Question

1. What is a bank run? Why is it so difficult to stop?

2. Describe how the lender of last resort function of a central bank can reduce runs on banks.

3. Describe how a financial panic can lead to a loss of income and employment in sectors of the economy seemingly unrelated to the financial sector.

Answer 1

1) A bank run is a phenomenon which occurs when a high percentage of the bank's depositors demand to withdraw their deposits from the bank, this generally occurs out of fear that the bank may be going bankrupt (insolvent), bank's face this problem because they carry illiquid assets such as long-term commercial loans and finance them with highly liquid liabilities like short-term deposits, demand deposits etc.

Bank runs are difficult to stop once triggered as banks generally maintain only a small portion of their assets as cash and most of the deposits are lent out as loans, as more customers withdraw their money from the bank the bank eventually runs out of cash triggering panic amongst its customers which can eventually lead to Bankruptcy.

2) The function of a Central bank as a lender of last resort in the formal credit system is to prevent panic or bank runs that may lead to a liquidity crisis in the bank. This is achieved by lending the bank enough money to sustain customer withdrawals for the short term, the loans are backed by good quality collateral such as highly rated loans.

3) Panic in financial sector leads to contraction of credit in the economy generally due to the fact that institutions are less willing to give out loans due to fear and uncertainty. This leads to liquidity and credit crunch in the entire economy. New loans for expansions are harder to get resulting in stagnation of industries, people tend to sell stocks and keep money in liquid form resulting in a stock market crash.

this leads people to put off non-essential consumption for later since there is less consumption overall in the economy, non-essential industries reduce production and people start to lose jobs which in turn triggers a recession like situation and this cycle of low credit leading to--> low consumption leading to--> job cuts leading to--> lower consumption continuous till there is a stimulus that triggers growth.