Understanding bank run, consequences for economy

It sparks industry-wide panic that can lead to financial crisis, deepen recession

KARACHI:

As the world tries to limp onwards from the Covid-induced supply chain challenges, economies are going into overdrive and heating up to a recession.

We are still grabbling to understand the cool-down impact on the economy of quantitative tightening, and waiting to witness any positive outcome of inducing recession via higher interest rates.

The zillion-dollar question that remains to be answered is whether the crisis has deepened, how far are we from the bottom and how long would the crisis linger on. The banking industry is bursting at the seams, as banks in the US, Switzerland, Germany, and South Africa have started to collapse. On the face of it, this looks counter-intuitive.

Textbook finance teaches us that as rates rise, banks tend to make higher spread as their NII (net interest income) rises. This is attributed to the fact that banks have more room to play with and charge a larger spread between the borrowing and lending rates. While this is true, there exists a difference in the sensitivity of assets and liabilities. Sensitivity is termed as the speed with which the rates on assets (loans made by a bank) and liabilities (deposits taken by the bank) align to the current market rates.

Generally, liabilities (deposits) have a higher sensitivity to interest rates while assets (loans) are repriced with a lag. Resultantly, in the immediate period of rate adjustments, interest spreads for the bank would be lower but as the market settles down the bank’s assets would be repriced and consequently, the spread would increase above the pre-rate rise times.

What we see currently happening in the banking industry can be termed a bank run. Simply stated, when a large number of depositors try to withdraw their money from a bank simultaneously, either as cash or as a transfer to other banks, the institution becomes unable to meet the demand for withdrawals and potentially becomes insolvent.

The banking system currently operates on what is referred to as the “fractional reserve banking system” under which institutions retain a small portion of their customer’s deposits in cash and liquid assets while the remaining amount is held in productive assets such as government bonds, corporate loans, mortgage-backed security, etc. Bank runs can have serious consequences for the affected bank, its customers, and the wider economy as a whole.

An uncontrolled bank run can wipe out shareholders, bondholders, and depositors (beyond the insured amount). As multiple banks get involved, it sparks a cascading industry-wide panic that can lead to a financial crisis and deepen the current economic recession.

There are several factors that can trigger a bank run such as a sudden loss of confidence in the bank’s ability to repay its obligations or rumours spreading about the bank’s financial health.

Issues that can cause ripples in the industry are potential or actual insolvency, the discovery of fraudulent activity, or as in the current situation concerns about capital adequacy due to huge mark-to-market losses in the bond portfolio. In some cases, the general unease about the economy can cause people to withdraw their money from banks and shift to other hard assets or cash, even if there is no evidence to suggest that their particular bank is in trouble.

The issue is that bank runs are a self-fulfilling prophecy, as the withdrawals of large sums of money by depositors would cause even a sufficiently strong bank to temporarily run out of cash and eventually collapse.

Bank runs have been a common occurrence throughout history, and have been known to lead to financial crises. Most famous example of a bank run was the Great Depression of the 1930s when millions of Americans lost their savings due to bank failures.

In 2008, the failure of Lehman Brothers triggered a series of bank runs and financial crises around the world and highlighted the need for better regulation and oversight of the banking industry, and saw the implementation of a series of new rules and regulations aimed at preventing future crises.

Not to mention just a few days back, comments from a senior representative of a group, holding minority shares in Credit Suisse, resulted in its share value going into a tailspin and culminating in its merger into UBS.

Proactive management from banks and regulators is required to ensure that the financial system remains stable and robust enough to absorb such shocks.

Insuring deposits, especially for small depositors, would create a sense of security such that they are less likely to withdraw funds in panic. Central banks can provide liquidity support to banks that are experiencing a liquidity crunch, by lending money to them or buying their assets, thus averting a potential crisis. Nevertheless, bank runs are bound to happen, and monitoring the health of financial institutions, improving risk management practices, and transparent communication by banks and regulators would be pivotal to maintaining a sense of calm during times of stress.

The writer is a student of behavioural finance, a treasury & wealth management professional and a visiting faculty at IBA

 

Published in The Express Tribune, April 10^th, 2023.

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