Banking Crisis: What is a ‘bank run’ and how are depositors protected against it? All you need to know

Updated: 28 Mar 2023, 09:12 AM IST

SVB's downfall began when depositors started withdrawing their money from the bank quickly. To cover up the draining deposits, the bank sold off a large portion of its securities for a loss of about $1.8 billion. On March 08, the bank also announced that it was raising $2.25 billion through the sale of shares to meet the deposit outflow.

The most significant bank runs in American history occurred during the Great Depression in 1929.

The recent failures of three United States banks and one major European investment bank in less than two weeks have sent shockwaves across the global economy. This has led to concerns about the stability of the global financial system and weakened confidence in the banking sector.

The current turmoil in the global banking system is on the back of the rapid hikes in interest rates by the United States Federal Reserve and the European Central Bank.

On March 10th, 2023, the United States banking sector was hit by a crisis with the collapse of Silicon Valley Bank, the 16th largest bank in the country and a bank that primarily serves tech startups.

SVB's downfall began when depositors started withdrawing their money from the bank quickly. To cover up the draining deposits, the bank sold off a large portion of its securities for a loss of about $1.8 billion. On March 08, the bank also announced that it was raising $2.25 billion through the sale of shares to meet the deposits outflow.

The announcement triggered panic among other depositors, leading to a massive withdrawal of nearly $42 billion in just one day on March 09. The bank was then seized by the U.S. regulators on the following day to stem the panic. Notably, the bank took just 36 hours to fall apart.

In this story, we will look at what is a ‘bank run’ and the significance of deposit insurance in the event of a bank failure. We will also delve into some of the largest bank failures in history.

What is a Bank Run?

To understand the concept of a bank run, we must first understand how banks operate.

Banks receive deposits from both individuals and businesses and subsequently use that money to lend it to other individuals and businesses.

Are banks allowed to lend all the deposits they have collected?

Banks use various factors to determine how much loans they can distribute from their overall deposits, one of which is the reserve requirement set by central banks. The reserve requirement determines the minimum amount of deposits that banks must keep as reserves.

For instance, if a bank collects 1,00,000 in deposits and the reserve requirement is 10%, banks must keep 10,000 in reserves and can lend out the remaining 90,000 to borrowers. Most commercial banks around the world follow a similar process and this system is called fractional reserve lending, where banks are only required to hold a fraction of their deposits as reserves and can lend out the rest.

Although fractional reserve lending is a key driver of the global economy, it also carries risks. Banks must balance the amount of money they lend out with the number of reserves they keep on hand to ensure they can meet depositors' withdrawal requests.

If too many customers withdraw their funds at once, the bank may not have enough reserves to meet their demands, leading to a ‘bank run’ and potentially causing the bank to fail.

Why would depositors suddenly rush to withdraw their money from the bank at the same time?

If depositors lose confidence in the bank or believe that their money is not safe, they may create a "run" on the bank by attempting to withdraw their money before the bank collapses.

What does history tell us about bank runs?

The most significant bank runs in American history occurred during the Great Depression in 1929. Some thousands of U.S. banks collapsed as depositors attempted to withdraw their funds. This caused banks to fail at an alarming rate, resulting in the loss of savings for millions of Americans.

The events leading to the Great Depression began with a significant moment on October 24, 1929, known as Black Thursday. On this day, the US indices experienced a dramatic decline in stock prices as investors began selling their shares in large volumes. The selling pressure quickly turned into a chain reaction, with many investors rushing to sell their stocks, which further drove down prices.

The heavy selling was driven by a variety of factors, including economic uncertainty, declining confidence in the stock market, and the tightening of credit by the Federal Reserve.

To make matters worse, US commercial banks had invested heavily in stocks using funds deposited by their clients, hoping to benefit from potentially higher returns. These investments left many banks overexposed to the market, and when the market crashed in 1929, these investments resulted in huge losses for the banks.

The situation deteriorated as investors who had borrowed money to buy stocks failed to repay their loans, leaving banks with large numbers of non-performing loans and significant losses. This, along with losses on their investments, made banks vulnerable to meeting deposit withdrawals.

In December 1930, the crisis reached a panic state when the privately owned - Bank of United States failed to pay back all its creditors, resulting in its collapse. This was the third-largest bank in the United States, and its failure was the biggest bank failure ever recorded at that time.

This created panic among depositors, who began withdrawing their funds to protect themselves, causing more bank failures in the following months. In total, it is estimated that over 9,000 banks failed between 1930 and 1933. This represented approximately 40% of all banks in the United States during that period.

The Establishment of the FDIC

As depositors were hit hard by the spate of bank failures that led to billions of dollars in losses. The U.S.government responded by creating the Federal Deposit Insurance Corporation (FDIC) in 1933. This decision was aimed at protecting depositors in case their bank goes belly-up.

But how exactly does it do that?

The FDIC provides deposit insurance to member banks, which is designed to ensure that depositors don't lose their money in the event of a bank failure.

If a member bank fails, the FDIC will step in and insures the deposits of the bank's customers, up to a certain limit, which is currently set at $250,000 per depositor per bank. This creates a safety net for depositors and helps maintain public confidence in the banking system.

However, there are limitations to this insurance. For instance, if a depositor has $200,000 in their savings account and the bank fails, the FDIC will pay them the full amount of the deposit. But if they had $300,000 in their account, the FDIC would only insure up to $250,000 of that amount. Therefore, the depositor would only be able to recover $250,000 and would lose the remaining $50,000.

Overall, the FDIC plays a crucial role in preventing bank runs and promoting public confidence in the banking system, but it is important to understand the limitations of its insurance coverage.

Does India have similar deposit insurance?

In India, the concept of insuring deposits kept with banks received attention for the first time in 1948, after the banking crises took place in Bengal. 12 years later the Deposit Insurance Corporation (DIC) Bill was introduced in the Parliament on August 21, 1961, after the crash of Palai Central Bank Ltd. and the Laxmi Bank Ltd. in 1960.

Under the scheme, each depositor is insured up to a maximum of Rs. 5 lakhs (as of 2023) for both principal and interest amounts held in the same capacity and with the same rights as on the date of the bank's default.

The scheme covers all commercial banks and foreign banks that operate in India, as well as regional rural banks, cooperative banks, and local area banks. However, it does not cover deposits held in non-banking financial companies (NBFCs), such as mutual funds, insurance companies, or stockbrokers.

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Deposit insurance
First Published: 28 Mar 2023, 09:12 AM IST