When Banks Run, Hold On to Your Wallets

In recent years, traditional banking systems have been challenged by a series of bank runs, raising concerns about the stability of the financial ecosystem. While the causes of bank runs can be multifaceted, they often stem from concerns about the solvency of a particular institution or the overall financial system. In some cases, rumors or misinformation can trigger panic, while economic crises and poor management practices are the root cause in other instances.

Regardless of the catalyst, bank runs pose significant risks to the health and stability of the financial ecosystem and should be a gentle heads-up for what lies ahead.

What causes bank runs?

Bank runs happen when a large number of customers withdraw their deposits from a financial institution simultaneously, oftentimes fueled by fear or panic. On Friday, March 10, California-based Silicon Valley Bank (SVB), was forced to close. SVB was among the top 20 US banks by assets and its collapse was the second-largest bank failure in US history. The first was the fall of Washington-Mutual Bank during the 2008 financial crisis.

Bank runs are triggered by a loss of confidence in a bank’s ability to meet its obligations, usually due to concerns about its solvency or liquidity. This can be caused by various factors, including economic downturns, rumors of insolvency, or regulatory actions. In SVB’s case, it was a culmination of more than one of these factors.

Some other notable historical examples of bank runs include:

• The Great Depression (1929–1933): During this period, widespread bank failures and bank runs occurred in the United States, with more than 9,000 banks closing their doors. This led to the creation of the Federal Deposit Insurance Corporation (FDIC) in 1933, aimed at restoring confidence in the banking system by providing deposit insurance.
• Northern Rock (2007): In the United Kingdom, the bank Northern Rock experienced a bank run after it sought emergency funding from the Bank of England. Customers queued for hours to withdraw their savings, and the bank was eventually nationalized to prevent its collapse.
• The Cyprus Banking Crisis (2013): The Cypriot banking sector faced a severe crisis due to its exposure to Greek debt, leading to bank runs and the imposition of capital controls. As part of a bailout agreement with international creditors, uninsured depositors faced significant losses, further eroding trust in the banking system.

The Role of Inflation and Interest Rates in Bank Runs

Inflation refers to the rate at which the general level of prices for goods and services is rising, leading to a decrease in purchasing power over time. It can be influenced by various factors, including changes in demand for goods and services, fluctuations in the money supply, and external factors like oil prices or geopolitical events.

Interest rates on the other hand are the cost of borrowing money, expressed as a percentage of the principal amount. They are set by central banks, such as the Federal Reserve in the United States or the European Central Bank in the Eurozone. A critical tool for managing inflation and ensuring economic stability. Central banks raise interest rates to reduce the money supply and curb inflation or lower them to stimulate economic growth and increase the money supply.

How do inflation and interest rates affect bank solvency?

1. Lending activities: Banks make a profit by lending money to borrowers at higher interest rates than they pay to depositors. When interest rates are low, banks may increase their lending activities, leading to higher profits. However, this can also expose banks to greater credit risk, as borrowers may become over-leveraged and struggle to repay their loans, especially if interest rates continue to rise.
2. Asset values: Inflation can impact the value of a bank’s assets, such as loans and investments. If the inflation rate is higher than the interest rates on these assets, their real value will decrease over time, reducing the bank’s net worth and potentially affecting its solvency. A prime example of this is the fact that a considerable amount of SVB’s assets were tied down in
3. Deposit rates: In a high-inflation environment, banks may need to offer higher interest rates on deposits to attract and retain customers. This can increase their funding costs and reduce their profit margins, putting pressure on their solvency.
4. Loss of confidence: High inflation rates erode the purchasing power of money, leading depositors to lose confidence in the value of their savings. This may prompt them to withdraw their deposits and seek alternative investments, increasing the likelihood of a bank run.

The Contagion effect

Monkey see, monkey do.

Bank runs can spread from one institution to another, especially if they share similar risk profiles or are interconnected through their lending activities. When a bank run occurs at one institution, depositors at other banks may fear a similar fate and withdraw their funds, leading to a domino effect.

The contagion effect refers to the phenomenon where financial instability or bank runs in one institution can spread to other banks or financial institutions. This domino effect can exacerbate financial crises and lead to broader economic challenges, as the fear and panic among depositors can quickly escalate and affect the entire financial system.

One reason the contagion effect occurs is due to the interconnected nature of the global financial system. Banks often engage in interbank lending, borrowing from each other to meet their short-term liquidity needs. In times of crisis, if one bank faces a run and is unable to meet its obligations, it may default on its interbank loans, causing the lending banks to suffer losses. This can create a chain reaction, as the lending banks may then face their own liquidity shortages and struggle to meet depositor demands. As a result, depositors at other institutions may become concerned about the safety of their funds and initiate withdrawals, causing bank runs to spread further.

Another factor contributing to the contagion effect is the role of perception and herd mentality. When depositors see bank runs occurring at one institution, they may assume that other banks are also at risk, even if the underlying causes of the initial bank run are not present at the other institutions(See also: The FTX crisis and its impact on other institutions that were linked or invested in FTX). This psychological aspect can prompt depositors to withdraw their funds preemptively, fearing that their bank could be the next to face liquidity challenges. In this way, the contagion effect can be both a result of actual interconnected risks and the perception of risk, as fear and uncertainty can quickly spread throughout the financial system.

There is hope yet still…

Of the two banks that went under in the past two weeks, one of them being the previously mentioned SVB, and the others being Silvergate and Signature Banks — that regulators decided to dissolve due to their customer base of risky cryptocurrency firms. This illustrates a typical practice in conventional finance, wherein regulators intervene to prevent a spillover effect.

Be your own bank?

Decentralized Finance (DeFi) solutions may yet offer a way to mitigate the risk of bank runs and strengthen the financial system based on some fundamental differences they possess over traditional banks.

Enhanced Liquidity Management

Traditional banks operate on a fractional reserve system, meaning they only hold a fraction of their customers’ deposits in reserve and lend out the remainder. This practice can leave banks vulnerable to liquidity crises during periods of high demand for withdrawals, potentially leading to bank runs. The 2007–2008 financial crisis, for example, saw several instances of bank runs, such as the case of Northern Rock in the United Kingdom.

In contrast, DeFi platforms often adopt more transparent and efficient liquidity management practices. For example, DeFi lending protocols typically require over-collateralization, which ensures that the value of collateral exceeds the value of the loans issued. This approach reduces liquidity risks and can prevent a chain reaction of withdrawals that could lead to a bank run. MakerDAO, a prominent DeFi lending platform, is one example of a protocol that implements over-collateralization to maintain stability.

Self-Custody and Ownership

One of the critical differences between decentralized finance and traditional banking is the concept of self-custody. In a DeFi system, users maintain control over their assets through private keys, giving them direct ownership and responsibility for their funds. This contrasts with the traditional banking system, where customers entrust their money to a third-party institution.

Self-custody can offer greater security and reduce the risk of bank runs, as users can confidently manage their own assets without relying on the solvency of a centralized institution. Additionally, this model can help to promote financial responsibility and awareness among users, fostering a more resilient financial ecosystem. Wallets like MetaMask and Ledger are popular solutions for self-custody in the DeFi space.

Decentralized Governance and Risk Distribution

Decentralized finance platforms operate on blockchain technology, which enables peer-to-peer transactions and removes the need for traditional intermediaries such as banks. This decentralized approach can lead to greater financial stability, as it reduces reliance on a single institution and distributes risk more evenly across the network.

By implementing decentralized governance models, DeFi platforms can minimize the impact of individual failures and reduce the likelihood of a system-wide collapse. In the case of digital banks, their digital-first approach and lack of physical branches allow for more agile operations, enabling them to adapt more quickly to changing market conditions and customer needs. Projects like Compound and Aave have introduced decentralized governance systems that allow users to participate in decision-making processes, further distributing risk and responsibility.

Enhanced Security through Smart Contracts

Another significant advantage of DeFi platforms is the use of smart contracts, which are self-executing contracts with the terms of the agreement directly written into lines of code. Smart contracts provide a secure and transparent way to execute transactions and agreements, reducing the need for intermediaries and providing greater security against fraud.

This added layer of security can help to alleviate concerns about the solvency and trustworthiness of financial institutions, reducing the likelihood of bank runs caused by panic or misinformation.

Transparency and Trust

DeFi platforms provide a higher degree of transparency compared to traditional banks. Through the use of blockchain technology, DeFi platforms offer an open and transparent ledger of transactions, allowing users to audit the system and verify its solvency. This increased transparency can help to build trust and reduce the likelihood of panic-driven withdrawals.

Digital banks, on the other hand, leverage technology to deliver real-time transaction notifications, personalized financial management tools, and seamless integration with other financial platforms. These features can help to foster trust and a sense of control among customers, reducing the fear that often leads to bank runs.

While it is still early days for DeFi, these innovative solutions hold significant promise for addressing the challenges posed by bank runs and bolstering the stability of the financial ecosystem. By embracing these new technologies and working to integrate them into the existing financial landscape, we can move toward a more resilient and secure future for all market participants. As more people become familiar with the benefits of DeFi, we can expect a shift towards these platforms, creating a more robust and crisis-resistant financial system.

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