What is a bank run?

A bank run is when large numbers of customers, fearing their bank will become insolvent, withdraw their money from that institution.

During the Great Depression, millions of consumers lost their life savings due to bank runs.

In response to that, Congress created the Federal Deposit Insurance Corporation (FDIC) to maintain stability and public confidence in the country’s banking system. The FDIC serves as an independent agency that protects consumer bank deposits should a financial catastrophe strike.

With this layer of protection, the risk of putting your money in a bank is significantly reduced. But there’s always a risk — which is why it’s helpful to understand bank runs and how to avoid being swept away by a wave of panic.

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How a bank run works

Wait, you’re probably asking yourself, why does a bank fail simply because people take their own money out of it?

Bank runs occur because, like most other developed countries, the United States operates on a fractional reserve banking system. What that means is that banks only keep a fraction of their customer’s deposits in cash in their vaults and ATMs.

The rest of the money is kept in loans and other investments.

You’ll find that most banks and financial institutions even have set limits on how much they can keep in their vaults day-to-day for security purposes. And the Federal Reserve Bank also limits in-house cash maximums for institutions.

Banks can run on this system because it’s extremely rare for all their customers to need their cash at the same time. But there’s a tipping point. When a large number of customers start clamoring to withdraw their money, the bank can become overwhelmed.

And if enough customers withdraw their funds, the bank will be forced to sell off investments or long-term assets to keep up.

If this is taking place during an already uncertain or depressed financial period, the bank may experience sizable losses when cashing in its investments, compounding its precarious position.

The impact of a bank run

The problem is the rumor of a bank’s possible insolvency can sometimes be a self-fulfilling prophecy. There’s a big difference between not doing well and being on the verge of bankruptcy.

But if consumers panic and pull their money out of a bank when they hear its future may be precarious, that may guarantee the financial institution’s failure.

At a certain point, the bank won’t be able to keep up with demand for withdrawals, which only increases consumer panic.

It’s kind of like a game of musical chairs: No one wants to be the last person to take a seat. But pushing each other out of the way to get a chair only increases the chaos.

The collapse of Lehman Brothers is the largest bankruptcy proceeding in U.S. history and kicked off the 2008 financial crisis. Following the Chapter 11 filing, the Dow Jones fell 504 points — its biggest drop since 2001 — and sent the financial markets into chaos.

Before it filed for bankruptcy, Lehman Brothers had been the fourth-largest investment bank in the U.S. The federal government could not nationalize an investment bank so the 164-year-old firm could not be taken over by the FDIC. The firm folded with more than $600 billion in debt and global markets plummeted.

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FDIC provides consumer insurance

Bank runs (and bank failures) have become far less common since the introduction of the FDIC.

But the most important thing the FDIC has provided is consumer confidence. Even if a bank run occurs and your institution fails, it doesn’t necessarily mean you’ll lose your deposits.

FDIC insurance covers any losses you see in your checking and savings accounts as well as other deposit accounts up to $250,000. Don’t panic if you have more money in the bank than that, the FDIC covers that limit for each of your qualifying accounts.

Sometimes another banking institution will assume the deposits of a failed bank. When that happens, you should be able to continue your regular banking without issue.

Best places for your money

We understand it can be scary to think your hard-earned dollars might disappear if your banking institution fails. But you’re not better off keeping it in cash under your mattress either.

A high-yield checking account or savings account are trustworthy and profitable places to keep your funds.

And there are still options out there for free checking accounts to help you save hundreds of dollars in fees.

Whatever you do, find an insured institution you trust and keep your money there.

If you’re just storing your money in cash, it’s not keeping up with inflation. Putting your money in the bank ensures it’s working as hard as you do.

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About the Author

Sigrid Forberg

Sigrid Forberg

Reporter

Sigrid is a reporter with MoneyWise. Before joining the team, she worked for a B2B publication in the hardware and home improvement industry and ran an internal employee magazine for the federal government. As a graduate of the Carleton University Journalism program, she takes pride in telling informative, engaging and compelling stories.

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