Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Experiencing bank runs: Why any bank can fail


As the preceding sections show, banks keep only a fraction of deposits in reserve. This observation has a startling implication: any bank can fail if depositors lose confidence in its ability to pay them back. To see how, in this section we consider a well-run, very conservative bank called Cautious Bank.


The rumours begin

Cautious Bank has a large reserve ratio and is careful about to whom it lends money. You’d have thought that such a bank would be the last candidate to fail.

But suppose that some mischievous fellow starts a (false) rumour that Cautious Bank is unable to honour its obligations. As a depositor you may be unsure whether the rumour is true, but to be on the safe side you decide to withdraw your funds. After all, you can easily transfer money to another one of your accounts and who knows, doing so may save you from losing your shirt.

Other depositors reason similarly to you and also decide to pull their funds. Now the executives at Cautious Bank are getting nervous, because they see the bank’s reserves depleting quickly. Depositors who initially didn’t believe the rumour see on the evening news that large queues of anxious customers are waiting outside bank branches. They decide that they too need to withdraw their funds. As you can see, things can quickly spiral out of control until Cautious Bank doesn’t have sufficient reserves to meet all the withdrawal requests.


The bank fails

At this stage without outside (usually government) support the game is up – Cautious Bank will fail. Notice that all the fundamentals at the bank were sound: it was well managed and didn’t engage in risky lending. Nevertheless, the mere rumour that it was in trouble led to a bank run, which meant that it was unable to meet its obligations.

Think of it as a kind of self-fulfilling prophecy: if people believe a bank is going to fail, in all likelihood it will fail. This shows just how important people’s beliefs and expectations are in determining macroeconomic events.