Bank Run and the Threat to Financial Sustainability
The stability of financial institutions is a precondition for financing sustainable development as a whole. A stable financial system can efficiently allocate resources, assess and manage financial risks, maintain employment levels, and eliminate relative price movements of assets that affect monetary stability or employment levels. As a result, situations that increase the risk of financial instability are among the threats to sustainability that must be addressed. Among these, one stands out due to the magnitude of impact should it happen—enter "bank run.”
WHAT IS BANK RUN?
A bank run occurs when many customers withdraw their deposits due to concern about the bank's solvency or financial stability and fear that a bank will be unable to meet their withdrawal requests. The sudden demand for cash then uses up the bank's reserves, causing it to fail. Bank runs can be catastrophic for both the affected bank and, in a broader sense, the economy. If a bank cannot meet its customers' demands, it may be forced to liquidate its assets at a loss or seek a government bailout. This may lead to a domino effect, causing the collapse of other financial institutions, credit markets, and economic activities.
CASE STUDIES FROM TWO RECENT BANK RUNS
Silvergate Bank, a crypto-centric financial institution, announced on March 8 that it would cease operations and voluntarily liquidate. The failure of FTX (the crypto exchange that collapsed in November last year) prompted Silvergate's customers to withdraw $8.1 billion of their deposits immediately, resulting in the bank's shutdown. Another case is Silicon Valley Bank (SVB), which many tech start-ups used for holding the cash for payroll and other expenses. The bank's downward spiral started with its earlier decision to invest a significant portion of the deposits in bonds. Bonds have an inverse relationship with the Federal Reserve (the Fed)’s interest rates—as rates rise, bond prices fall. Therefore, when the Fed started to hike rates rapidly to combat inflation, SVB's bond portfolio lost significant value. When customers caught wind of this news, the mass withdrawal of money began and the rest is history.
HOW TO PREVENT THIS?
According to the International Monetary Foundation, one of the most robust and needed tools is the deposit guarantee system, a central bank's strategy for guaranteeing that the best interests of financial service consumers are protected. Another tool is for the central bank to perform its lender-of-last-resort (LOLR) function, which protects depositors and prevents customers from withdrawing in panic from banks with temporarily limited liquidity. Moreover, as rising interest rates to combat inflation are one of the primary causes of bank failure, the government and central bank must ensure the banking system's stability through specific measures to assist banks in the face of drastically rising interest rates. Financial institutions can modify their portfolios to avoid bank runs, such as by locating alternative sources of liquidity in order for interbank markets to provide this when there is little doubt about the institution's solvency.
Without financial institutions’ stability, it is impossible to achieve a sustainable society. Therefore, the government and central bank must step in to prevent the bank run by providing measures to ensure financial stability in situations where banks are facing a hard time with liquidity and for banks to offer better risk management in time of uncertainty.
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