Hailey College of Banking & Finance Lahore

Oct 13 - 19, 2008

The inherent instability of banking systems has always been a matter of concern for policymakers. Before the great depression of 1930 in USA, the world witnessed recurrent episodes of banking panics, where depositors suddenly demanded conversion of deposits into cash at all or many banks, forcing banks to suspend convertibility. Since then, the common view is that governments must intervene to prevent or reduce the frequency of panics and a myriad of regulatory schemes have been implemented across many countries. In spite of the repeated attempts to stabilize banking systems, most countries experienced episodes of banking crises whose frequency and intensity increased in the last twenty years. A panic that encompasses a large part of the banking system can seriously disrupt economic activity. During a run, a bank experiences much heavier demand for deposit withdrawals than it can easily meet. If the run is severe enough, the bank will not be able to meet the demands of all depositors trying to withdraw money and, consequently, will have to suspend payments. During a panic, runs occur on a large number of banks. Panics may occur because of regional or economy wide problems, such as a real estate bust, during which the portfolios of many banks lose value. If depositors have not completely lost confidence in the banking system, they will transfer their deposits from failing banks to solvent banks. But panics may also occur because runs on a few banks cause depositors at other banks to lose confidence and, therefore, to withdraw indiscriminately from both solvent and insolvent banks. These types of panics, which involve runs on a few banks spreading to otherwise solvent banks, are said to involve contagion.

One of the major roles of banks is to provide liquidity in the economy by allowing depositors to withdraw money from their bank accounts whenever they want to. But while banks have liquid liabilities, they invest a large part of their portfolios in long-term illiquid assets, for example, real estate or business loans. In normal circumstances, the bank's loan portfolio has some returns from loans that borrowers are paying back. Also, the bank holds enough liquid assets, such as Treasury securities, to meet the usual demand for withdrawals. However, if too many depositors want to withdraw their money, the bank will have to begin liquidating some of its long-term assets, for example, by selling them in a secondary market, before they mature. Typically, this early liquidation means the assets will not pay off as much as they would have, had the bank been able to hold them to maturity: the bank may have to sell the assets at "fire sale" prices. In other words, deposits are liquid-depositors can withdraw their money from the bank at any time. But loans are illiquid-it can be very costly to recall them and difficult for the bank to find a suitable buyer for them. While innovations in financial markets have permitted bank portfolios to become increasingly liquid-for example, through the securitization of mortgages and consumer loans-other bank assets, such as corporate loans, remain illiquid. Since all banks keep only a fraction of their deposits as cash, any level of illiquidity makes them vulnerable if demand for withdrawals is high enough. This problem can become so severe that it can lead to insolvency.

When depositors at one bank start a run, why do depositors at other banks often follow suit? Banks' ability to handle unusually large withdrawals depends on what proportion of their assets is liquid and the quality of their illiquid assets. If a depositor believes that other depositors at his bank plan to withdraw their funds, he may start worrying about his own money. He knows that if withdrawals are large enough, the bank could fail. In this case, an amount less than the initial deposit will be left for him if he waits too long, so he may decide to withdraw his deposits immediately. If all depositors share his beliefs, a run could start and that bank could fail regardless of the condition of its assets. A run on one bank may lead depositors at other banks to form similar beliefs about the behavior of other depositors and to start a run on their banks. In this case, failures could spread among both solvent and insolvent banks because runs on a large number of banks could lead depositors to lose confidence in the banking system as a whole.

Alternatively, depositors might have some information about the quality of their bank's assets. If the assets turn sour-for example, during a period of unfavorable economic conditions-these depositors might start a run on the bank. Subsequently, depositors at other banks may start runs if they think their banks have assets similar to those of the first bank. Thus, panics can be triggered when depositors, in the light of new information, revise their beliefs about the quality of their banks' assets.