What is a Bank Run?

An Introduction to Bank Runs and the Modern Banking System

Crowds entering bank
Crowds entering bank. Getty Images/Katrina Charmatz/Illustration Works

Definition of a Bank Run

The Economics Glossary gives the following definition for a bank run:

"A bank run takes place when the customers of a bank fear that the bank will become insolvent. Customers rush to the bank to take out their money as quickly as possible to avoid losing it. Federal Deposit Insurance has ended the phenomenon of bank runs."

Simply put, a bank run, also known as a run on the bank, is the situation that arises when a financial institution's customers withdraw all of their deposits simultaneously or within short succession out of fear for the bank's solvency, or the bank's ability to meet its long-term fixed expenses.

Essentially, it is the banking customer's fear of losing their money and distrust in the sustainability of the bank's business that leads to a mass withdrawal of assets. To gain a better understanding of what occurs during a bank run and its implications, we first must understand how banking institutions and customer deposits work.

How Banks Work: Demand Deposits

When you deposit money into a bank, you will generally make that deposit into a demand deposit account such as a checking account. With a demand deposit account, you have the right to take your money out of the account on demand, that is, at any time. In a fractional-reserve banking system, however, the bank is not required to keep all of the money in demand deposit accounts stored as cash in a vault. In fact, most banking institutions only keep a small portion of their assets in cash at any time. Instead, they take that money and give it out in the form of loans or otherwise invest it in other interest-paying assets.

While banks are required by law to have a minimum level of deposits on hand, known as a reserve requirement, those requirements are generally quite low as compared to their total deposits, generally in the range of 10%. So at any given time, a bank can only pay out a small fraction of the deposits of its customers on demand.

The system of demand deposits works quite well unless a large number of people demand to take their money out of the bank at the same time and over the reserve. The risk of such an event is generally small, unless these is reason for banking customers to believe that money is no longer safe in the bank. 

Bank Runs: A Self-Fulfilling Financial Prophecy?

The only causes required for a bank run to occur is the belief that a bank is at risk of insolvency and the subsequent mass withdrawals from the bank's demand deposit accounts. That is to say that whether the risk of insolvency is real or perceived does not necessarily impact the outcome of the run on the bank. As more customers withdraw their funds out of fear, the real risk of insolvency or default increases, which only prompts more withdrawals. As such, a bank run is more a result of panic than true risk, but what may begin as mere fear can quickly produce a real reason for fear.

Avoiding the Negative Effects of Bank Runs

An uncontrolled bank run can result in a bank's bankruptcy or when multiple banks are involved, a banking panic, which at its worst can lead to an economic recession. A bank may try to avoid the negative effects of a bank run by limiting the amount of cash a customer can withdraw at one time, temporarily suspending withdrawals altogether, or borrowing cash from other banks or the central banks to cover the demand.

Today, there are other provisions to protect against bank runs and bankruptcy. For instance, the reserve requirements for banks have generally increased and central banks have been organized to provide quick loans as a last resort. Perhaps most important has been the establishment of deposit insurance programs such as the Federal Deposit Insurance Corporation (FDIC), which was set up during the Great Depression in response to the bank failures that exacerbated the economic crisis. Its aim was to maintain stability in the banking system and to encourage a certain level of confidence and trust. The insurance remains in place today.