Financial Crises: Explanations, Types, and Implications; by Stijn Claessens and M. Ayhan Kose; imf working Paper 13/28; January 1, 2013

Bank Runs and Banking Crises 

 

Financial institutions are inherently fragile entities, giving rise to many possible coordination 

problems. Because of their roles in maturity transformation and liquidity creation, financial 

institutions operate with highly leveraged balance sheets. Hence, banking, and other similar 

forms of financial intermediation, can be precarious undertakings. Fragility makes 

coordination, or lack thereof, a major challenge in financial markets. Coordination problems 

arise when investors and/or institutions take actions – like withdrawing liquidity or capital – 

merely out of fear that others also take similar actions. Given this fragility, a crisis can easily 

take place, where large amounts of liquidity or capital are withdrawn because of a self-

fulfilling belief – it happens because investors fear it will happen. Small shocks, whether real 

or financial, can translate into turmoil in markets and even a financial crisis.  

 

A simple example of a coordination problem is a bank run. It is a truism that banks borrow 

short and lend long. This maturity transformation reflects preferences of consumers and 

borrowers. However, it makes banks vulnerable to sudden demands for liquidity, i.e., “runs” 

(the seminal reference here is Diamond and Dybvig, 1983). A run occurs when a large 

number of customers withdraw their deposits because they believe the bank is, or might 

become, insolvent. As a bank run proceeds, it generates its own momentum, leading to a self-

fulfilling prophecy (or perverse feedback loop): 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 as it cannot liquidate assets fast enough to 

cover its short-term liabilities.  

 

These fragilities have long been recognized, and markets, institutions, and policy makers 

have developed many “coping” mechanisms (see further Dewatripoint and Tirole, 1994). 

Market discipline encourages institutions to limit vulnerabilities. At the firm level, 

intermediaries have adopted risk management strategies to reduce their fragility. 

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Furthermore, micro-prudential regulation, with supervision to enforce rules, is designed to 

reduce risky behavior of individual financial institutions and can help engineer stability. 

Deposit insurance can eliminate concerns of small depositors and can help reduce 

coordination problems. Lender of last resort facilities (i.e., central banks) can provide short-

run liquidity to banks during periods of elevated financial stress. Policy interventions by 

public sector, such as public guarantees, capital support and purchases of non-performing 

assets, can mitigate systemic risk when financial turmoil hits.  

 

Although regulation and safety net measures can help, when poorly designed or implemented 

they can increase the likelihood of a banking crisis. Regulations aim to reduce fragilities (for 

example, limits on balance sheet mismatches stemming from interest rate, exchange rate, 

maturity mismatches, or certain activities of financial institutions). Regulation (and 

supervision), however, often finds itself playing catch up with innovation. And it can be 

poorly designed or implemented. Support from the public sector can also have distortionary 

effects (see further Barth, Caprio and Levine, 2006). Moral hazard due to a state guarantee 

(e.g., explicit or implicit deposit insurance) may, for example, lead banks to assume too 

much leverage. Institutions that know they are too big to fail or unwind, can take excessive 

risks, thereby creating systemic vulnerabilities.

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 More generally, fragilities in the banking 

system can arise because of policies at both micro and macro levels (Laeven, 2011).