Financial & Economic Crisis

Banking Crisis


A banking crisis, also called bank run, occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent. As a bank crisis progresses, it generates its own momentum, in a kind of self-fulfilling prophecy: as more people withdraw their deposits, the likelihood of default increases, and this encourages further withdrawals. This can destabilize the bank to the point where it faces bankruptcy.

A banking panic or bank panic is a financial crisis that occurs when many banks suffer runs at the same time. A systemic banking crisis is one where all or almost all of the banking capital in a country is wiped out. The resulting chain of bankruptcies can cause a long-term economic recession. Much of the Great Depression's economic damage was caused directly by banking crisis. The cost of cleaning up a systemic bank crisis can be huge, with fiscal costs averaging 13% of GDP and economic output losses averaging 20% of GDP for important crises from 1970 to 2007.

Several techniques can help to prevent bank crashes and failures. They include temporary suspension of withdrawals, the organization of central banks that act as a lender of last resort, the protection of deposit insurance systems such as the U.S. Federal Deposit Insurance Corporation, and governmental bank regulation. These techniques do not always work: for example, even with deposit insurance, depositors may still be motivated by beliefs they may lack immediate access to deposits during reorganization of a bank.

How it works

Banks retain only a fraction of their deposits as cash. The remainder is invested in securities and loans. No bank has enough reserves on hand to cope with more than a fraction of deposits being taken out at once.

Diamond and Dybvig developed an influential model to explain why bank runs occur and why banks issue deposits that are more liquid than their assets. They view the bank as an intermediary between borrowers who prefer long-maturity loans and depositors who prefer liquid accounts.

In their model, business investment requires expenditures in the present to obtain returns that take time in coming, for example, spending on machines and buildings now for production in future years. A business or entrepreneur that needs to borrow to finance investment will want to give their investments a long time to generate returns before full repayment, and will prefer long maturity loans, which offer little liquidity to the lender. The households and firms who have the money to lend to these businesses may have sudden, unpredictable needs for cash, so they require fast access to their money in the form of liquid demand deposit accounts, that is, accounts with shortest possible maturity. Since borrowers need money and depositors fear to make these loans individually, banks provide a valuable service by aggregating funds from many individual deposits, portioning them into loans for borrowers, and spreading the risks both of default and sudden demands for cash.

If only a few depositors withdraw at any given time, this arrangement works well. Depositors' unpredictable needs for cash are unlikely to occur at the same time; that is, by the law of large numbers banks can expect only a small percentage of accounts withdrawn on any one day because individual expenditure needs are largely uncorrelated. A bank can make loans over a long horizon, while keeping only relatively small amounts of cash on hand to pay any depositors who may demand withdrawals.
However, if many depositors withdraw all at once, the bank itself as opposed to individual investors may run short of liquidity, and depositors will rush to withdraw their money, forcing the bank to liquidate many of its assets at a loss, and eventually to fail. If such a bank calls in its loans early, this may force businesses to disrupt their production, or individuals to sell their homes, causing further losses to the larger economy.

A bank crisis can occur even when started by a false story. Even depositors who know the story is false will have an incentive to withdraw, if they suspect other depositors will believe the story. The story becomes a self-fulfilling prophecy. Indeed, Robert K. Merton, who coined the term self-fulfilling prophecy, mentioned bank runs as a prime example of the concept in his book Social Theory and Social Structure.

The Diamond-Dybvig model provides an example of an economic game with several Nash equilibriums where it is logical for individual depositors to engage in a bank run once they suspect one might start, even though that run will cause the bank to collapse.

A bank failure affects just one bank. A banking panic or bank panic is a financial crisis that occurs when many banks suffer runs at the same time. In a systemic banking crisis, all or almost all of the banking capital in a country is wiped out.

Systemic banking crises are associated with substantial fiscal costs and large output losses. Frequently, emergency liquidity support and blanket guarantees have been used to contain these crises, not always successfully. Although fiscal tightening may help contain market pressures if a crisis is triggered by unsustainable fiscal policies, expansionary fiscal policies are typically used. In crises of liquidity and solvency, central banks can provide liquidity to support illiquid banks. Depositor protection can help restore confidence, although it tends to be costly and does not necessarily speed up economic recovery. Intervention is often delayed in the hope that recovery will occur, and this delay increases the stress on the economy.

Some measures are more effective than others in containing economic fallout and restoring the banking system after a systemic crisis. These include establishing the scale of the problem, targeted debt relief programs to distressed borrowers, corporate restructuring programs, recognizing bank losses, and adequately capitalizing banks. Speedy intervention appears to substantially decrease stress on the economy. Programs that are targeted, that specify clear quantifiable rules that limit access to preferred assistance, and that contain meaningful standards for capital regulation, appear to be more successful. Government-owned asset management companies are largely ineffective due to political constraints.

A silent run occurs when the implicit fiscal deficit from a government's unbooked loss exposure to zombie banks is large enough to deter depositors of those banks. As more depositors and investors begin to doubt whether a government can support a country's banking system, the silent run on the system can gather steam, causing the zombie banks' funding costs to increase. If a zombie bank sells some assets at market value, its remaining assets contain a larger fraction of unbooked losses; if it rolls over its liabilities at increased interest rates, it squeezes its profits along with the profits of healthier competitors. The longer the silent run goes on, the more benefits are transferred from healthy banks and taxpayers to the zombie banks.

The cost of cleaning up after a crisis can be huge. In systemically important banking crises in the world from 1970 to 2007, the average net recapitalization cost to the government was 6% of GDP, fiscal costs associated with crisis management averaged 13% of GDP or 16% of GDP if expense recoveries are ignored, and economic output losses averaged about 20% of GDP during the first four years of the crisis.

What can be done to prevent banking crises

Individual banks

Some prevention techniques can be used for individual banks, independently of the rest of the economy.

A bank can take deposits from depositors who do not observe common information that might spark a run. For example, in the days before deposit insurance, it made sense for a bank to have a large lobby and fast service, to prevent a line of depositors from extending out into the street, causing passers-by to infer that a bank run is occurring.

A bank can temporarily suspend withdrawals to stop a run. In many cases the threat of suspension prevents the run, which means the threat need not be carried out.

Bank regulation or other constraints can impose a reserve ratio requirement, which limits the proportion of deposits which a bank can lend out, making it less likely for a bank run to start. This practice sets a limit on the fraction in fractional-reserve banking; in the extreme and hypothetical case, full-reserve banking requires a reserve ratio of 100%.

Collective prevention

Some prevention techniques apply across the whole economy, although they may still allow individual institutions to fail. These techniques create moral hazard, since they reduce incentives for banks to avoid making risky loans; the goal is for the benefits of collective prevention to outweigh the costs of excessive risk-taking.

Central banks act as a lender of last resort. To prevent a bank run, the central bank guarantees that it will make short-term loans to banks, to ensure that, if they remain economically viable, they will always have enough liquidity to honour their deposits.

Deposit insurance systems insure each depositor up to a certain amount, so that depositors' savings can be protected even if the bank fails. This removes the incentive to withdraw one's deposits simply because others are withdrawing theirs. However, depositors may still be motivated by fears they may lack immediate access to deposits during a bank reorganization.

History of bank failures

Bank failures first appeared as part of cycles of credit expansion and its subsequent contraction. In the 16th century onwards, English goldsmiths issuing promissory notes suffered severe failures due to bad harvests plummeting parts of the country into famine and unrest. Other examples are the Dutch Tulip manias (1634-1637), the British South Sea Bubble (1717-1719), the French Mississippi Company (1717-1720), the "Post Napoleonic Depression" (1815-1830) and the Great Depression (1929-1939).

Bank failures have also been used to blackmail individuals or governments; for example in 1830 when the British Government under the Duke of Wellington overturned a majority government under the orders of the king, George IV, to prevent reform, he angered reformers and so a run on the banks was threatened under the rallying cry "To stop the Duke go for gold!".

Many of the recessions in the United States were caused by banking panics. The Great Depression contained several banking crises consisting of runs on multiple banks between 1929 and 1933; some of these were specific to regions of the U.S. Much of the Depression's economic damage was caused directly by bank runs, and institutions put into place after the Depression have prevented runs on U.S. commercial banks since the 1930s, even under conditions such as the U.S. savings and loan crisis of the 1980s and 1990s. The Depression's bank runs left a lasting mark on the American psyche, exhibited in sometimes disturbing images such as the bleak scenes where the fictional hero George Bailey contemplates suicide in the movie ‘It's a Wonderful Life’.

Recent examples of bank failures

In 1999, a bank crash happened in Malaysia where Bank Negara Malaysia (the Malaysian central bank) had to take control of MBf Finance Berhad, the biggest finance company in Malaysia during that time. Many of the finance company's 120 branches saw runs on their deposits, totalling around 17 billion Ringgit (US$4.49 billion).

During the Argentine economic crisis during 1999-2002, a bank crisis and corralito was experienced in Argentina. This contributed towards the bank crashes in neighbouring Uruguay during the 2002 Uruguay banking crisis.

In early August 2007, the American firm, Countrywid Financial suffered a bank run as a consequence of the sub-prime mortgage crisis.

On 13 September 2007, the British bank Northern Rock arranged an emergency loan facility from the Bank of England, which it claimed was the result of short-term liquidity problems. The bank's defenders claimed its cash shortage was the result of over-exposure to the failing US sub-prime mortgage market, while its critics argued that it was the result of Northern Rock's own careless lending practices. A failure began the following day, Friday, with reports of its internet banking site being overloaded, and long queues outside branches that day, Saturday morning and the following Monday. News reports on 17 September stated that an estimated £2 billion GBP of retail deposits had been withdrawn by customers since the bank had applied for emergency funds.

On Tuesday, 11 March 2008, a bank run began on the securities and banking firm Bear Stearns. While Bear Stearns was not an ordinary deposit-taking bank, it had financed huge long-term investments by selling short-maturity bonds (Asset Backed Commercial Paper), making it vulnerable to panic on the part of its bondholders. Credit officers of rival firms began to say that Bear Stearns would not be able to make good on its obligations. Within two days, Bear Stearns's capital base of $17 billion had dwindled to $2 billion in cash, and Bear Stearns told government officials that it saw little option other than to file for bankruptcy the next day. On Friday, the Federal Reserve decided to lend Bear Stearns money, the first time since the Great Depression that it had lent to a non-banking institution. Stocks sank, and that day JPMorgan Chase began an effort to buy Bear Stearns as part of a government-sponsored bailout. The deal was arranged by Sunday in an effort to calm markets before overseas markets opened.

On 11 July 2008, U.S. mortgage lender IndyMac Bank was seized by federal regulators. IndyMac had been a stressed institution for months. The bank was capital-constrained and possibly heading for regulatory intervention. However, both regulators and the bank itself blamed its troubles on a letter from Sen. Charles E. Schumer questioning its viability. Following the public release of the letter on June 26, IndyMac customers withdrew amounts averaging $100 million a day from the bank, or a total of $1.3 billion in cash. The run caused a liquidity crisis which forced IndyMac to announce it was halting new loan submissions, closing its retail and wholesale lending divisions, and laying off 3,800 employees.

On 25 September 2008, due to a massive run the Office of Thrift Supervision was forced to shut down Washington Mutual, the largest savings and loan institution in the United States and the sixth-largest in the world. Over the previous 10 days, customers had withdrawn $16.7 billion in deposits. This is currently the biggest bank failure in American financial history. Normally, banks are seized on Fridays to allow the FDIC the weekend to prepare the failed bank for takeover by another bank. However, WaMu's size led regulators to shut it down on a Thursday.

On 6 October 2008, Landsbanki, Iceland's second largest bank, was put into government receivership. The Icelandic government used emergency powers to dismiss the board of directors of Landsbanki and took control of the failed institution. Prime Minister Geir Haarde also rushed measures through parliament to give the country's largest bank, Kaupthing, a £400m loan. In addition, Iceland pleaded with Russia to extend 3bn in credit as western countries refused to help. With over 5 billion in savings held by Britons in Landsbanki, the Icelandic collapse threatens private citizens in the United Kingdom as well as companies in Iceland.


This article uses material from the Wikipedia article "Bank Run"



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