Question

What is a bank run and why does it happen? Can you find a real life example of a bank run and discuss the circumstances leading up to it.

During the financial crisis, the Federal Reserve deemed some banks as “too big to fail.” Do you think that there is a moral hazard associated with this or is it a necessary reality of the banking system?

Answer 1

A Bank run is a failure of a bank which occurs when a large number of depositors and customers withdraw their money from the bank simultaneously. This significantly impact the solvency of the bank, since most of the money that a bank have will be already given out as loans and reserves. Due to this the bank will fail to honour all of their customers which ultimately leads to its failure.

eg: Many bank runs happened during the recession period in 1930. In 2007 an American firm Countrywide Financials faced a bank run due to subprime mortgage crisis.

There is a moral hazard associated with Federal Reserves statement. In 2008, many big Financial institutions faced failure due to subprime crisis, but since due to the active intervention of the Federal Reserve and US government, only Lehman Brothers had to take a hit and all the other big banks were saved. This basically gives a license for such banks to take huge risks compared to its capital since they will be confident that Fed will eventually come for their rescue. Also such statements can bring down the peoples trust in financial systems which is an important factor that holds up the entire financial world.