Bank Run definition
A bank's inability to cover large unexpected withdrawals by depositors in a short period.
What is Bank Run?
First, this is how the banking business model works — it accepts deposits and allocates the funds in the economy in the form of loans to households and businesses. This means that the funds are not readily available except for the reserves held by banks due to regulatory capital requirements.
If a large number of bank depositors try to withdraw their money at the same time the bank may not have the needed amount available at hand, meaning it cannot pay out all depositors within a short period of time.
The “bank panic” may be widespread through the financial market, and remaining depositors will start withdrawing their money in an attempt to take back as much as they can from their deposits. Since the bank faces liquidity problems and these problems can be transferred in insolvency, it may not be able to cover all withdrawals. If the demand for deposits continues, the bank closes its operations and eventually goes out of business.
A bank run not necessarily occurs only with troubled banks. It can happen to banks with good financial health if savers suddenly start taking their money out due to speculative reasons. Therefore, even a stable bank can be a victim of a bank run.
Bank Run meaning
An increase in withdrawals by savers causes liquidity problems for the bank. The bank can make an attempt to cover the sudden withdrawal by selling off its assets and cash in on the loans. But if the withdrawal rate is too excessive, the bank will not be able to satisfy it.
There are numerous reasons which lead to a bank run. Some of them are:
Bank panic can cause even a healthy bank into a bank run. It happens when the speculation arises that a given bank is faced with liquidity problems and that depositors may lose their savings, forcing them to demand their money. Hence, it augments the liquidity problem even further for a bank faced with liquidity problems or initiates issues for a financially stable bank.
Liquidity problems are a real problem that could arise in the banking business. A bank may face it because of unexpected loss or because of the decrease in asset value. During the reconciliation of the financial position, the bank lacks the ability to pay off a larger number of savers. If there are unexpected withdrawals in a short time, the bank is in trouble.
Bad loans can cause a bank run because the bank loses part of its assets. If a large number of the loans default, the bank can't maintain its liquidity.
To limit the possibility of bank runs, there is a regulatory framework that imposes the need for holding adequate regulatory capital. Moreover, there are different deposit insurance schemes established in the market. If a bank run happens, they pay out the depositors up to the insured limit.
Bank run example
Let’s say a bank has 10 savers, and each of them deposited $5,000 in the bank. Now the bank has a total available capital of $50,000 collected from the saver.
If there is a 10 per cent reserve requirement, the bank can provide loans up to $45,000. The bank keeps $10,000 in cash for daily operations and provides $35,000 to its borrowers. After a while, two of the savers withdraw their deposit with a total value of $10,000 (each deposit is $5,000). In this situation, the bank has liquidity issues since it has no cash on hand.
The other depositors have heard somewhere about the liquidity problem the bank is facing. They all rush to the bank to withdraw their deposits with a total value of $35,000. The bank is not able to cover these withdrawals because the funds are tied up in the loans provided. Accordingly, a bank run happens.