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What if Banks Run out of Cash?

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In times of crisis, people like a sense of certainty. After all, haven’t we all been burned before for trusting in the wrong institutions? And for a lot of people, nothing feels more certain than a big, comforting pile of cold, hard cash.

However, problems start to arise when a lot of people have this same idea at once. This raises the question: Can a bank literally run out of cash if everyone withdraws their money at the same time? And while this may seem like a silly question, the answer is actually a resounding “Yes.”It’s called a Bank Run – they’ve happened before, and it’s possible they might happen again.

First, let’s take a look at the basics. During periods of financial instability – take, for example, the Great Depression of the 1930s and the global financial crash of 2008 – a so-called “Bank Panic” begins. During those panics, customers of a commercial bank believe that the bank may close and lose their money as a result.

This then becomes a self-fulfilling prophecy, as depositors begin a mass-withdrawal of their savings, leading to a so-called “run on the bank.”

The vicious cycle continues – Banks lose financial liquidity, savers pull out their deposits, news of this reduces confidence in the bank’s stability, and more savers pull out their deposits as a result.

The end result is typically the bank entering a total nosedive. Eventually, the bank becomes totally insolvent and their cash reserves run dry.

They end up imposing restrictions on withdrawals, and at that point, the jig is essentially up.

You’re probably wondering: How on Earth does this happen? The two main priorities of a commercial bank are to handle deposits and withdrawals from customers, so shouldn’t there be safeguards for this kind of thing?

Well, the problem with Bank Runs is that they’re pretty much tailored to take advantage of vulnerabilities inherent in the system.

There are regulations on how much physical cash your local bank branch can keep on its premises, for both their expected daily usage of said cash and security reasons. In other words, if a bank’s vault is carrying way more cash than it needs on an average day, and that bank is robbed, that’s an extremely expensive robbery right there.

The Federal Reserve also imposes limits on the amount of in-house cash a bank can carry, and even this cash isn’t all entirely devoted to customer savings withdrawals. This is called fractional reserve banking – as each bank only keeps a fraction of its overall cash reserves for daily use.

Banks also need this cash to provide money for small in-house loans, as well as for investmentprojects.

When the bank’s customer base is pulling out money like crazy, they need to siphon extra cash from other areas in order to keep up with withdrawal demand. This is known as increasing their cash position.

In order to increase their cash position fast so they can keep up with demand, banks in the process of a bank run will often sell off their assets at significantly lower than asking price.

The selling off of assets goes public, which feeds into public panic, and more withdrawals.

Banks will be hemorrhaging money throughout this process just to stay above water. These financial catastrophes are a mix of economics and mob psychology, as increasing public instability manifests directly in the instability of the bank.

Seeing as bank runs typically happen in times of crisis, selling off long-term investment assets will fetch an even lower price than usual, plunging the financial institutions even further into the hole.

While one might think it would be easy to nip a bank run in the bud by quelling the fears of the consumer base and assuring them that a panicked withdrawal will only worsen the situation, talking sense into the public is often easier said than done.

The lead-up to a bank run can almost feel like a Mexican Standoff – just like nobody in a standoff situation wants to be the first to put down their gun, customers fear being the “last one to exit” and losing their hard-earned savings if the bank does eventually fail.

The cruel irony is that fear that a bank will fail is often one of the greatest contributors to its failure. Currently, during today’s times of economic instability, there have been whispers of restricted cash withdrawals on savings in some United States and European banks.

Bank runs are almost always at least a slight risk during times of panic – right now, we’re seeing a microcosm of the same psychology that drives bank runs in toilet paper buyouts.

You can apply the exact same cyclical formula: People fear toilet paper shortages and therefore buy more toilet paper.

People buying more toilet paper fans the flames of shortage fears, and the panic buying continues, leading to real shortages.

It’s an extremely basic pattern that feels almost engraved into human society.

Let’s take a look at a few more historical bank runs to see if the pattern holds true. The period of time that brought Bank Runs into the national conversation was the Great Depression of the 1930s. It all started with the stock market crash of Thursday, October 24th, 1929, which reached its grim peak on October 28th, also known as Black Tuesday.

The United States had just experienced the Roaring Twenties – one of the greatest periods of economic prosperity in history – but that was all about to come crashing down. The market and the general public had been massively overconfident due to the prior trend of market growth, overpricing the stock and artificially inflating the market as a result. This led to what economists called an “asset bubble.” And the thing about bubbles is, no matter how attractive they seem, or for how long, they always burst. And that’s exactly what happened.

Bank credit also rose rapidly, and they were handing out loans like candy. The public wasn’t afraid of debt because the market had been so stable, for so long. The general public was buying on margin, which means – in a very simplified sense they were making down payments on the stock with money borrowed from the bank.,Meanwhile, industrial and agricultural overproduction was hurting share prices and a sudden 1% interest hike from the Federal Reserve Bank of New York added to the pile of factors in this economic chemical reaction.

The resulting explosion effectively collapsed the entire US economy, kicking economic growth to the curb and sending the Gross Domestic Profit into freefall. This brings us full circle, back to Bank Runs.

The public was terrified by the sudden shock of the economy that’d been doing so well abruptly disintegrating around them. As a result, they wanted the comfort of having cold, hard cash in their hands and under their mattresses.

Americans flocked to banks and withdrew cash en masse, exacerbating what was already a complete, economic dumpster fire.

Financial newspapers at the time were releasing headlines like “Huge Selling Wave Creates Near-Panic as Stocks Collapse” and “Prices of Stocks Crash in Heavy Liquidation “, fuelling the panic further.

The American public lost faith in the banking system, pulling out their funds and forcing the banks to sell off their assets in order to keep up with demand. It was a textbook series of bank runs, leading to bank failures and an inability to invest in businesses that lead to widespread economic stagnation across the nation.

Bank runs are never the sole cause of an economic collapse, but they’re almost always a component of economic downturn. By necessity, they’re something that occurs after a period of economic instability has already begun, and then goes on to make the whole situation even worse. Which brings us to a much more recent example of economic catastrophe: The 2008 stock market crash.

Unless you’re a keen economics enthusiast, or you’ve seen or read The Big Short, you probably need a quick refresher on what exactly happened there.

Dubbed the worst financial crisis since the Great Depression, the stock market crash was caused by the huge and dangerously unstable subprime mortgage market – wherein millions of people with obscenely terrible credit were given mortgages that lenders often knew they couldn’t ever really pay back, creating a housing bubble.

You may have gathered by this point that there are major similarities in pretty much all the economic disasters of the 20th and 21st centuries, and you wouldn’t be wrong. Just like we said earlier, economics and human psychology are intrinsically tied together, and tend to run in endlessly repeating cycles.

Much like the Great Depression, the devastating economic collapse precipitated by the 2008 stock market crash set fire to the tinderbox of an already financially-paranoid public.

The collapse of the Lehman Brothers Bank suddenly reminded the world that the financial institutions around them weren’t infallible forces of nature.

Banks could go down, and if they went down, they could take all of your savings with it. As a result, the bank runs began, and people across the globe started once again making mass withdrawals.

Banks like the Northern Rock Bank in the UK were devastated by the sudden influx of terrified consumers who wanted their money where they could see it, soon being pushed into insolvency by people who just didn’t trust the system anymore. And honestly, who could blame them?

Bank runs are the financial expression of pure public panic, occurring only in times when customers simply don’t trust banks to keep their money safe. By now, we imagine you’re probably feeling a little paranoid yourself – is it possible that, in the next few weeks, the banks we’ve been entrusting all our savings to will just collapse under the weight of their customers worst fears? Well, thankfully, it’s really not that simple.

After the devastating effects of two different rounds of a bank run, central banks like the Federal Reserve have put in protections and regulations to keep banking institutions and their customers from falling victim to bank runs.

The Fed ensures that bank customers are given deposit insurance – the purpose of which is making sure that, even if a bank does indeed go under, customers are ensured that they’ll get their savings back.

This isn’t a new development, either – the Federal Deposit Insurance Corporation, or FDIC, was first formed in 1933 as a response to the ravages of the Great Depression. In fact, it was the existence of this deposit insurance scheme that prevented the bank runs during the 2008 financial crisis from being a heck of a lot worse.

In the event of a bank failure, the FDIC can help transition the customer savings accounts into a different bank. Or even, in worst-case scenarios, auction off the assets of the collapsed bank as collateral to pay off the customers for their lost savings.

The banks themselves also have some methods for counteracting the potentially devastating effects of a bank run.

One method is slowing down the process by artificially lengthening withdrawal queues in order to hold back the tide and cling onto some stability.

The bank may also borrow money in order to put themselves in a better cash position, rather than immediately resorting to siphoning out investment and loan money or selling off assets at a reduced price. They can receive a loan from other commercial banks or from the Federal Reserve in these kinds of exceptional circumstances, another innovative method commercial banks use to prevent the threat of bank runs is the introduction of term deposits.

These are a particular kind of savings account where the customer forgoes their right to withdraw their deposit at any time in exchange for holdings at a fixed interest rate. This means that the bank ultimately retains unilateral control over when the deposit can be removed – up until the agreed-upon term date – making bank runs for these kinds of deposits effectively impossible.

These days, while bank runs will continue to be a risk for as long as human beings are panicky and erratic, measures put in place to mitigate them mean they won’t be nearly as devastating as in prior instances.

Banks are more familiar with the threat, and insurance measures put in place by the FDIC ensures that the average joe won’t be left penniless as a result of other customers’ fear and impulsivity.

But in any situation where mob mentality causes problems, it’s important to be part of the change: Don’t panic and pull your money out at the slightest sign of instability, because if you do, you’re just another part of the cycle.

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