Recent Bank runs
We’re in 2023 and experiencing Bank runs again. The collapse of Silicon Valley Bank, the second-biggest bank failure in U.S. history, took place over less than 48 hours.
Bank runs are considered unavoidable in a fractional reserve banking system because banks hold only a fraction of their deposits as reserves, while lending out the rest. This system allows banks to earn profits on the interest charged on loans, but it also exposes them to the risk of not having enough cash on hand to meet sudden, large withdrawals by depositors.
What is Bank Run
A bank run is a financial crisis that occurs when a large number of depositors, either individuals or institutions, withdraw their deposits from a bank or financial institution at the same time. Bank runs can have severe consequences, including bank failures, economic recession, and even social unrest.
Bank runs typically occur due to a loss of confidence in the financial institution. This loss of confidence can be caused by several factors, such as rumors of insolvency or bankruptcy, news of fraud or embezzlement, or a sudden decline in the value of assets held by the bank. When depositors fear that their deposits may be at risk, they rush to withdraw their funds, causing a run on the bank.
Bank runs can quickly spiral out of control, as depositors’ withdrawals further reduce the bank’s reserves, making it difficult for the bank to meet all of its obligations. This can trigger a chain reaction, as other depositors also rush to withdraw their funds, leading to a vicious cycle of bank failures and economic contraction.
In conclusion, bank runs are a serious threat to the stability of the financial system, and they can have severe economic and social consequences. It is essential for governments, financial regulators, and banks to work together to prevent and mitigate the effects of bank runs, in order to ensure the safety and stability of the financial system for everyone.
Bank run mitigation
To prevent bank runs, governments and financial regulators often take steps to ensure the stability of the banking system. These measures may include deposit insurance schemes, which provide a safety net for depositors by guaranteeing their deposits up to a certain amount.
Central banks may also provide emergency liquidity support to banks in distress to prevent a bank run. This has also happened now with events around Silicon Valley Bank in the US. But also a “merger” of two largest swiss banks USB and Credit Suisse was backed by 260 billion Swiss francs ($280 billion) of state funds.
One of the possibilities is the usage of the Discount window. The discount window is a lending facility offered by a central bank to commercial banks and other financial institutions. Banks can borrow funds from the discount window on a short-term basis, typically overnight, to meet their liquidity needs or to fulfill reserve requirements. The interest rate (See Fed Discount Rate) charged on these loans is typically higher than the central bank’s target interest rate, making it a lender of last resort option.
However, banks are usually hesitant to borrow from the discount window, as it sort of sigma and may signal to the market that they are facing financial difficulties.
In the current situation, after the failures of Silicon Valley Bank and Signature Bank, Fed has additionally created The Bank Term Funding Program (BTFP). BTFP is a lender of last resort facility. It was created to lend to banks that had big unrealized losses on their holdings of government bonds and were, therefore, at risk of large-scale withdrawals of deposits. The new facility allows banks to exchange assets such as U.S. Treasuries for cash at their full-face amount, regardless of the current market value.
- Rate: The rate for term advances will be the one-year overnight index swap rate (This is essentially the average market interest rate on overnight loans) plus 10 basis points; the rate will be fixed for the term of the advance on the day the advance is made.
- Collateral Valuation: The collateral valuation will be par value. Margin will be 100% of par value.
- Duration: These loans are for up to one year.
As of March 15, banks borrowed $11.9 billion through the Bank Term Funding Program.
- Bank Term Funding Program rate: 4.70% as of March 23, 2023
Measures during financial crisis
During the financial crisis, central banks around the world took various steps to prevent bank runs and stabilize the financial system.
The Federal Reserve, for example, implemented several programs to provide liquidity to banks, including the Term Auction Facility, which provided short-term loans to banks, and the Term Asset-Backed Securities Loan Facility, which provided loans to financial institutions secured by asset-backed securities.
The European Central Bank also took measures to provide liquidity to banks, including the provision of emergency loans and the purchase of distressed assets.
The Bank of England introduced measures such as the Special Liquidity Scheme, which provided banks with access to long-term funding, and the Funding for Lending Scheme, which incentivize banks to increase lending to households and businesses.
Central banks also worked closely with governments to provide fiscal support and implement regulatory reforms to prevent future financial crises. These measures included increasing capital requirements for banks, implementing stress tests, and strengthening regulation of the financial sector.
Overall, the actions taken by central banks during the financial crisis helped to prevent widespread bank runs and stabilize the financial system.
How Bank runs can be prevented
Bank runs can be prevented or mitigated through several measures:
Strong financial regulation: Effective regulation can promote transparency and accountability, thereby improving the public’s confidence in the banking system.
Adequate bank reserves: Banks should maintain sufficient cash reserves to meet the expected withdrawals of depositors. This can help prevent a liquidity crisis during a bank run.
Deposit insurance: Deposit insurance schemes provide a safety net for depositors by guaranteeing their deposits up to a certain amount. This can reduce the risk of bank runs by assuring depositors that their money is safe.
Central bank support: In cases of extreme stress, central banks can provide emergency liquidity support to banks to prevent a bank run.
Communication: Banks can also communicate effectively with their depositors to address any concerns and maintain confidence in the banking system.
Implementing these measures can help prevent bank runs or at least mitigate their impact.