Bank Runs Happen When Customers Fear Losses

A Rush for the Exits

Black and White Bank Line
Before federal deposit insurance, losses at banks were a greater risk. SuperStock/Getty Images

A bank run is an event where bank customers try to withdraw more money from the bank than the bank can provide. Banks do not keep all customer deposits available in cash for immediate withdrawal. Instead, those assets are invested in loans and other types of investments. Likewise, banks only keep small amounts of cash stocked in vaults and automatic teller machines (ATMs). As a result, an overwhelming demand for deposits can leave a bank unable to give customers their money.

When a bank cannot satisfy customer demands for withdrawals—or if there’s a rumor that the bank will be unable to do so—the situation worsens. Customers fear being the “last one to the exit,” and they attempt to withdraw as much as possible. In a worst-case scenario, a bank may be unable to meet obligations, leading to complete failure.

Why They Happen

Fear of loss: Bank runs are based on the fear of losing money. Customers think (sometimes accurately) that if a bank goes belly-up, they’ll lose all of their money in the bank. This fear is understandable—your hard-earned savings seem to be at risk—and everybody makes a desperate rush for the exits.

Downward spirals: Unfortunately, bank runs can create self-fulfilling prophecies. A bank might be on somewhat shaky ground, but still far from failure. However, when everybody pulls funds out at the same time, the bank suddenly becomes much weaker.

The bank might be forced to generate cash by selling investments at an inconvenient time, which often means taking losses on investments. For example, selling in the height of a financial crisis is generally a bad time for the bank to redeem assets for cash. If a bank wasn’t going to fail before, the likelihood of insolvency increases during and after a panic.

Fractional reserve banking: Unlike what dramatic movies show, banks keep very little money in physical bank branches. Customer deposits are not sitting in the vault waiting for people to come in and cash out. Instead, banks lend that money to borrowers and invest the funds in financial markets. Money is more or less electronic now, but banks might only have 10 percent of total customer assets available for transfers and electronic withdrawals.  Fractional reserve banking allows banks to keep only small reserves available because, in most situations, the majority of customers don’t need their money at the same time.

National bank runs: A bank run can happen with one particular financial institution, or it can happen on a national level. If investors or account holders believe that the banking system or financial system of a given country is about to collapse, they’ll attempt to move funds to foreign banks. Again, this can worsen existing problems and become a self-fulfilling prophecy.

Do Bank Runs Make Sense?

Bank runs are a result of a very scary prospect, and nobody wants to lose money. But consumer bank runs in the U.S. are typically unnecessary for the majority of the population.

Federal deposit insurance: Most depositors in the U.S. will not lose money if their bank fails.

In fact, they might not be inconvenienced in any meaningful way. The federal government helps to ensure that some deposits in banks and credit unions are protected in case the institution fails. Through Federal Deposit Insurance Corporation (FDIC) insurance, customers at participating banks may get full or partial protection. Federally insured credit unions enjoy similar coverage through the National Credit Union Share Insurance Fund (NCUSIF). Protection is limited to $250,000 per depositor per institution, but there are ways to cover more than that in a single bank or credit union.

Impact of bank failures: In many bank failures, covered customers can continue to write checks, deposit money, and make electronic transfers as if nothing happened. At some point, they may notice that the name and logo on their statements change, but their account balance is the same as it would have otherwise been regardless of the bank’s failure.

Uncovered deposits: Those who are not fully covered by the FDIC or NCUSIF are putting money at risk, and it may make sense for them to withdraw assets. However, sometimes that’s easier said than done, and it may be too late by the time the news breaks. Given the number of choices you have for spreading your money around, why take that risk? Likewise, a total collapse of the financial system might warrant a bank run, but you may find that local currency is more or less worthless if your country is in turmoil.

Historical basis: Bank runs gained notoriety around the time of the Great Depression, when consumers really did lose all of their money. Shortly after that, the FDIC was formed, and the risk consumers take is dramatically less than it used to be.