Bank Runs

“XYZ bank is going to become insolvent, get your money out.” Said Dev in a concerned tone to me. This was a few months back if you remember. In short that is a bank run for you. As it progresses it generates its own momentum and becomes a self -fulfilling prophecy. This can destabilize the bank to an extent that it might as well be staring at bankruptcy.

But then you may be tempted to ask after all where did the money go? What’s the problem in returning it to the depositors? You are right, but first we need to understand the function of a bank.
Banks are intermediaries between savers who prefer to deposit and borrowers who prefer to take out loans. Thus they provide a valuable service by channeling funds from many individual deposits into loans for borrowers. The problem occurs in the timelines that we set for our deposits and the timelines set by borrowers for their loans.Generally business investment often requires expenditures in the present to obtain returns in the future (for example, spending on machines and buildings now for production in future years). Therefore, when businesses need to borrow to finance their investments, they prefer loans with a long maturity (that is, low liquidity). On the other hand, individual savers (both households and firms) may have sudden, needs for cash, due to unforeseen expenditures. So they demand liquid accounts which permit them immediate access to their deposits (that is, they value short maturity deposit accounts). Under normal circumstances all goes fine since savers unpredictable needs for cash are unlikely to occur at the same time.Thus a bank can make loans over a long horizon, while keeping only relatively small amounts of cash on hand to pay any depositors that wish to make withdrawals.

Now, if all depositors attempt to withdraw their funds simultaneously, a bank will run out of money long before it is able to pay all the depositors. This means that even healthy banks are potentially vulnerable to panics.So what is the solution?

Insurance is a nice concept that comes into picture over here.Say the government was to insure your deposit, that is if the government was to promise that no matter what happened you will get your money back. Thus you now have no incentive to participate in the bank run. Now that all or atleast most depositors would think on the same lines thus almost wiping out the probablity of bank runs. What an elegant solution!! Are we missing something?

Well yes, though we have solved the original problem we have introduced a new one. Banks which took the risk now come to believe that they will not have to carry the full burden of losses. The government is there to take care in case things turn sour.Now will this make the bankers aggressive lenders? Will they lend to any Tom Dick and Harry (read sub prime borrowers ) who do not have enough resources to pay back the debt.I bet they will. We were trying to make our deposits safe but it turns out we have just made it all the more unsafe without realizing it. Any ideas to get out of this ? Keep posting.

Cheers !!