What are Bank Runs? | Barita Insights | March 21, 2023

Introduction
Silicon Valley Bank (SVB) was a California-based commercial bank that specialized in banking for venture-backed tech startups and many firms in Silicon Valley. The bank failed on March 10th, 2023, and management was taken over by the Federal Deposit Insurance Corporation (FDIC). On this day, deposits also began to leave Signature Bank, a New York-based bank that specialized in lending to real estate companies and law firms. Both bank failures were the result of runs on the bank, that is large swaths of depositors withdrew their funds at the same time, leading to the bank being unable to meet its obligations

The Banking System
The modern banking system is characterized by fractional reserve banking. This means that banks need to only keep a fraction of the total deposits made by customers in reserve, while the remainder is lent out to borrowers or invested. As a result, the bank can lend out more money than it has in reserves, which allows for increased lending and investment activities.

For example, if a bank has $1,000 in deposits and a reserve requirement of 10%, it must keep $100 in reserve and can lend out the remaining $900. This $900 loaned out can then be deposited into another bank, which in turn can lend out a fraction of that deposit, and so on, creating what is known as the money multiplier effect.

However, this system also carries risks for both the bank and the economy. If too many depositors demand their deposits in too short of a period, a bank run is established, and the bank may fail due to its inability to make funds available to pay out all customers at once. As more people withdraw their funds, the probability of default increases which leads to more people withdrawing their deposits. In extreme cases, such as the start of the great depression in the 1930s, bank runs can be systemic, and the failure of multiple banks can seriously hurt the economy.

Why fractional reserve banking?
Fractional reserve banking is the norm in almost every country on Earth due to its many benefits to economic activity and efficiency. Banks use fractional reserves primarily to allow loans to be written to consumers and businesses. Without this, an economy’s growth is incredibly limited as the money needed for investing activities and capital expenditure simply would not be in circulation. To compensate and incentivize depositors for this activity, banks then pay interest on clients’ accounts. This system makes banks more efficient as banks simply do not need to hold large amounts of capital. Depositors rarely need access to all their savings at once, so freeing up this capital for further economic activity is a net benefit. Mortgages, auto loans, commercial and other loans are all made possible by fractional reserve banking.

So what causes bank failures and should you be worried?
The American and broader global banking industry has become volatile because of the quickly changing interest rate environment. Among speciality banks, such as SVB and Signature, a combination of two main factors influenced the uncertainty in the market. These were the large portion of deposits being held outside of the FDIC insurance limits. The Federal Deposit Insurance Corporation (FDIC) insures all US bank deposits up to a US$250,000 limit per depositor. This means that in the event of a bank failure, amounts up to US$250,000 are federally insured and depositors will receive funds. We have a similar corporation, the Jamaica Deposit Insurance Corporation (JDIC) which insures deposits of up to JMD$1,200,000. In the rising rate environment, overall liquidity and access to short-term funding have become more difficult for the speciality clients served by SVB and Signature Bank; withdrawal of deposits has increased in the prior months, leading to liquidity issues in these banks. An attempt by SVB to raise equity capital to ease these concerns triggered a bank run on the largely uninsured deposits causing the failure of the institution. It is notable that despite large amounts of deposits being uninsured at these banks, in a joint statement between the Federal Reserve, the Treasury Department and the FDIC, it was announced that all deposits held in SVB and Signature bank would be protected and that all depositors will be made whole. This was achieved through the FDIC’s “systematic risk exception” allowing them to pay back uninsured deposits. Swift action by the US central bank and the US government has seemed to prevent short-term contagion from spreading throughout the banking sector. There is a commitment to maintaining the integrity of the banking sector throughout the US and by proxy the world. The failures seen in the US were atypical and were the result of a specialized client base combined with poor risk management.