What Is a Bank Run in Economics and How Does It Work?

A bank run occurs when a large number of depositors simultaneously attempt to withdraw their funds due to a loss of confidence in a financial institution. This phenomenon remains relevant for understanding the stability of modern banking systems. Understanding bank runs illustrates how trust and perception are fundamental to banks and the broader economy. This topic also provides insight into the protective measures safeguarding financial stability today.

Defining a Bank Run

A bank run occurs when many depositors, driven by fear, attempt to withdraw their money simultaneously. This challenges banks because they operate on fractional reserve banking. Under this system, banks hold only a fraction of deposits as reserves and lend out the majority.

While this practice facilitates economic growth by providing credit, it also creates a vulnerability. If all depositors demanded their money back simultaneously, a bank would lack sufficient liquid assets. These large-scale, simultaneous withdrawals are fueled by a collective fear that the bank might fail and depositors could lose their savings. The stability of a banking system relies heavily on public confidence that their money is secure and accessible.

How Bank Runs Unfold

Bank runs often begin with a trigger, such as a rumor, a negative news report about a bank’s financial health, or broader economic concerns like a recession. These concerns quickly erode public trust, leading some depositors to withdraw funds as a precautionary measure. The rapid spread of information, especially in the digital age, can amplify these fears, creating urgency among other depositors.

As more people withdraw money, the bank’s cash reserves diminish, forcing it to sell assets, often at a discount, to generate liquidity. This fire sale can confirm depositors’ fears about the bank’s instability, accelerating withdrawals. What starts as a liquidity problem—a temporary cash shortage—can quickly become a solvency crisis, where the bank’s assets are insufficient to cover liabilities. Herd behavior and panic play a significant role, as individuals may follow suit even if the bank is fundamentally sound.

Preventing Bank Runs

Modern financial systems employ several mechanisms to prevent or mitigate bank runs, primarily by shoring up public confidence. One safeguard is deposit insurance, which guarantees depositors’ funds are protected up to a certain limit even if a bank fails. In the United States, the Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000 per depositor, per FDIC-insured bank, for each account ownership category. This government-backed insurance eliminates the incentive for panic withdrawals for most depositors, knowing their money is safe. Since the FDIC’s inception in 1933, no depositor has lost any FDIC-insured funds.

Central banks, such as the Federal Reserve, also serve as a “lender of last resort.” The Federal Reserve provides short-term loans to depository institutions, including commercial banks, through its discount window. These loans, which require collateral, help banks manage temporary funding shortfalls or unexpected liquidity strains without selling assets quickly. By providing liquidity during stress, the central bank assures the public that banks can meet withdrawal demands, stabilizing the financial system.

Banking regulations and supervision further reinforce stability and public trust. Regulatory bodies, including the Federal Reserve System, the Office of the Comptroller of the Currency (OCC), and the FDIC, oversee bank operations. They enforce capital requirements, mandating that banks hold equity as a buffer against potential losses. For example, under the Basel III framework, banks are required to maintain a common equity tier 1 capital ratio.

Regulators also conduct regular stress tests, particularly for larger banks, to assess their ability to withstand severe economic downturns. These tests and ongoing oversight ensure that banks operate safely, maintain adequate financial strength, and are transparent. By establishing a regulatory framework, these measures collectively restore and maintain public confidence, preventing bank runs.