Blog Post

Preventing bank runs – a primer

Worries about Cyprus  at first decreased with the second agreement between the Cypriot government and euro area partners. Controversially, however,capital controls have been used as a way to prevent an outright bank run. This blog briefly reviews the literature on bank runs and comments on different ways to prevent them.

By: Date: April 2, 2013 Topic: European Macroeconomics & Governance

Worries about Cyprus  at first decreased with the second agreement between the Cypriot government and euro area partners.[1] Controversially, however, capital controls have been used as a way to prevent an outright bank run (see Darvas and Wolff 2013 and Wolff 2013). This blog briefly reviews the literature on bank runs and comments on different ways to prevent them

 Diamond and Dybvig (1983) showed that deposit-taking banks are vulnerable to a bad equilibrium where all depositors rush to withdraw their money simultaneously without the bank being able to repay them. This is because of the mismatch between liquid liabilities and illiquid assets, which renders it impossible for banks to reimburse all deposits instantaneously. Crucially, bank runs can be triggered not only as a result of negative new information about the solvency of a bank, but also as a self-fulfilling prophecy.[2]

To prevent the economically destructive recalling of loans once a stampede starts, banks subject to a run need to find an alternative source of liquidity. If there is little doubt about the solvency of the institution, interbank markets are able to provide this. The fall of Lehman Brothers showed though that these markets can seize up in situations of high uncertainty. Therefore more secure institutional arrangements are needed.

These are primarily the suspension of convertibility (up to a limit) and/or deposit guarantees. Both aim to ensure depositors that they will be able to withdraw their money when they need it instead of feeling forced to do it immediately. Capital controls can be considered a weaker, although often longer lasting, form of suspension of convertibility. Instead of limiting access to cash, they only confine it in a given geographical area.

However, bothsuspension of convertibility and deposit guarantees also have their weaknesses. Limits to convertibility can prevent not only panic-induced withdrawals but also restrict access to cash for households that genuinely need it. Ennis and Keister (2009) argue that such limits are therefore time inconsistent. Because governments are unwilling or find it hard to implement them, suspension of convertibility is not necessarily enough to prevent bank runs. A deposit guarantee system is more robust. Ultimately though, it is only as good as the creditworthiness of its guarantor.

An alternative way to respond to banking panics is for the central bank to perform its lender-of-last-sort (LOLR) function (Bagehot 1873). Nevertheless, it is primarily a complement and not a substitute to a deposit insurance system. The former primarily deals with illiquidity whereas the latter ensures depositors that they will be repaid even if a bank goes bankrupt. Deposit insurance aims to prevent a liquidity crunch by depositors whereas the LOLR is meant to ensure the provision of liquidity as a response to a dearth of general liquidity, not only deposits.

LOLR is less certain to prevent a bank run than a deposit guarantee because the central bank is only allowed to lend against eligible collateral and because it requires discretionary action, which renders it less certain than pre-specified rules (Cecchetti 2007). If depositors fear that banks are insolvent they have a reason to doubt that central banks will save them. This comes with Goodhart’ (1999) qualifier that it is difficult for central banks to ensure the solvency of the counterparty when acting as a LOLR. If a bank cannot obtain financing from the market, it most often means that its solvency is in doubt.

Repullo (2000) studies if it is better to allocate the responsibility for LOLR to the deposit insurance agency or the central bank. The division matters because of agency considerationsif the two institutions are primarily interested in their individual instead of social benefit. Repullo shows that if liquidity shocks are sufficiently small, it is optimal to entrust the central bank with LOLR responsibilities. Conversely, in the case of large shocks the deposit insurance system is the better guardian of the LOLR facility. The deposit insurance is always too stingy relative to social optimum to provide liquidity whereas the central bank is too lenient in the case of small shocks and even stingier than deposit insurance in case of large shocks.

The result stems from the fact that for small shocks the central bank prefers to avoid the certain cost of liquidation in favor of a positive probability of a loss on its loan. As the expected loss for the central bank increases with the size of the loan though, it becomes less and less willing to provide liquidity in the case of a large shock even if this would be socially optimal. The deposit insurance corporation on the other hand does not face increasing losses as a function of the size of the shock, because its maximum liabilities are capped by the total amount of deposits. However, this result depends on the assumption that banks only finance themselves with deposits that are fully insured. If this is not the case, the interests of the two agencies become more similar in case of a large liquidity shock. This leads to an expanded range of shocks for which the central bank should be the LOLR.[3]

Another relevant issue is the distinction between essentially random self-fulfilling runs and those based on revealed information about banks’ (in)solvency because they imply distinct optimal policy responses. If a run is random, there should be no costs to government from deposit guarantees and liquidity provision. Indeed, deposit insuranceshould prevent the run in the first place and inhibit any damage to the real economy. But if governments guarantee the liabilities of banks that are in fact insolvent, the fiscal costs of accommodating policies tend to be high (Honohan and Klingebiel 2003). Furthermore, Claessens et al. (2005) argue that government support during these ‘real’ banking crises does not even accelerate the subsequent recovery (even the contrary). The optimal policy in these cases is to restructure the banking system. To allow this to be done in the most efficient manner, governments should ensure the existence of a proper institutional resolution framework.

References

Allen, Franklin & Douglas Gale, 1998. "Optimal Financial Crises," Journal of Finance, American Finance Association, vol. 53(4), pages 1245-1284, 08.

Bagehot, Walter 1873, “Lombard Street: A Description of the Money Market”, revised edition with a foreword by Peter Bernstein. New York: Wiley (1999). 

Cecchetti, Stephen, 2007, “Subprime Series, part 2: Deposit insurance and the lender of last resort”. VoxEU column. http://www.voxeu.com/article/subprime-series-part-2-deposit-insurance-and-lender-last-resort

Claessens, Stijn & Daniela Klingebiel & Luc Laeven, 2005, “Crisis Resolution, Policies, and Institutions: Empirical Evidence” in eds. Honohan, Patrick & Luc Laeven, 2005, “Systemic Financial Crises: Containment and Resolution”.

Darvas, Zsolt & Wolff, Guntram, 2013, “It is not yet too late to drop the idea of capital controls in Cyprus, Bruegel blog 27.3.2013. /nc/blog/detail/article/1061-it-is-not-yet-too-late-to-drop-the-idea-of-capital-controls-in-cyprus/#.UVqSpReLCSo

Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.

Huberto M. Ennis & Todd Keister, 2009. "Bank Runs and Institutions: The Perils of Intervention," American Economic Review, American Economic Association, vol. 99(4), pages 1588-1607, September.

Goodhart, Charles A E, 1999. "Myths about the Lender of Last Resort," International Finance, Wiley Blackwell, vol. 2(3), pages 339-60, November.

Gorton, Gary, 1988. "Banking Panics and Business Cycles," Oxford Economic Papers, Oxford University Press, vol. 40(4), pages 751-81, December.

Honohan, Patrick & Klingebiel, Daniela, 2003. "The fiscal cost implications of an accommodating approach to banking crises," Journal of Banking & Finance, Elsevier, vol. 27(8), pages 1539-1560, August.

Kahn, Charles M. & Santos, Joao A.C., 2005. "Allocating bank regulatory powers: Lender of last resort, deposit insurance and supervision,"European Economic Review, Elsevier, vol. 49(8), pages 2107-2136, November.

Repullo, Rafael, 2000. "Who Should Act as Lender of Last Resort? An Incomplete Contracts Model," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 580-605, August.

Saunders, Anthony & Wilson, Berry, 1996. "Contagious Bank Runs: Evidence from the 1929-1933 Period," Journal of Financial Intermediation, Elsevier, vol. 5(4), pages 409-423, October.

Wolff, Guntram, 2013, “Capital controls will put euro at risk”, Bruegel blog 26.3.2013, /nc/blog/detail/article/1060-capital-controls-will-put-the-euro-at-risk/#.UVqQBReLCSo


[1] http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ecofin/136487.pdf

[2] For a model of an information-based bank run, see e.g. Allen and Gale (1998). Gorton (1988) and Saunders and Wilson (1996) have shown that most bank runs are indeed based on revealed information about banks’ increased insolvency risk.

[3] Kahn and Santos (2005) develop Repullo’s model further for example by studying the incentives for information sharing between different regulators.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.


Warning: Invalid argument supplied for foreach() in /home/bruegelo/public_html/wp-content/themes/bruegel/content.php on line 449
View comments
Read about event More on this topic

Upcoming Event

Apr
25
12:30

Central banking in turbulent times

This event will look at fundamental questions about the central banking systems and how the Great Recession might have prompted a reassessment of the old central banking model.

Speakers: Maria Demertzis, Paul De Grauwe, Marianne Nessén and Francesco Papadia Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Apr
26
16:30

Youth UP Europe: Future of democracy in Europe

Bruegel and the European Youth Forum are teaming up to organise an event series in which young people, researchers and policy makers debate policy issues relevant to the future of Europe.

Speakers: Anna Ascani, Alice Mary Higgins, Luis Alvarado Martinez, Thodoris Georgakopoulos and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More by this author

Podcast

Podcast

Director's Cut: EU risks US tariff pain in standing by the WTO

As global trade war continues to unfold, Bruegel director Guntram Wolff is joined for this Director's Cut of 'The Sound of Economics' podcast by Bernd Lange MEP, chair of the Committee on International Trade (INTA), to discuss Europe's options.

By: The Sound of Economics Topic: European Macroeconomics & Governance, Global Economics & Governance Date: April 18, 2018
Read article More on this topic

Blog Post

The European Globalisation Adjustment Fund: Time for a reset

It is only in the last decade that the EU has had an active policy to reintegrate workers who lost their jobs as a result of globalisation, through the European Globalisation Adjustment Fund (EGF). In this blog, the authors assess the performance of the Fund and make three recommendations to improve its effectiveness. To be more successful, the Fund should improve its monitoring and widen the scope of its usage.

By: Grégory Claeys and André Sapir Topic: European Macroeconomics & Governance Date: April 11, 2018
Read article More by this author

Opinion

How Should the EU Position Itself in a Global Trade War?

It is high time for the EU to work on more than just wishful thinking in response to the US challenge to global trade. With the first cracks appearing in the multilateral system, it will be difficult for the EU to maintain a middle course between the US and China.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance, Global Economics & Governance Date: April 5, 2018
Read article More by this author

Podcast

Podcast

Director's Cut: Developing deposit insurance in Europe

In this week’s Director’s Cut of ‘The Sound of Economics’ podcast, Bruegel director Guntram Wolff talks with Nicolas Véron, senior fellow at Bruegel, about the implementation of a European Deposit Insurance Scheme (EDIS), one of the three pillars needed for the completion of banking union.

By: The Sound of Economics Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: April 3, 2018
Read article More on this topic

Blog Post

Do wide-reaching reform programmes foster growth?

With growth gathering momentum in the eurozone, some have claimed this is the proof that structural reforms implemented during the crisis are working, re-opening the long-standing debate on the extent to which reforms contribute to fostering long-term growth. This column employs a novel empirical approach – a modified version of the Synthetic Control Method – to estimate the impact of large reform waves implemented in the past 40 years worldwide.

By: Alessio Terzi and Pasquale Marco Marrazzo Topic: European Macroeconomics & Governance Date: March 28, 2018
Read article More on this topic

External Publication

Europe in a new world order

The EU is a relatively open economy and has benefited from the multilateral system. We argue that the EU should defend its strategic interests. The Singapore ruling has offered a useful clarification on trade policy. Addressing internal imbalances would also increase external credibility. Finally, strengthening Europe's social model would provide a counter-model to protectionist temptations.

By: Maria Demertzis, Guntram B. Wolff and André Sapir Topic: European Macroeconomics & Governance Date: March 26, 2018
Read article More on this topic More by this author

Blog Post

The Brexit Transition Deal

Michel Barnier, the European Union’s Brexit negotiator, and David Davis, Britain’s Brexit secretary, announced a transition deal on March 19. We review recently published opinions about the deal and its implications.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: March 26, 2018
Read article More on this topic More by this author

Opinion

Greece must capitalise on its growth momentum

Better-than-expected growth performance reflects the underlying positive changes in the Greek economy – but net investment is in fact negative, while Greece has various institutional weaknesses. Further improvements must be made regarding Greece’s attractiveness to foreign direct investment. A new (at least precautionary) financial assistance programme would improve trust in continued reforms and also address eventual public debt financing difficulties.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: March 26, 2018
Read about event More on this topic

Past Event

Past Event

Could uncertainty derail the European recovery?

It is a contradictory time for Europe. The economy is recovering but the political climate is uncertain. There is excitement about common projects but also rifts and increasing nationalism and populism.

Speakers: Franco Bruni, Maria Demertzis, Zsolt Darvas and Marietje Schaake Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: March 22, 2018
Read article Download PDF More on this topic

Policy Contribution

The European Globalisation Adjustment Fund: Easing the pain from trade?

With the European Globalisation Adjustment Fund (EGF), the EU now has an instrument to help workers negatively affected by trade find new jobs. However, only a small proportion of EU workers affected by globalisation receive EGF financing. How to improve the EGF? Revising the eligibility criteria to qualify for EGF assistance, enlarging the scope of the programme beyond globalisation and collecting more and better data to enable a proper evaluation of the programme.

By: Grégory Claeys and André Sapir Topic: European Macroeconomics & Governance Date: March 22, 2018
Load more posts