A bank run occurs when a large number of customers of a bank or other financial institution withdraw their deposits simultaneously due to concerns about the institution's solvency. This sudden and massive withdrawal of funds can lead to the collapse of the institution, as it may not have enough liquid assets to meet the demand for withdrawals.
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Bank runs can occur when depositors lose confidence in a bank's ability to repay their deposits, often due to rumors or concerns about the bank's financial health.
The fractional reserve banking system, where banks only hold a fraction of their deposits as reserves, makes banks vulnerable to bank runs, as they may not have enough liquid assets to meet withdrawal demands.
Deposit insurance, such as the Federal Deposit Insurance Corporation (FDIC) in the United States, is designed to prevent bank runs by guaranteeing the safety of deposits up to a certain amount.
Bank runs can have a contagion effect, where the failure of one bank can trigger runs on other banks, leading to a systemic crisis in the banking system.
Central banks often act as lenders of last resort during bank runs, providing emergency liquidity to banks to help them meet withdrawal demands and prevent the collapse of the banking system.
Review Questions
Explain how the fractional reserve banking system contributes to the risk of bank runs.
The fractional reserve banking system, where banks only hold a fraction of their total deposits as reserves and lend out the rest, makes banks vulnerable to bank runs. This is because if a large number of depositors attempt to withdraw their funds simultaneously, the bank may not have enough liquid assets to meet the demand, leading to its collapse. The fractional reserve system allows banks to create money through the multiplier effect, but this also increases their susceptibility to bank runs when depositor confidence is shaken.
Describe the role of deposit insurance in preventing bank runs.
Deposit insurance, such as the FDIC in the United States, plays a crucial role in preventing bank runs by reassuring depositors that their funds are safe up to a certain amount. By guaranteeing the safety of deposits, deposit insurance removes the incentive for depositors to withdraw their money en masse, even in the face of concerns about a bank's financial health. This helps maintain confidence in the banking system and prevents the contagion effect, where the failure of one bank can trigger runs on other banks.
Analyze the potential impact of a bank run on the broader economy and the measures central banks can take to mitigate the crisis.
Bank runs can have a significant impact on the broader economy, as the failure of one or more banks can lead to a systemic crisis in the banking system. This can disrupt the flow of credit, reduce economic activity, and erode consumer and business confidence. To mitigate the impact of a bank run, central banks often act as lenders of last resort, providing emergency liquidity to banks to help them meet withdrawal demands and prevent the collapse of the banking system. Additionally, central banks may implement other measures, such as lowering interest rates or implementing quantitative easing, to stabilize the financial system and promote economic recovery.
A banking system where banks only hold a fraction of their total deposits as reserves, and lend out the rest, allowing them to create money through the multiplier effect.