In times of financial volatility people love cash in hand more than anything. During such times having a lot of cash with you gives a sense of security and satisfaction. During such times you don’t feel confident keeping money in banks as you never know when it might restrict your withdrawal or even when the bank might collapse and your money is gone, at least for some time. Historically such situations have taken place and during those times people queued for long hours to get their money out of the banks. This is called a bank run. In such times banks can actually run out of cash.
During the great depression of the 1930’s and the financial crisis of 2008 people panicked and lost faith in the banks, thinking that it can close down and they may lose the money. Depositors then start withdrawing their money. At the beginning it starts with a limited number of people but slowly as words spread and thanks to the media, this thing gets hyped. Then more and more people start rushing towards the bank to withdraw. The banks start imposing restriction on withdrawals so that they don’t run dry.
A local bank branch has a limit of holding cash depending on the average demand of cash and security reasons. And that entire amount a bank can keep is not for withdrawals. It is also used for in house loans and investment projects. So when more than the expected number of people starts withdrawing then it has to divert cash from the other reserves to increase the cash position. They can also bring cash from other banks temporarily but when all banks are facing the same situation then no bank will be in a position to help other banks. Information of such a situation spreads fast creating more panic. During such times trying to talk sense and reassuring the public just don’t work. The fear that a bank can fail seems to be the biggest reason for a bank to fail.
The same psychology was seen this year only, when the lock down period started. People started hoarding toilet paper in anticipation of a long lock down. What started as a trickle ended in a mad rush to buy and hoard them leading to shortage of supply in major super markets.
The classic example of bank run was the great depression of the 1930’s. It started with the stock market crashing in October 1929. Before that America was having a great time- the roaring twenties with heightened economic prosperity. The people were ever bullish on the market trend leading to over pricing and inflating the stock market. This created an asset bubble but eventually all bubbles have to burst and this happened. Deposits in banks rose and so the lending by banks also rose. Banks were handing out loans like cookies and candies. The public were confident that the market would sustain that they were playing with margin money.
Meanwhile the agriculture and industrial production was at a all time high and also hurting the stock market. The Federal Bank of New York increased the interest rate by 1 percent and the other overhyped factors led to an economic chain reaction. The combined effect of so many things led to the collapse of the US economy, plummeting the GDP into free fall. To the public it came as a shock and they wanted to hold as much cash as possible in their hands. The news papers further fuelled the fear leading to further panic. The people lost faith in the banks and started pulling out funds. To keep up with the demand for cash the banks started selling their assets. Bank runs are the outcome of a sudden economic downturn and uncertainty.
The 2008 stock market crash was due to the subprime mortgage market where people were getting loans so easily that it created a housing bubble. The collapse of the Lehman Brothers bank created a great panic and proved that even large banks were not infallible. This also created the same effect as that of the great depression and its effect was profound in US and Europe. Some banks even became insolvent.
However, now the central banks have systems in place to avoid such things in future. One thing is the deposit insurance which guarantees the customer money even of the bank falters in paying them immediately. But such guarantees are not for the full amount and this guarantee amount varies from country to country. Second is to reduce the withdrawal limit or reduce the number of withdrawals. This happened in India during the demonetization a few years back. Banks can take money from other banks or the central bank to tide over such a situation rather than selling off assets. The banks can also convert the savings deposit into term deposits with a postponed date of maturity.
Though nobody knows that such incidents will be repeated again or not but one thing is that now banks are more prepared to handle such situations, based on previous experience. But on the counter side when public fear overshadows logic then no amount of preparation and persuasion can hold the public back.
Thank you Telesfor sir.