Bank Runs and Deposit Insurance
Because banks fund illiquid loans with deposits that can be withdrawn on demand, a loss of confidence can spark a bank run where everyone withdraws at once. Deposit insurance, which in the US guarantees up to $250,000 per depositor per insured bank, removes the incentive for insured depositors to run.
Try it yourself
A solvent bank can still fail if depositors expect others to run, and deposit insurance removes the reason to run first.
The bank holds A$100 of deposits: a slice as liquid reserves, the rest lent out as illiquid loans worth full value at maturity but only a fraction if dumped early. Depositors are served in order. Move the sliders and watch the till.
Why it matters
If you fear others will withdraw first and drain the bank, your best move is to run too, which makes the fear self-fulfilling. A credible guarantee on your deposit removes the reason to run.
Deposit insurance prevents bank runs mainly by
Worked examples
A solvent bank faces a sudden rumor about its health. Why can it still fail, and what stops the panic?
It cannot sell illiquid loans fast enough to pay every depositor at once, so a pure liquidity run can sink even a healthy bank. Deposit insurance stops the panic by guaranteeing insured deposits regardless of the rumor.
Silicon Valley Bank, March 2023. On 8 March 2023 the bank disclosed it had sold about US$21 billion of available-for-sale securities, mostly long-dated Treasuries and mortgage-backed securities, at a realized after-tax loss of about US$1.8 billion because their market value had fallen after the sharp 2022-23 interest-rate rises. Why did this trigger a run, and what is the lesson?
The disclosure revealed a large unhedged interest-rate (duration) loss on long-dated bonds funded by a highly concentrated base of uninsured deposits, who had every incentive to flee first. A run of about US$42 billion in withdrawals hit on 9 March, and the FDIC placed the bank in receivership on 10 March 2023, the second-largest US bank failure at the time. The lesson is that a bank that looks solvent on a hold-to-maturity basis can still fail on a liquidity run once uninsured depositors rush the exit.
Common mistakes
- ✗Only insolvent banks suffer runs. Even a solvent bank can be brought down by a self-fulfilling liquidity run.
- ✗Deposit insurance is a free fix. It creates moral hazard, the hidden cost of the safety net.
Revision bullets
- •Banks are liquid for depositors but hold illiquid loans
- •Runs can be self-fulfilling, even at a solvent bank
- •Deposit insurance removes the incentive to run
Quick check
Deposit insurance prevents bank runs mainly by
Connected topics
More in Banking & Financial Regulation
Sources
- Mishkin (2018), Ch. 10Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.Bank runs, the government safety net, and deposit insurance.