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Run on the Bank: Definition & Overview

Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and a PhD in Higher Education Administration.

When too many customers distrust their bank and start demanding their money, problems arise. In this lesson, you'll learn what is meant by the phrase 'run on the bank' and why it quickly becomes a financial disaster.

Retail Banks and What They Do

Retail banks are banks that conduct business with individuals and small businesses. When you go to your local credit union or a big name bank down the street to open a checking account, you are working with a retail bank. Retail banks are a critical part of the U.S. economy; not only as a place to deposit your money safely, but as a source of money to lend.

When you deposit your money at the bank, the bank doesn't keep all of your money in a safe. Your account is credited with your deposit, and then your deposit gets swept with the rest of the deposits that day. Some of those funds are kept with the bank and others are lent to other banks or used to payback interbank loans. In fact, only 10% of the money you deposit is kept on hand at the bank. That 10% is called the reserve requirement and is set by the Federal Reserve, the same agency that determines interest rates.

The Setup for a Run on the Bank

Having only 10% of deposits on hand at any given time can be a recipe for disaster. Banks absolutely rely on the trust of their customers. If customers doubt their bank's ability to safely protect their money, even a little, they'll go and ask for all their money back.

Adding to that risk is the tendency for people to panic. Money is an important thing to most people, and the fear of losing their money because their bank ceases to exist will make it easy for people to panic.

Bank Failures

Run on the Bank

Panic over losing money coupled with the low reserve requirement banks are required to have on hand set the stage for a run on the bank. A run on the bank is when many customers demand their funds at the same time, putting the bank at risk of having to hand out all of their cash on hand and simply running out of money.

Since nobody wants to be the first person to be told 'Sorry, we don't have your money,' runs on the bank tend to be very serious and can even be started by just a rumor. Runs on the bank aren't about the news customers are worried about; they are all about how worried the customers get, and how many head straight to the bank to get their money.

Example of a Run on the Bank

In 2005 and 2006 no retail banks in the United States were closed by the FDIC. In 2007, the year the Financial Crisis began, three were closed. In 2008 that number increased to 25. At the time, 25 closures was pretty significant, but ended up being insignificant next to the 140 closed in 2009 and the 157 closed in 2010.

Figure 1 above shows the history of bank runs through most of the 20th century and the first decade of the 21st. If ever there was time for people to panic about the safety of their money, it was during the financial crisis of 2007-2008.

Wachovia for Sale

This panic hit a fever-pitch in September of 2008. Washington Mutual, the sixth-largest bank in the United States, had a ten-day period when customers withdrew nearly $17 billion in deposits. This proved too much, and on September 25, 2008 regulators shut down Washington Mutual. September 25 was a Thursday, which doesn't sound like it is a big deal, but regulators generally shut down banks on Friday. That gives the bank, the regulators, and customers two days to calm down and figure out the transition.

As a side note, but an applicable and important one, we should emphasize that when a bank is closed the people that had deposits at that bank aren't out of luck. Even if the bank has a negative net worth (meaning it doesn't have enough assets to cover everyone's deposits), the Federal Deposit Insurance Corporation (FDIC) will pay customers up to $100,000 of their lost deposits (that amount was increased to $250,000 during the financial crisis to help consumers maintain trust in the banking system).

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