation. However, sometimes, the banks are actually in financial distress, and therefore, depositors become concerned about the safety of their funds and withdraw their money in large numbers. This can create a self-fulfilling prophecy, as the bank’s financial situation worsens as a result of the withdrawals. Economic uncertainty or recession can also trigger bank runs as depositors may become worried about the safety of their funds and seek to withdraw their money from banks. This can lead to a widespread bank run that can exacerbate the economic downturn. Apart from financial reasons, unstable political environments such as the takeover of Afghanistan by the Taliban, widespread protests against the Prime Minister in Sri Lanka, or the military genocide in Myanmar, can also trigger fear in the minds of depositors that their funds could be seized, frozen or taken away. This can cause them to withdraw their funds from banks and seek to move their money to other countries or assets.
What happens during a bank run?
During a bank run, a large number of depositors try to withdraw their funds from a bank within a short time. This leads to liquidity problems as a large number of depositors withdraw their funds from a bank, and the bank may not have enough cash on hand to meet the demand for withdrawals. This liquidity crisis can quickly spiral out of control if the bank is unable to obtain additional funds. Banks with strong balance sheets and reputations in the industry usually receive the liquidity shortfall from other banks or investors, and avert the short-term situation. However, if the bank is unable to meet the demand for withdrawals, it has to forcefully sell its loan book at a loss, or sell its investments in bonds at any market price to get the remainder of the money to pay the depositors. If the bank has made profits from its previous activities, such losses can be squared off. However, if the bank hasn’t made profits from its regular operations, the depositors will not get their money back. To mitigate such risks, banks usually buy insurance, on their loan books and investments. However, these insurances come at a cost, and the bank has to pay a percentage of the loan book and investments they want to insure.
Sometimes, the bank is unable to procure funds from other banks and investors as in the case of Credit Suisse. In some cases, the bank is unable to meet its requirement even by selling all its investments, as in the case of the Silicon Valley Bank which had occurred a huge loss on its investment. In such cases, has no choice but to find a buyer for the bank who will take over the business. This usually happens in the case of good banks that have a customer base, reach and established operations, however, run into losses due to various reasons including NPAs. Credit Suisse was successful at finding a buyer in UBS who overtook the bank for three billion Swiss Francs. New investors infuse the required liquidity and continue the operations, in hope of turning around the business into a profitable venture over future years. However, when the bank also doesn’t receive any bids from other investors, it has no choice but to declare bankruptcy. If one bank experiences a run, it can spread to other banks as depositors become concerned about the safety of their funds. This can create a broader crisis that can destabilize the entire financial system. The bank run can even have broader economic consequences, such as a contraction in the money supply, a reduction in lending, and a decline in economic activity which can exacerbate an economic downturn or recession. Therefore, to prevent bank runs, governments and central banks often implement policies such as deposit insurance and lender-of-last-resort facilities to ensure that banks have sufficient liquidity to meet the demand for withdrawals.
How do bank runs cause inflation?
Inflation usually occurs when there is more money in the hands of the businesses and the public, leading to an increase in demand and spending which in turn, increases the prices of goods and services if the supply doesn’t match the demand. When a commercial bank faces a bank run, the bank usually needs access to liquidity to meet the demand for withdrawals from depositors. In such cases, the central bank usually steps in to provide the commercial bank with liquidity support to weather the crisis and prevent the bank run from spreading to other banks. However, this liquidity support can potentially increase inflation as it involves an increase in the money supply without any corresponding increase in the supply of goods and services in the economy. When the central bank provides liquidity support to a commercial bank, it effectively creates new money that enters the economy. As the commercial bank uses liquidity support to meet the demand for withdrawals, it may resume normal lending activities to borrowers, who may then use the funds to spend or invest in the economy. This increase in spending can drive up the demand for goods and services, leading to inflation. If the increase in the money supply is not matched by an increase in the supply of goods and services, then the economy may experience inflation. This is because there is more money chasing the same amount of goods and services, which can lead to price increases. Sometimes, the central bank also lower interest rates during bank runs to make it easier for the commercial bank to borrow the liquidity it needs. However, this can also stimulate borrowing and investment which also drive up the demand for goods and services in the economy. Therefore, while central bank liquidity support may be necessary to prevent a bank’s run and maintain financial stability, policymakers also need to be mindful of the potential inflationary effects of their actions. They may need to take steps to manage the money supply and ensure that it does not grow too quickly, which could destabilize the economy and harm consumers.
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