They can start with as little as a rumor; whether fact or fiction, some new information emerges that spooks depositors or investors, or otherwise convinces them that the institution to which they have entrusted their money isn’t going to be able to cover its debts or obligations. Predictably, those who had deposited or invested their money at the institution in question lose confidence, and this loss of confidence sparks a run on the bank.
The image that comes immediately to mind probably looks something like this: long lines of anxious depositors queued down the block, more frantically hustling from their jobs to join; inside, tellers issue bills at a plodding pace, counting out notes to those lucky depositors who got to the bank at the first news of trouble, while in back the bank manager paces and frets as the bank’s reserves run lower and lower.
This scene, familiar to anyone who has seen the 1946 Frank Capra classic It’s a Wonderful Life or is otherwise familiar with the black-and-white photos in economic history textbooks, has virtually no bearing whatsoever on modern bank runs—Northern Rock standing as a notable exception.
For one thing, in the case of most depositors the entirety of their bank balance is ensured by the Federal Deposit Insurance Corporation (FDIC); that is, whether the bank goes bust or not, they stand to get all the money they lost paid back to them by the government. Second, most money has been digitized; by the time Tom, Dick, and Harry get the news and start running for their cars to get downtown, it’s all over. Third, and most important for understanding systemic risk in modern finance and banking, is the short-term funding mechanisms institutions use to fund their balance sheets.
To highlight and examine the mechanics behind a modern bank run, the climax of the global financial crisis in the autumn of 2008 provides a textbook example, because it was precisely this third facet of modern bank runs that caused Lehman Brothers to collapse so abruptly.
Banks borrow short to lend long; this is the basic premise of all modern banking, whether commercial, investment, or so-called shadow lending. In the classic case, and even, to an extent, under the early fractional reserve banking of the Federal Reserve System, banks’ biggest stock of capital came from their depositors. These depositors placed their money in the bank, thereby enabling it to make loans, open new locations, or branch out into other product services. The spread, the difference between the lower rate paid to depositors and the higher rate it charged borrowers, formed the basis of the bank’s profits.
This period of so-called 3–6–3 lending, borrow at 3 percent, lend at 6 percent, and be on the golf course by 3 o’clock, was primarily driven to extinction by the onset of high and persistent inflation caused by government overspending. Beginning in the late 1960s, and worsening in the following decade, the hitherto safe and stable banking system operating under the monetary auspices of the Bretton Woods system broke down. The high inflation rates ate away the bankers’ spread, making their former business of taking deposits and lending for thirty-year mortgages a money-losing venture.
So began thirty years of rapid financial innovation. One of these innovations, the repo (repurchase) market, is at the heart of modern bank runs.
Simply put, the repo market is a short-term funding mechanism allowing borrowers to access liquidity from willing lenders. This is done by way of repurchase agreements: contracts that allow a borrower to exchange a securitized asset for cash in exchange for a small premium, or implicit interest rate, to be repaid upon repurchase. These contracts can range as long as a month or three months but typically span just a single day. In the context of modern bank runs, then, it is best to think of these as short-term deposits: losing confidence in the institution into which they are “depositing” money daily, repo lenders pull back, refusing to renew the repo: the following day, shut out of short-term credit markets, the borrowing institution faces an immediate liquidity crisis.
Take the example of Bear Stearns, on the eve of the financial crisis one of the most profitable investment banks on Wall Street. It was regularly financing $70 billion each day through the repo market. This was far from ordinary. Bear Stearns just happened to be the first major Wall Street firm to get shut out of the repo market because of word that it was in trouble due to its exposure to subprime collateralized debt obligations (CDOs) and mortgage-backed securities (MBS). The same thing would happen to Lehman Brothers a week later.
Like deposit-based fractional reserve banks, these financial institutions don’t keep enough assets on hand to cover their obligations. When access to cheap credit dries up, or the value of the assets backing the commercial paper they issue drops suddenly, their hitherto profitable loan book becomes unserviceable. An attempt to sell assets by an institution facing such a sudden liquidity crisis can drastically drop the prices of a wide range of assets, thereby endangering the short-term financed balance sheets of similar institutions. This is why the Fed, following Lehman’s collapse, took the approach that any single failure could mean systemic failure.
Though the profits to be made by leveraging investments using short-term credit instruments were and are enormous, it is almost certain banks would think twice about engaging in such risky behavior were it not for the moral hazard built into the modern US financial system. Beginning in the late 1980s major institutions came to expect that if they got themselves into trouble the Fed or Treasury would bail them out—either directly or by forcing a deal on another bank to absorb their own failing enterprise.
It is a straight line from the savings and loan (S&L) bailout to Long-Term Capital Management to Bear Stearns.
But moral hazard in modern banking is another topic entirely.
