Question

FDIC insurance, beginning in 1936, of bank deposits greatly reduced the potential for runs on commercial banks. We did not experience a bank run until the financial crisis of 2007-09. Recessions in the interim period were mild (shorter and less deep) in comparison to the early 1930s and 2000s.

a. Why didn't the presence of deposit insurance prevent the most recent run?

b. What measures did the FED and Treasury Department adopt to cope with this run?

Answer 1

Bank run/run on banks happen when a large number of people rush to the bank to withdraw their money believing that the bank may fail to run in the coming future or may become insolvent. Fear of not getting their deposit money back cause people to go to the bank to withdraw money before anything risky happens. A bank run can put pressure on a bank or even destabilize banks, in such situation Bank may face sudden bankruptcy. Bank runs can cause damage to the overall economy of a nation.

Deposit Insurance is meant to protect deposits of banks from heavy withdrawals and from losses caused by bank failure to pay its debts. For the United States, the institution is the Federal Deposit insurance corporation.

a. Why didn't the presence of deposit insurance prevent the most recent run?

For any type of insurance to operate, insurers assume that there would be no catastrophic loss like bank runs. So insurers have an assumption that total economic catastrophic event would never occur, so they keep small amount to hand to banks in case of small bank failures. Therefore this small amount kept as a insurance money is not able to fulfill or indemnify the loss of huge Bank runs. The amount of this deposit insurance is peanuts compared to the amount of cost of damage of bank runs.

b. What measures did the FED and Treasury Department adopt to cope with this run?

The measures adopted by FED & Treasury Department are -

• Strengthning Capital Reserve requirements (to keep more of reserves as cash)
• Regulation and supervision of banks
• Deposit Insurance to insure each depositers.
• Transparency through Banking system.
• Central Bank to act as a lender of last resort to make shot term loans to banks.
• Encouragememnt by commercial banks to make term deposits by customers.