Question

a) Explain the cycle mechanism of a bank run. b) How does a deposit insurance stop the bank run cycle? 1 c) How do discount window loans stop the bank run cycle?

Answer 1

A . Bank runs are situations where depositors withdraw their deposits from banks for the fear of the safety of their deposits. Historically, bank runs were a prominent feature of the great depression era in the U.S, prompting the introduction of federal deposit insurance. Yet bank runs continue to be an important phenomenon, as witnessed by current trends, the dire financial condition of some banks, and recent aborted runs both in the US, and internationally [e.g., Countrywide Bank, IndyMac Bank (U.S.), Northern Rock Bank (U.K.), ICICI Bank (India)]. Even in countries which did not experience bank runs recently, the attempt to avoid them is at the root of deposit insurance, and capital adequacy requirements, which in turn have led to a large literature on the agency problems inherent in deposit insurance or “too big to fail” policies. Given the costs associated with bank runs or crisis, understanding what factors drive depositor runs on banks is important.
The theoretical literature on bank runs has helped identify potential causes for depositor runs.
The literature can broadly be divided into two classes. In one class of models, bank runs are a result of coordination problems among depositors. Runs occur due to self-fulfillment of depositors’ expectations concerning the behavior of other depositors. In the other class of models, bank runs are a result of asymmetric information among depositors regarding bank fundamentals. In these models, depositor beliefs regarding the solvency of a bank play an important role in determining depositor actions.

As many of the theoretical models and some evidence suggest, even if the bank is fundamentally solvent, bank runs can still occur because depositors can run in anticipation of a run. An important question is how does such contagion effects of bank runs spread? What factors mitigate this? Are there costs of a bank run, even if the bank survives? Understanding these factors are important from multiple perspectives – from the point of view of the bank, its
customers, and regulators.

B . Deposit insurance started in the U.S. during the Great Depression, and it persists today. That's why you see the letters "FDIC" on the door of every bank in the country today. It's a promise that even if the bank goes under, the government will guarantee that ordinary people get their money back. This promise alone has ended bank runs almost entirely.

There is deposit insurance in Europe today. But it's issued by individual governments. So if people are worried that the government itself might run out of money, even deposit insurance may not be enough to prevent a run.

"The problem we have today, is that the Spanish guarantee is looked upon by Spaniards as maybe yes, maybe no," says economist Charles Wyplosz. "That's not the kind of risk you like to take with your money." The problem is even more acute in Greece.

One solution that's been proposed: Deposit insurance that's backed by the entire eurozone. In that case, depositors in Greek and Spanish banks would know that their savings were guaranteed not just by their own governments, but by Germany and other, more financially sound governments.

Of course, this would also leave taxpayers in Germany (and every other eurozone country) on the hook for the behavior of banks throughout the continent.

C . People rush to withdraw their money from the bank when they're afraid the bank is about to run out of money. So if the bank can borrow a bunch of money, that usually stops the run.

The European Central Bank has been lending massive amounts of money to European banks. And that's been essential so far in preventing a full-scale bank run in Europe. This weekend's agreement to bail out Spain's banks goes further. It's a huge pool of loans that should make ordinary savers confident that their bank isn't about to go under.