Bank Runs and Systemic Risk

Edwin H. Neave

• Publisher: Wiley
• Year: 2010
• ISBN:
  9780470944790
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

This chapter examines performance and stability issues associated with bank operations. It first shows how bank portfolio structures pose a trade-off for both bank and system stability. It next considers policies for reducing the likelihood of speculative bank runs, examining the roles of lender of last resort, deposit insurance, and information production. Finally, the chapter considers how system risks differ from the risk of individual bank operations, and sketches policies for dealing with them.

CHAPTER 20

Bank Runs and Systemic Risk

This chapter examines performance and stability issues associated with bank operations. It first shows how bank portfolio structures pose a trade-off for both bank and system stability. It next considers policies for reducing the likelihood of speculative bank runs, examining the roles of lender of last resort, deposit insurance, and information production. Finally, the chapter considers how system risks differ from the risk of individual bank operations, and sketches policies for dealing with them.

This chapter discusses why bank runs and bank failures occur, and the risks that these phenomena can present. The chapter also considers how simultaneous runs on several banks can amount to a bank panic, examines the system risks that a panic can present, and offers some comments for dealing with system risks.1

Financial history reports episodes of banking instability in several countries, indicating that bank runs and bank failures are not uncommon features of a financial system. For example, England witnessed many bank failures before the Bank of England was established as a state bank2 in 1946. Similarly, there were almost 100 failures of United States banks in the late 1930s and early 1940s, although between the 1940s and the 1980s failures3 were relatively rare. The difference in U.S. failure rates was attributed to both a changed environment and a stronger regulatory framework. However U.S. regulatory revisions did not prove adequate to the task, and another spate of nearly 250 failures occurred between the late 1980s and early 1990s. In yet another series of examples, bank runs and bank failures occurred in several Asian countries during the late 1990s. The problems began with individual banks, but eventually spread throughout the banking system and ultimately affected the creditworthiness of the countries themselves. Similarly, the credit crisis of 2007–2008 began with U.S. banks and U.S. investment banks, and later spread to financial institutions in many other parts of the world.

Despite failures in many countries, however, banking instability is not universal. For example, Scotland has never had a bank run, although its banking history extends over more than 300 years, beginning with the formation of the Bank of Scotland in the late 1600s. Bank shareholders faced unlimited liability during the earlier years of Scottish banking history, but even after changing to limited liability ownership the Scottish banking system exhibited no instabilities. Similarly, Switzerland reports no bank runs over its lengthy banking history. At least part of the explanation for such differences appears to lie in countries' political differences. Both Allen and Gale (2007) and Rochet (2008) argue that political interference can play an important role in creating difficulties.

A bank run is a loss of confidence in an individual bank, and can be a proximate cause of bank failure, although the fundamental reasons for bank failure are operating or loan losses.4 To reflect these differences, many authors distinguish between speculative and fundamental bank runs. Speculative bank runs are those in which depositors withdraw a disproportionate amount of funds from a solvent bank, while fundamental bank runs occur when depositors attempt to recover their funds from an insolvent bank. As we show later, one difficulty with this definition is that of distinguishing between a solvent and an insolvent bank.

One bank's failure can create an atmosphere in which depositors lose confidence in other banks, possibly causing them to fail as well. If several failures do occur, the situation can develop into a bank panic, in which depositors lose confidence in a country's entire banking system. A loss of confidence in some banks, or a panic affecting all banks, can develop from either speculative runs or fundamental failures. The possibilities present real dangers, as the 2007–2008 worldwide credit crisis vividly demonstrates. Nevertheless, and also as shown later, bank runs or bank panics are less likely when credible safety net provisions such as deposit insurance schemes or lender of last resort facilities have been set up. Similarly, restoration of confidence in a system experiencing difficulties has historically been brought about by combinations of private sector and government support.

LIQUIDITY PROVISION AND SYSTEM STABILITY

Banks provide liquidity services by issuing liquid claims that are backed mainly by illiquid assets. Chapter 6 showed that banking operations can increase consumer welfare if they provide a liquidity service that would otherwise be unavailable to depositors.5 Banks provide liquidity both by agreeing to redeem deposits when depositors request withdrawals, and by lending funds to their borrowing clients. Since deposits are mainly available on demand and since most loans are repaid in installments over time, the combination means that the liquid assets held by the system's banks are typically only a fraction of their short-term (i.e., liquid) liabilities. In such a fractional reserve system, only banks' liquid assets are immediately available to meet a sudden increase in withdrawals, and consequently banking systems are subject to instability problems.

The extent and severity of the instability problems that can be created by a fractional reserve system depends critically on both institutional arrangements and the attitudes of banking clients, as will be shown in greater detail later. Nevertheless, the speculative runs to which a fractional banking system can prove vulnerable are really a proximate rather than a fundamental cause of bank failure. The fundamental cause of bank failure is not a run on its deposits, but the fear that led to the run. That fear is one of being unable to redeem one's deposits if the bank were to suffer sufficiently large losses, especially in its lending business. The possibility of such losses can be either real or imagined, but once that fear lodges in the minds of the public, a run on a bank becomes much more likely.

The fact that insurance companies also fail from time to time strengthens the conclusion that a run on deposits is not the fundamental cause of a financial intermediary's failure. Insurers cannot be subject to runs on deposits, since (at least up until the time of this writing) most insurance companies have not offered extensive deposit services.6 Rather, insurance companies fail because they incur unanticipated losses, either on their underwriting business or on their investments.7

The Diamond-Dybvig Model

Diamond and Dybvig (1983) explain how speculative runs can stem from a loss of depositor confidence in a given bank. The model assumes a fractional...