A bank run is one of those rare financial terms that’s exactly what it sounds like.
It literally starts with a crowd of people sprinting to the bank.
And while that may sound like a mere nuisance to bank tellers trying to go home at 5:30, even the smallest bank runs can have devastating consequences.
Bank runs have precipitated the Great Depression, collapsed modern banks, and even played a major role in modern warfare.
So what are bank runs? What should every young American investor know about them? Why are they so devastating, and should you ever join a bank run?
What’s Ahead:
What is a bank run?
A bank run occurs when a large group of people all try to withdraw their cash from the bank at once. Since banks don’t carry that much cash, they must sell assets to meet demand, risking default. When they risk default, people panic even more and cause a bigger bank run.
Bank runs are nasty business, so let’s start with the basics.
Why would everyone rush to withdraw cash all at once?
People may rush to the bank to withdraw their cash for a variety of reasons:
- They’re afraid the bank will default.
- They’re afraid the economy is going to collapse.
- They’re trying to convert cash into goods or foreign currency to avoid inflation.
- They need cash to cross the border during wartime.
- They fear that a bank run will happen, and ironically cause the bank run.
OK, so there are a lot of reasons why folks might want their cash. But if you have $2,000 in a Chase checking account, why should Chase be scared or surprised if you actually go and take it?
Why bank runs are a big issue for banks
Let’s say that you have a net worth of $25,000:
- $5,000 in checking and savings.
- $10,000 in your 401(k) and other investments.
- $10,000 of equity in your car.
Suddenly, you get a surprise medical bill for $25,000.
Could you pay that bill?
Technically speaking, yes.
But net worth doesn’t mean cash on-hand. You have $5,000 in cash (effectively) and $20,000 in places that are much less accessible.
So to pay the bill, you’d have to empty your accounts, sell your car, and exit all of your investing positions in a short window of time.
- Even if you pulled it off and paid the bill in full, you’d be insolvent, which is basically the formal economic term for broke AF — no assets, savings, nada.
- When you’re unable to pay your next bill, you go into default.
- When you’re in default and falling behind on bills, you might declare bankruptcy to solicit legal help managing your debt.
That’s essentially what’s happening to a bank during a bank run; they’re forced to convert assets into cash, leaving them high and dry.
Let’s say a bank has $100 million total assets but only $5 million in cash.
- If clients try to withdraw just $10 million in cash in one day, that would force the bank to sell off some assets prematurely, reducing their solvency.
- Reduced solvency may lead clients and investors to worry that the bank will go into default.
- The fear of the bank defaulting makes more people want to withdraw their cash.
- The bank is now forced to sell off so many assets to meet cash demands that they now actually might go into default.
Are you starting to see why bank runs are widely considered a self-fulfilling prophecy?
It’s no wonder, then, that FDR opened his 1933 inauguration speech with the following choice words: “The only thing we have to fear is fear itself.”
Bank runs vs. silent bank runs vs. bank panics
In addition to bank runs, anyone considering themself fiscally savvy should know about silent runs and panics, too.
- Bank runs occur when people quite literally run to the bank to withdraw cash in-person.
- Silent bank runs occur when folks withdraw funds electronically, still effectively moving money out of the bank.
- Bank panics occur when multiple banks face bank runs at once, risking the collapse of an entire domestic economy.
That covers the basics of the term, so let’s layer in some context. Have we ever experienced a bank run?
Has the U.S. ever experienced a bank run?
We sure have, and I bet you’re a smart enough cookie to guess when.
When the stock market crashed in 1929, Americans started pulling their cash out of banks and literally stuffing it under their mattress to protect it.
And who could blame them? Back then, if your bank collapsed with your money inside, it was simply gone.
The mattress-stuffing strategy spread like wildfire, and when rumor spread that banks were barring folks from withdrawing money, it led to a full-on panic.
Bank run in New York, circa 1932
Source: moneyunder30.com