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Bank Runs and Private Remedies

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Bank Runs and Private Remedies 43 Gerald P. Dwyer, Jr. and R. Alton Gilbert Gerald P. Dwyer, Jr., a professor of economics at Clemson University, is a visiting scholar and R. Alton Gilbert is an assistant vice president at the Federal Reserve Bank of St. Louis. Erik A. Hess and Kevin L. Kliesen provided research assistance. Bank Runs and Private Remedies URRENT banking regulation in the United lessened their impact. These private remedies States is based in part on the notion that both did not solve the problem of runs, but they did the banking system and the economy must be mitigate the effects of the runs on the banks protected from the adverse effects of bank and the economy. In this article, we explain the runs. An example often cited as typical is the private remedies for runs and provide some string of bank runs from 1930 to 1933, which evidence on the frequency and severity of runs conventional wisdom holds responsible for on the banking system. thousands of bank failures and the Banking Holiday of 1933 when all banks closed. The BANK RUN’S: THE THEORY runs on savings associations in Ohio and Mary- land in 1985 are more recent examples. Before examining the history of bank runs, it This conventional view is reflected in a recent is useful to consider why banks at-c vulnerable comment on the “Panic of 1907” in the Wall to runs. This examination establishes a frame- Street Journal (1989): work for determining the kinds of observations that would be consistent with their occurrence. Long lines of depositors outside the closed doors of their banks signaled yet another financial crisis, Runs on Individual Banks an all-too familiar event around the turn of the century. In a run, depositors attempt to withdraw cur- rency from a bank because they think the bank Research in the last few years on bank runs will not continue to honor its commitment to indicates that the conventional view is mistaken. pay on demand a dollar of currency for a dollar Runs on the banking system were not common- of deposits.’ One aspect of the contract banks place events, and their impact on depositors and make with their customers is central to under- the economy easily can be overstated. Prior to standing why depositors would run on their the formation of the Federal Reserve System in bank. Banks make contractual promises that 1914, banks responded to runs in %vays that they cannot always honor: exchange of gold or ‘Salant (1983) provides a general analysis of the break- liabilities at par. The mapping from speculative attacks into down of such arrangements as bank redemption of its bank runs is discussed by Flood and Garber (1982). MAY/JUNE 1SBE 44 currency at par value for bank liabilities.’ When The effects of a run by depositors on one banks issued notes as a form of currency, the bank can be illustrated by an example. Table 1 promise was a contractual agreement to deliver shows the balance sheet of a hypothetical na- specie (gold or silver) in exchange for the bank’s tional bank in New York City in the national notes at par value. Banks currently promise to banking period (1863 to 1914). Its liabilities in- deliver U.S. currency to depositors on demand clude deposits and national bank notes backed at par value. Because banks hold reserves that by securities deposited with the Treasury. In are only a fraction of their liabilities payable on the event of the bank’s failure, the notes were demand, they cannot honor this promise if all guaranteed by the U.S. Treasury, whether or of their depositors try to convert deposits into not the deposited bonds were sufficient backing currency at the same time. for the notes. Apparently as a result of this Fractional-reserve banking by itself is not suf- guarantee, runs on banks in the national bank- ficient to make it impossible for banks to honor ing era were runs by depositors, not by note their promises to deliver currency in exchange holders.’ for deposits on demand. Banks always could During tlus period, national banks in New honor a promise to pay currency at a variable York City were required to maintain reserves of exchange rate of currency for deposits. If all specie and legal tender equal to 25 percent or depositors want to exchange their deposits for more of deposits, with the required ratio of currency at the same time, banks do not have reserves to deposits lower for national banks in sufficient currency (or’ other reserves that can other cities. Banks generally held excess re- be transformed into currency on a dollar-for- serves as a buffer stock to meet deposit with- dollar basis instantaneously) to meet that de- drawals, but we use a reserve ratio of 25 per- mand for currency at a price of one dollar of cent to keep the numerical example simple. ‘l’he currency for one dollar of deposits.’ second part of table I shows the initial loss of in the normal course of affairs, the inability reserves upon withdrawal of $2 million of of all depositors to exchange their deposits for deposits, while the last part indicates the reac- currency is irrelevant. As some depositors with- tion of the bank to the decrease in deposits. An draw currency from a bank, others deposit it. individual bank can replenish its reserves by The low probability of every depositor closing selling assets; in the example, the bank returns his or her account at the same time is the its reserve ratio to 25 pci-cent by selling $1.5 reason a bank usually can operate with frac- million in assets. At least part of the reserves tional reserves and pay currency on a dollar- are from other banks, thereby transmitting the for-dollar basis. reserve loss to other banks. A low probability is not the same as a zero In a i-un on a single bank, the specie and legal probability though. Information or rumors tender withdrawn from the bank are likely to which suggest a capital loss by a bank may in- be largely deposited in other banks. As a result, duce its depositors to attempt to convert their 4 a run on a single bank is not likely to drain deposits to currency. The mere expectation reserves from the banking system or increase that other depositors will attempt the same con- currency held by the public. If the currency version also can cause a run on a hank. A run withdrawn is deposited in other banks, the net on a single bank is unlikely, however, to have effect on the bank’s balance sheet is that shown substantial effects on the economy. The primary in table 1, and the deposit and reserve loss at effect of a single bank closing is that the bank this bank is matched by a similar’ increase in winds up its affairs and no longer operates. deposits and reserves at other banks. ‘Whether this promise is a result of market forces or While default generally is not the expected outcome of a government regulation is an open question. Davis (1910) contract, it does happen. 4 summarizes the laws in the United States in the 19th cen- Among others, Diamond and Dybvig (1983) and Gorton tury, and Schweikart (1987) provides the historical devel- (1985a) present models of runs. opment of these laws in the South in the 19th century. 5 In banking panics prior to the national banking era, ‘Promises that cannot be kept in all states of the world are hardly unique to banking. For instance, firms often cannot customers of banks attempted to redeem their bank notes for specie. For details on the backing for notes in the na- make payments on debt if there is a large decrease in the tional banking era, see Friedman and Schwartz (1963), pp. demand for their products. The common legal word for 20-23, 781-82. failure to honor contractual commitments is “default.” FEDERAL RESERVE BANK OF St LLU-tS 45 N’ ,,, ‘ Tabiel ,, N BaI~à$beet*1 a t4~tIonaIBank In New York CityWith a Large Nw8thdtawai of*wo (mi1Iion~of dollars) 1uthAl~BAIAN* ~HEE? Assets N LisF~dtt1es 5 DØ)~OSS *09 tsØsf$rtd*) Nota I 0 ,n*ssn~itig~a$S~ “I~te , ,N~t~vorth , \zs Ssásets~ “s” “ Totstiiabthtes’ $36 ‘~~MMS!S~. tfl$aRA~~$2~tUOMS\p~, NN Assets N -\ ~“ N N “ NN V ~‘N\~tGtVSt\ ~N\ ,~ N’ , ~poS $80 N N,, N’,N Sti~s ‘‘N N$wt’, NN N Tawlla~lnttes N Afl~NEsTOSXtK*’ÔP RESE~W~!$AT1o ‘ton ~ACENT N NN~N :“ N UIbilttes 4fl N NotesD~posi$ N\M$rN ~$SSN t4wfl 25 NN \‘N tIS T1a~brfrtt~S $14 N Runs on the Banking System term that has a connotation of unreasoning fear or hysteria. Contagious runs, however, can be Runs on a single bank can develop into runs 6 based on the optimal use of all information by on the banking system. An important, if seem- all agents. As a simple example, suppose that ingly obvious, aspect of banking is that the like- two banks are identical in all respects known lihood of a bank’s default on its deposit agree- by depositors, and one of the two fails because ment is not known with certainty by depositors. of loan losses. Because of the first failure, de- Instead, depositors estimate this likelihood as best they can with available information. One positors will increase their estimate of the pro- type of information that can be useful in bability that the second bank will fail.
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