The most recent panic story about the US economy came a few days ago, when the IndyMac bank failed, following a classic run on the bank. Pretty well everyone knows a run on the bank is a bad thing: older readers will remember having heard about the bank runs that were the opening act of the Great Depression — which, of course, makes the phrase “bank run” all the more frightening.
Reading about it in the papers, listening to the legacy media talk about it, it has become clear that people know a bank run is a bad thing, but they don’t know just what a bank run is.
To understand a bank run, the first thing we need to do is think about how a bank works as a business. What banks do is loan money, charging interest. To do that, they have to have money: that comes from the bank’s stockholders to start with, then is followed by money from depositors; the bank pays the depositors interest, and then if all goes well, they make a profit to pay back to the stockholders.
To keep this to a reasonable sized article, we’re going to think about a really simple bank — the Bailey Savings and Loan of Bedford Falls. It’s a small, family-run savings and loan in a mill town. In addition to the investment of the stockholders — primarily the Bailey family members themselves — there are a lot of small depositors. The depositors have savings accounts (this is an old-fashioned S&L, no checking accounts) and the bank loans money on mortgages and real-estate. People get mortgages in order to buy homes. This lets them pay for the home over a long time, while paying the Bailey S&L interest. The income from mortgage interest lets the Baileys pay the depositors and, with luck, keep a little for themselves.
Bailey S&L, like other banks, has to do a bit of a balancing act. They want to loan out as much money as they can, because the more they loan out, the more revenue they get. That’s what they make money on.
On the other hand, when they loan out the money, it goes to builders and plumbers and the people who sell homes. It’s not in a swimming pool in the basement where George Bailey can play Scrooge McDuck with it. So when a depositor comes in and wants some of their savings back for Christmas presents, Bailey S&L needs to have some cash — not a swimming pool full, but at least maybe a bathtub’s full. So the Bailey S&L keeps a cash reserve, say five percent of their total deposits. The other ninety-five percent is in their part ownership of houses and businesses through those mortgages. This is called fractional reserve banking, and it’s the way all banks, credit unions and similar institutions work.
This fractional reserve is what makes a bank run possible. For whatever reason, the rumor gets around that the Bailey S&L has financial problems. The people who have their savings in the bank (perfectly reasonably) don’t want to lose their money, and go to see George Bailey asking for their money back. If enough people do this, the bank becomes “illiquid,” which just means the bathtub is empty. When that cash reserve is exhausted, the bank has to shut down until it can get more, and since the other ninety-five percent of its money is in real estate mortgages, it can’t do that easily. So someone has to come along and buy the assets, providing cash for the panicky depositors, and since it’s a forced sale, the odds are good they’ll buy the assets at a discount. Someone gets the assets cheaply, but the Bailey S&L (and the Bailey family) is ruined, and the depositors may not get all their savings back either.