Bank Run – What Happens to Your Money When the Bank Fails?

Most of us don’t keep our money under our mattresses. We keep it in a bank, where we trust it will be safe until we need it.

This trust is the reason banks stay in business. If enough people lose that trust, it can set off a series of events known as a bank run.

A bank run happens when a large group of customers lose trust in their bank and try to withdraw their funds at the same time. When a bank doesn’t have the funds to cover these withdrawals, it runs the risk of failing.

What Causes Bank Runs

Simply put: panic.

When customers worry their bank is about to go under, they want to get their cash out ASAP. But banks don’t have enormous vaults with Scrooge McDuck levels of cash. Banks lend most of the money customers deposit to borrowers or invest it in assets that earn interest.

Banks keep only a small amount of cash on hand. Usually, this cash is enough to cover typical daily customer withdrawals. But if too many customers withdraw their money at once, the bank may not have enough funds to cover it.

A famous scene from the classic Christmas movie “It’s a Wonderful Life” shows this concept in action. (Except that in real life, bankers rarely hand out cash from their own pockets.)

How Banks Can Address Runs

If a bank experiences a run, it has a few options. It can:

  • Sell assets to generate the cash it needs.
  • Limit the number or amount of withdrawals customers can make or pause withdrawals altogether.
  • Borrow money from other banks or the Federal Reserve.

If a bank sells some of its assets and they aren’t worth as much as they were when the bank bought them, it results in a loss. The bank can become insolvent (unable to pay its debts) and fail.

Ironically, customer fears become a self-fulfilling prophecy, even if the bank was perfectly healthy to begin with.

Historical Bank Runs

There have been several significant bank runs in U.S. history. These are some of the most well-known ones.

The Panic of 1907

The Knickerbocker Trust, one of the largest banks in New York, collapsed in 1907 as a result of bad investment speculation.

Hoping to corner the copper market, two small brokerage firms bought a large number of shares in United Copper Co. They planned to drive the price up and resell them for a handsome profit. Instead, the price plummeted, bankrupting the brokerages and shaking Americans’ confidence in the banking system.

Because the Knickerbocker Trust had connections to the brokerages, it was the first bank to be hit with a panic and fail. What started as bank runs in New York City quickly spread across the nation, setting off a series of runs known as the Panic of 1907.

The panic and the recession that followed led to the passage of the Federal Reserve Act in 1913. This Act created the Federal Reserve, the central bank of the United States. The Fed oversees and regulates the banking industry, sets monetary policy, and provides economic stability.

Great Depression Banking Panics (1930 – 1931)

The 1929 stock market crash severely damaged people’s confidence in financial institutions. The reasonably new Federal Reserve responded by cutting the national money supply, reducing banks’ liquidity. In the resulting bank panics of 1930 and 1931, thousands of banks failed, and many Americans’ life savings went with them.

In response, Congress passed the Emergency Banking Act of 1933, which gave the president executive powers to act without the Federal Reserve’s approval in a financial crisis. President Franklin Roosevelt declared a bank holiday that shut down banks and the Federal Reserve for a week.

This gave Congress time to create the Federal Deposit Insurance Corporation, which covers customers’ deposits in the event of a bank run. The FDIC created a safety net for customers and boosted public confidence in the banking system, reducing the likelihood of future runs.

The Great Recession (2007 – 2009)

Like in the Panic of 1907, The Great Recession resulted from risky speculation, this time in the form of subprime lending.

Banks were bundling mortgages into investment assets called mortgage-backed securities, which can generate stable returns if the market is doing well. Incentivized by this, banks began issuing mortgages to borrowers with lower credit ratings than they usually approved (subprime credit) — a riskier bet that came with higher potential returns.

When the housing bubble burst, many of these subprime borrowers defaulted, leaving banks to cover the losses of the remaining loan amount and losing out on any interest they would have collected. Banks large and small failed, including Washington Mutual, the biggest bank failure in U.S. history.

“Bailout” was the word of the moment. To keep the financial industry from collapsing, Congress passed the Emergency Economic Stabilization Act and the Troubled Asset Relief Program in 2008. These acts enabled the U.S. Treasury to purchase ill-fated mortgage-backed securities from banks and buy bank shares to shore up shaky institutions.

FTX Collapse (2022)

The recent FTX implosion can be considered a new kind of run: a virtual bank run. The cryptocurrency exchange collapsed in a span of days when people learned it had lent customers’ funds to investing firm Alameda Research (which FTX’s founder owned). Worried about FTX’s trustworthiness and the safety of their funds, users withdrew around $8 billion, and FTX’s value nose-dived.

One of cryptocurrency’s major criticisms has been its lack of regulation and recourse to crypto holders who lose money on their investments. Until the government addresses these issues, we may see more runs like FTX’s.

Final Word

Traditional bank runs are less likely now thanks to the oversight and regulations created after the Panic of 1907. But they can still happen (see: The Great Recession).

Should a bank run occur, the government can help the bank by:

  • Bailing out the bank
  • Allowing another bank to acquire it
  • Increasing federal cash reserve requirements

The good news for customers is that FDIC insurance has you covered. So even if your bank is in trouble, your money is safe — unless your money is in cryptocurrency. Then, you’re out of luck unless the government passes new regulations.

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