Five Thoughts On Bank Runs: Observations and Issues

Bank runs are a critical issue that can cause significant disruptions in the economy. Recent events involving banks like Silvergate, Silicon Valley Bank, First Republic, and Signature have highlighted the complexities and repercussions of bank runs. Here are five key observations to understand the causes, implications, and responses to these events.

Managing Risk

Why Banks Have Exposure

Banks often find themselves exposed to financial risk due to mismanagement, bad loans, and mismatched durations of their assets and liabilities. In a rising interest rate environment, this exposure becomes even more pronounced. For example, if a bank offers short-term CDs at higher interest rates but holds long-term treasuries with lower yields, it creates a mismatch. As interest rates rise, the value of these long-term securities decreases, while the bank’s obligations to pay higher interest rates on deposits remain. This mismatch leads to a decrease in the value of the bank’s collateral, increasing its financial vulnerability.

Why Customers Withdraw Funds

Bank runs are primarily driven by a loss of customer confidence. When customers believe that a bank is exposed to risky assets or see others withdrawing their funds, they may rush to do the same. This herd mentality can quickly escalate, leading to a full-blown bank run. The fear of losing their deposits drives customers to withdraw their money en masse, exacerbating the bank’s liquidity problems and potentially leading to its collapse. Trust is a fundamental aspect of banking, and once it is eroded, the stability of the institution is at serious risk.

Risk and Reward of Lending

Lending practices play a crucial role in a bank’s financial health. Loans typically offer limited upside—interest payments—while carrying the potential for significant downside if borrowers default. This asymmetric risk profile requires banks to be prudent in their lending decisions. For instance, Silicon Valley Bank was known for its entrepreneurial approach, lending to ventures that might not secure loans elsewhere. While this risk tolerance can support innovation, it becomes problematic if the potential rewards do not justify the risks. If a substantial portion of a bank’s loan portfolio consists of high-risk, low-reward loans, it can jeopardize the bank’s financial stability.

Macro Considerations

Government Intervention

When a bank run occurs, government intervention is often necessary to prevent a cascade of failures throughout the financial system. Historical precedents, such as the interventions during the 2008 financial crisis with Lehman Brothers and Bear Stearns, highlight the importance of timely government action. By guaranteeing deposits and shoring up confidence in the banking system, the government can prevent widespread panic and maintain economic stability. However, these interventions often spark debates about bailouts and moral hazard, questioning whether such measures encourage risky behavior by banks.

FDIC and Bailouts

The role of the Federal Deposit Insurance Corporation (FDIC) in protecting deposits is crucial in maintaining customer confidence. Currently, the FDIC insures deposits up to $250,000. However, there is ongoing debate about whether this limit should be increased, especially during crises when larger institutions face failure. Expanding FDIC protection could enhance depositor security but also raises concerns about moral hazard. If banks know that all deposits are fully protected, they might be more inclined to take excessive risks. Balancing depositor protection with the need to encourage prudent banking practices is a complex regulatory challenge.

Conclusion

Understanding the dynamics of bank runs involves examining the interplay between financial mismanagement, customer behavior, lending practices, government intervention, and regulatory frameworks. Banks can become vulnerable due to mismatched asset-liability durations and high-risk lending. Customer trust is fragile, and once lost, it can trigger a bank run. Government intervention is often necessary to stabilize the situation, but it brings up issues of moral hazard and regulatory consistency.

Bank runs are a reminder of the delicate balance within the financial system. By addressing the underlying causes and implementing robust regulatory measures, the risk of such events can be mitigated. However, it is essential to remain vigilant and adaptable to ensure the stability and resilience of the banking sector.