How and Why Banks Runs Happen [Within a Macro Context]
What Is a Bank Run?
A bank run occurs when a large number of depositors, or customers, of a bank or other financial institution simultaneously withdraw their funds because they fear that the bank may become insolvent, or unable to meet its financial obligations.
Bank runs can be triggered by rumors or news of financial instability or by actual financial difficulties of the bank.
The fear of losing their savings can create a domino effect, causing more and more depositors to withdraw their funds, leading to a rapid depletion of the bank’s reserves and ultimately the failure of the institution.
Bank runs can have severe consequences not only for the bank and its depositors but also for the wider economy.
They can lead to financial crises, as well as to social and political instability.
In response, governments and central banks have developed various measures to help prevent and manage bank runs, such as deposit insurance, lender of last resort facilities, and regulations and supervision of the financial sector.
Bank Runs Within a Macro Context
In this article, we will explore bank runs within the context of a macroeconomic framework.
This means that we will examine the impact of bank runs on the broader economy, as well as the factors that can contribute to the occurrence of bank runs and the measures that can be taken to prevent or mitigate their effects.
At the macro level, bank runs can have significant implications for the stability of the financial system and the overall economy.
If a large number of banks experience runs simultaneously, this can lead to a credit crunch, where lending dries up and businesses and households struggle to access financing. This, in turn, can lead to a contraction in economic activity and even a recession.
Moreover, the occurrence of bank runs can undermine public confidence in the banking system and the wider economy. This can lead to a loss of trust in financial institutions and a reluctance to invest or save, which can further exacerbate economic problems.
To understand bank runs in a macroeconomic context, we will examine the factors that can contribute to their occurrence.
These include weaknesses in the banking system, such as:
- inadequate capitalization
- poor risk management practices, and
- lax regulation
We will also look at the role of economic conditions, such as high levels of debt and financial market volatility, in creating an environment where bank runs are more likely.
We’ll also talk about the measures that can be taken to prevent or mitigate the effects of bank runs.
These include policies such as deposit insurance, lender of last resort facilities, and supervision/regulation of the financial sector.
Problems Bubble to the Surface
At the onset of the problem, a wave of debt defaults and restructurings overwhelms various players.
Leveraged lenders such as banks as often the first dominoes to fall (e.g., Silicon Valley Bank and Silvergate Capital in 2023).
The legitimate anxieties of both lenders and depositors exacerbate each other, resulting in runs on financial institutions that are typically unable to meet them unless they are protected by government measures.
Reducing interest rates is sometimes insufficient because the floors on risk-free rates have already been reached and, as credit spreads increase, the interest rates on risky loans rise, making it difficult to service those debts.
Interest rate cuts also provide little relief to lending institutions facing liquidity issues and suffering from runs. Moreover, rate cuts may often not be done when the problem is localized/not systematic.
At this stage of the cycle, the forces of deflation, namely debt defaults and austerity, dominate, and are not adequately counterbalanced by the stimulative and inflationary forces of debt monetization via printing money to cover debts.
As investors refuse to extend loans and borrowers scramble to acquire funds to cover their debt payments, the capacity for liquidity – i.e., the ability to sell investments for cash – becomes a crucial concern.
For instance, when one owns a $1,000 debt instrument, it’s expected that the investment can be exchanged for $1,000 in cash, which in turn can be exchanged for $1,000 worth of goods and services.
However, because the ratio of financial assets to money is high, when many people attempt to convert their financial assets into cash at the same time, it can lead to run-like situations.
In such case, it necessitates that the central bank either print more money to provide the liquidity required or allow defaults to happen.
SVB Races to Avoid Bank Run as Funds Advise Pulling Cash
Solvency Problems, Cash-Flow Problems, or Both
During a contraction, solvency problems or cash-flow problems can either be the cause of, or result from, the situation.
Usually, there are a lot of both types of problems present during this phase.
A solvency problem arises when, according to accounting and regulatory standards, the entity lacks sufficient equity capital to operate, rendering it “bankrupt” and necessitating its closure.
Accordingly, the severity of the debt problem at this moment is greatly influenced by accounting laws.
A cash-flow problem occurs when an entity does not have enough cash to meet its obligations, typically because its own lenders are withdrawing funds, resulting in a “run.”
A cash-flow problem can arise even if the entity has enough capital because the equity is tied up in illiquid assets.
The lack of cash flow is an immediate and severe problem and, as a result, is the trigger and primary issue of most debt crises.
How to Handle Each
Each problem will require a different approach.
If a solvency problem arises – i.e., the debtor lacks adequate equity capital – it involves an accounting/regulatory issue that can be resolved by either:
- supplying sufficient equity capital or
- modifying the accounting/regulatory laws to conceal the problem
Governments can accomplish this directly via fiscal policies or indirectly through innovative monetary policies if the debt is in their own currency.
In the case of Silicon Valley Bank, the new policies offered by the Federal Reserve in light of that situation didn’t address the fundamental duration mismatch problems that many of these financial institutions have – e.g., shorter-term variable-rate liabilities (e.g., deposits) against long-duration, low-yielding assets whose valuations were declining and eating away their capital cushion, which made them mark-to-market insolvent when the risks weren’t well-managed.
Similarly, if a cash-flow problem arises, fiscal and/or monetary policy can provide either cash or guarantees to address it.
Accounting Standards Are Important
The significance of accounting and regulatory standard is demonstrated by the differences between the debt/banking crises of the 1980s and 2008.
In the 1980s, there was less use of mark-to-market accounting – as the crisis involved loans that were not frequently traded in public markets.
This resulted in the banks being less “insolvent” than they were in 2008.
With greater use of mark-to-market accounting in 2008, the banks required capital injections and/or guarantees to strengthen their balance sheets.
Both crises were effectively managed, although the methods employed were different.
As the cycle enters the the “severe contraction” phase, certain safeguards learned from previous depressions are typically in place and beneficial.
- bank deposit insurance
- the capacity to provide lender-of-last-resort financial aid and guarantees, and
- the ability to inject capital into systemically important institutions or nationalize them
However, they are often inadequate because the exact nature of the debt crisis has not been seen before and therefore not well thought through.
And usually there are risks in two main forms:
- a significant amount of lending has occurred in relatively unregulated areas (often called the “shadow banking system”) and/or
- new financial instruments have been created that possess unforeseen risks and aren’t adequately regulated.
How well these situations are dealt with depends on the capabilities of policymakers in charge as well as the freedom they have to make the right decisions.
Contraction Periods Are Not Just Psychological
There’s a common misconception that falls in market and contractions in economies are primarily psychological, with investors moving their funds from riskier investments to safer ones (such as from equities and high-yield credit assets to government bonds and cash) out of fear, and that the markets and economy can be restored by “restoring confidence” to invest in riskier assets again.
This is not accurate for two main reasons.
First, contrary to popular belief, the deleveraging dynamic is not predominantly psychological.
It is primarily driven by the supply and demand, as well as the relationships between, credit, money, and goods and services.
However, psychology does play a role, especially in terms of the liquidity positions of various players.
Nonetheless, if everyone simply forgot what had happened, the situation would remain unchanged because debtors would still have obligations to deliver money that would be too large relative to the money they are receiving.
The government would still be faced with the same choices that would result in the same consequences, and so forth.
In connection with this, if the central bank increases the money supply to alleviate the shortage, it will devalue the worth of money, thus making creditors anxious about receiving an amount of money that is worth less than what they lent out.
While some people believe that the quantity of money in circulation stays about the same and merely shifts from riskier to less risky assets, this is incorrect.
Most of what people think of money is actually credit; credit is created out of thin air during good times and disappears during bad times.
For instance, when you purchase an item using a credit card or a loan, you are essentially saying, “I promise to pay.”
For example, if you go into a supermarket and pay for $100 worth of groceries with a credit card, you get the groceries and create a credit asset and credit liability.
Where does the money come from? Nowhere. You created credit.
Credit goes away in the same manner. If the owner of the supermarket thinks that you and others will not pay the credit card company, and the credit card company will not pay the store, then the owner accurately perceives that the credit “asset” they possess does not really exist.
It did not move somewhere else. It simply disappeared.
Deleveragings Involve Realizing A Lot of Wealth Doesn’t Actually Exist
A significant part of the deleveraging process is individuals realizing that much of what they believed was their wealth was merely a pledge from others to provide them with money.
Now that these commitments are not being honored, that wealth no longer exists.
When investors attempt to convert their investments into cash to generate funds, they put their capacity to receive payment to the test.
If they are unable to receive payment, panic-driven “runs” and sell-offs of securities arise.
Naturally, those who experience runs, particularly banks (though this applies to most entities that depend on short-term funding), encounter difficulties in obtaining money and credit to satisfy their needs, resulting in a cascade of debt defaults.
When debt defaults and restructurings occur, they impact individuals, particularly leveraged lenders – banks being the most notable – and trigger a chain reaction throughout the system.
These apprehensions intensify and result in a dash for cash, causing a shortage (i.e., a liquidity crisis).
The process operates in the following manner:
Initially, the money coming in to debtors via earnings and borrowing is insufficient to fulfill their obligations. This requires the sale of assets and a reduction in expenditures to raise cash.
This leads to a drop in asset values, which reduces collateral worth, resulting in reduced earnings.
Since the creditworthiness of borrowers is assessed based on both:
- a) the values of their assets/collateral relative to their debts (i.e., their net worth) and
- b) the sizes of their earnings relative to their debt-service payments
- both their net worth and earnings decline more rapidly than their debts…
- borrowers become less creditworthy, and…
- lenders become more hesitant to lend…
…this process continues in a self-perpetuating manner.
Deflationary Forces Dominate at First
During the contraction phase, the dominant forces are deflationary in nature, caused by debt reduction (i.e., defaults and restructurings) and austerity measures (i.e., less spending) without significant efforts to reduce debt burdens through the printing of money.
Since one person’s debts are another’s assets, aggressively reducing the value of those assets can significantly reduce the demand for goods, services, and investment assets, hurting both markets and economies.
For write-downs to be effective
For a write-down to be effective, it must be substantial enough to enable the debtor to service the restructured loan.
If the write-down is 40 percent, the creditor’s assets are reduced by that amount.
Why write-downs are more significant than advertised
While a 40 percent write-down may seem like a large reduction, it is actually much greater.
Since most lenders are leveraged (i.e., they borrow to purchase assets), the impact of a 40 percent write-down on their net worth can be much more significant.
For instance, a creditor who is leveraged at a ratio of 2:1 would experience an 80 percent decline in their net worth. Because their assets are double their net worth, the decline in asset value has twice the impact.
Given that banks are often leveraged at ratios of around 10:1 or 15:1, the consequences can be catastrophic for both the banks and the economy as a whole when such risks are not well-managed.
How The Math Works
If you’re levered 2:1, the value of your assets is twice your net worth.
To do an example, let’s say you own $1,000 of assets and your debts are $500. In that case, your net worth is $500.
If the value of your assets falls by 40 percent, you’re left with $600 of assets and $500 of debt.
Your net worth is now $100.
That’s 80 percent less than the net worth of $500 you started with, even though your assets fell by only 40 percent.
Being levered 2:1 doubles the impact of the asset price decline on your net worth (similarly 3:1 leverage would triple it, and so on).
And, for example, if you are levered 5:1 and your assets fall by more than 20%, then you’re “underwater” (i.e., have a negative net worth).
Debt burdens increase
Despite debt write-downs, debt burdens continue to increase as spending and incomes decline.
Additionally, debt levels rise, hitting net worth.
As debt-to-income and debt-to-net-worth ratios increase, and credit availability decreases, the credit contraction naturally perpetuates.
During depressions, the capitalist/investor class encounters a significant decline in “real” wealth due to the collapse in the value of their investment portfolios (with equity prices typically dropping around 50%), lower earned incomes, and higher tax rates.
Consequently, they become exceedingly defensive.
Frequently, they are compelled to move their money (and sometime themselves) outside the country (contributing to currency weakness), avoid taxes, and seek to put their money in liquid, non-credit-dependent investments (such as gold or low-risk government bonds or cash in countries not suffering from these problems) to ensure their financial security.
Both the real economy and the financial economy suffer during these phases.
With monetary policy limitations, the credit contraction results in bad economic and social outcomes.
Workers encounter significant challenges as job losses escalate.
If policymakers do not counteract the deflationary forces of the depression with sufficient monetary stimulation in a new form, these circumstances can persist for many years.
In cases where there already exists inflationary conditions, they are further constrained, which can lead to longer recessions.