A bank panic would have unique features in the modern world
Could a run on the bank happen today? As the economy continues to struggle, it’s something we need to consider.
Most of us have seen photos of the Wall Street Panic of 1929. The massive crowds gathered around wondering what had happened to their investments, word spreading from person to person, panic and fear growing by the minute.
But today, it’s easy to forget that the Wall Street Crash of 1929 was not seen at the time as the decisive moment that wrecked the economy. There were some false signs of hope when some of America’s top bankers including J.P. Morgan got together to show their confidence in the system and initiate a private sector bailout. The market went up a few times. Many investors – desperate to believe their investments were not lost forever – kept their money in the market in the hope it would start growing again.
As we know, the stock market was only going to get worse. The Great Depression had begun. And banks started to fail. According to History, “Some 650 banks failed in 1929; the number would rise to more than 1,300 the following year.”
While there have been big changes since the Great Depression, there are many similarities between the banking system of the late 1920’s and today. In both cases, our banks use a system called fractional reserve banking.
What is Fractional Reserve Banking?
Here is how Investopedia defines Fractional reserve banking:
“Fractional reserve banking is a banking system in which only a fraction of bank deposits are backed by actual cash on hand and are available for withdrawal. This is done to expand the economy by freeing up capital that can be loaned out to other parties.”
What does this mean exactly? It means that the bank doesn’t actually have your money. If you deposit $100 in a bank, the bank may only keep $10 in reserve and lend out the other $90. The person the bank loans the $90 to can deposit it in another bank. That bank may keep $9 in reserve and lend out the other $81. This can keep on going and going.
If the reserve ratio was 10% (meaning banks could lend out 90% of all money deposited with them), from the initial $100, a total of almost $1000 could be created. The key point to understand is that, although the bank lent out your money, it still shows up as $100 in your account. The same for the person who was lent $90 and deposited it in another bank. The bank only kept $9 and lent out $81, but it shows up as $90 in the borrowers account.
The banking system is a confidence game
This sounds like a confidence game and it is. Our entire banking system – and thus economy – functions on confidence. And it usually works. It is extremely rare for people to empty out their bank accounts. People make deposits and withdrawals, their balance goes up a bit, down a bit, but rarely makes huge moves quickly. So, banks can lend out most of your money since chances are you won’t ask for it.
If this seems strange, consider the fact that our entire monetary system is nothing more than a shared mental agreement. Money has value because we agree it has value. Paper money and digital money have no inherent value – a $100 bill buys more than a $10 bill only because a critical mass of people accept that it does.
So, it makes sense that our banking system would function on confidence. This confidence is its greatest strength. Fractional reserve banking allows more people to have access to money than would otherwise be possible, fuelling spending and investment. Of course, the fact that it’s based on confidence is also its biggest flaw. The system is constantly at risk.
What causes a run on the bank?
So, the bank runs that caused the American Banking system to collapse in the early 1930’s happened because people had lost confidence in the economy. Unemployment was rising, the stock market kept declining, life was getting worse and worse. People kept pulling their money out of the bank, and sooner or later the bank couldn’t pay people back. Once that happened, word started to spread and more and more people ran in desperation (hence bank ‘run’) to the bank to get their money. Once that happened, the party was over.
Note that since the system runs on confidence, every bank – even those managed well – is vulnerable. Rumours of a bank crash can cause a real bank crash, even if the initial rumour is totally false.
Could a run on the bank happen today, and if so, what would it look like?
In order to prevent a bank collapse, there have been some significant changes to the regulations surrounding the banking industry since the Great Depression. In the early 1930’s, the government provided little assistance to people who lost their money to bank runs. Now, most governments guarantee bank deposits up to a certain amount. For example, the United States guarantees all deposits up to $250,000. The idea is that even if the bank runs out of money, the government will ensure you get back the money you had in your account – up to a limit.
Not all governments can do the same. Greece – constrained in their monetary authority due to European Union membership – could not offer the same guarantees to its citizens, and had to shut down banks and pay out only portions of deposits to prevent a full collapse of the banking system. Though Greece guarantees deposits, their deposit fund was far too small to cover potential demand, and since they use the Euro they were unable to print their own money to fill the fund.
The idea of government guaranteeing the money in your account is called deposit insurance and it takes the confidence game to a new level.
Bank runs happen because people lose confidence that the banks will have their money. Government backed deposit insurance gives everyone the reassurance that they can get their money out of the bank in a crisis. That reassurance leads to increased confidence in the banking system, making people less likely to try withdrawing all their money, thus lessening the chance of a bank run and lessening the chance that deposit insurance will ever have to be used.
For reference, here is what the Federal Deposit Insurance Corporation (deposit insurance in America) says on their website
FDIC insurance covers all deposit accounts, including:
- Checking accounts
- Savings accounts
- Money market deposit accounts
- Certificates of deposit
FDIC insurance does not cover other financial products and services that banks may offer, such as stocks, bonds, mutual funds, life insurance policies, annuities or securities.
The standard insurance amount is $250,000 per depositor, per insured bank, for each account ownership category.
How a bank run could still happen
The big reason a bank run could happen today is the speed with which information spreads and the ease with which we can withdraw our money. And as noted above, people could still lose a lot in a banking collapse, since stocks, bonds, and life insurance – among other categories – are not covered.
Fear of a bank collapse would spread rapidly through Twitter, and many people would go to their nearest ATM machine as fast as possible. People would also try to transfer money to different sources, taking it out of their bank account and putting it on their credit card, buying foreign exchange, even transferring it into mutual funds or other investments. Some people would probably even go buy some tangible goods to convert their digital money to a store of real physical value.
Despite deposits being insured, fear would still drive panic. Once word spread that ATM’s were running out of cash, irrational behaviour would start to take over. We could end up seeing some modern parallels to old bank runs. Instead of closing physical bank branches, some banks might be forced to shut off their apps and temporarily limit electronic transfers.
You would get your money back if a modern bank run happened
Of course, some of this panic would subside once people realized they were getting their money back. There would be some coordination delays and snafus, but the government would pay people what was in their accounts. And in the United States, Canada, and the vast majority of nations who retain control over their monetary policy, the printing press would get a good workout.
Governments would print money to deal with a modern bank run
A nationwide bank run would be a sign of a wider economic crisis. Considering that the average American has roughly $4,000 in their bank account, government deposit insurance payouts could easily reach tens and even hundreds of billions of dollars. Governments would have to pump massive amounts of money into the economy to keep consumers and businesses afloat.
The money could be injected into the economy quickly, since it can all happen by computer. Though we talk about “printing money,” it’s more like “typing money” now. So, just as the initial fear and withdrawals would be quick in a modern bank panic, the response would be swift.
The consequence of rapid and massive government intervention are difficult to predict. It was previously thought that mass “printing of money” would lead to inflation, but despite trillions being added to books of the Federal Reserve, inflation remains stable even with interest rates near zero.
If a bank run happened today, it would be quick by historical standards
For all the reasons discussed above, a 1930s style bank run is unlikely. Having learned some lessons from that time, governments will guarantee deposits and print tons of money instead of letting banks collapse. Panic could arise for a short time, and some banks would run into trouble – at least temporarily – a bank run today would be much different from what happened at the beginning of the great depression
So yes, a bank run could happen today. But it would be dealt with far more swiftly, and with far less damage to depositors than in the 1930’s.
Follow Spencer Fernando on Twitter: @SpencerFernando
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