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February 15, 1988

•

Footnotes

1. For a formal treatment of these types of
bank runs, see Douglas W. Diamond and
Philip H. Dybvig, "Bank Runs, Deposit
Insurance, and Liquidity," journal of Political Economy, vol. 91, no. 3 (june 1983),
pp.401-419.
2. See Charles Mackay, Extraordinary
Popular Delusions and the Madness of
Crowds, London: Richard Bentley, 1841.
For a dissenting opinion to this popular
belief, see Peter Garber, "Digging for the
Roots of Tulipmania," The Wall Street
journal
January 4, 1988. He argues that
the "tulip bubble" was not a bubble but in
fact is explainable by market fundamentals.
3. See Gary Gorton, "Banking Panics and
Business Cycles," Working Paper No. 86-9,
Federal Reserve Bank of Philadelphia,
March 1986.
4. See George]. Benston, Robert A.
Eisenbeis, Paul M. Horvitz, Edward]. Kane,
and George G. Kaufman, Perspectives on
Safe and Sound Banking: Past, Present,
and Future, Cambridge, MA: The MIT
Press, 1986, p. 64.

eCONOMIC
COMMeNTORY

Learn What from the Failure and Delayed
Bailout of the ODGF?" in Merging Commercial and Investment Banking: Proceedings of A Conference on Bank Structure and Competition, Federal Reserve
Bank of Chicago, May 1987.

Federal Reserve Bank of Cleveland

6. That is, of a group of assets that seem
identical, banks will sell off the least
desirable of the assets first. In the case of a
run, the bank will want to minimize the
costs of getting quick cash and will first
sell assets with no informational problems
(such as government securities) and will
then sell highly rated corporate bonds.

Bank Runs, Deposit Insurance,
and Bank Regulation, Part II

7. See Gary Gorton, "Clearinghouses
and
the Origin of Central Banking in the United
States," journal of Economic History, vol.
45, no. 2 (june 1985), pp. 277-284.
8. See Gary Gorton, "Bank Suspension of
Convertibility," journal of Monetary Economics, vol. 15, no. 2 (March 1985), pp.
177·194.

by Charles T. Carlstrom

9. See Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the
United States, 1867·1960, Princeton, NJ:
Princeton University Press, 1963, p. 316.
10. See Benston, et aI., op. cit., p. 64.
11. See Friedman
p.318.

and Schwartz, op. cit.,

mentals-such
as the amount of solar
activity-a bank's solvency would, in

Part I, which was presented in the February 1 Economic Commentary, described some of the costs and benefits
of providing deposit insurance and
concluded that an analysis of contagious bank failures is necessary in
order to understand these benefits.

5. See]. Huston McCulloch, "The Ohio
S&L Crisis in Retrospect: Implications for
the Current Federal Deposit Insurance Crisis," and Edward Kane, "Who Should

ContagiOUS
bank failures are often
thought to be a possible consequence of a banking system without
federal deposit insurance. This article
considers whether federal deposit
insurance is necessary to prevent
these types of bank runs.

It would seem irrational for depositors to run on a solvent bank. How-

Part II continues

BULK RATE
U.S. Postage Paid
Cleveland,OH
Permit No. 385

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 4410 1

with an examination

of contagious bank runs and a discussion of how the market handled banking panics prior to the Federal
Reserve System and the Federal Deposit Insurance Corporation.
• Contagious Bank Failures
The last apparent difference between
banks and other businesses is the possibility for a rumor or a failure of
another bank to ignite bank runs and
cause the failure of financially sound
banks.
These types of bank
"sunspots" because,
believe that a bank's
on events unrelated

Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.
Address Correction Requested:
Please send corrected mailing label to the Federal Reserve Bank of Cleveland, Research Department,

P.O. Box 6387, Cleveland, OH 44 IOI
ISSN 0428·1276

failures are termed
if depositors truly
solvency depends
to market funda-

fact, depend on the amount of solar
activity. In the typical example, a
sunspot is the failure of one bank or a
group of banks, which ignites rumors
that other banks might also fail.

-

Part I of this article, presented
1 Economic

February

described

in the

Commentary,

some of the costs and

benefits of providing federal deposit
insurance.

The major benefit of pro-

ever, because a bank's liquidity and
solvency depend in part on the number of depositors wishing to withdraw
money, it is rational for each depositor to queue up if he expects other
depositors also to stand on line.'

viding deposit insurance

Sunspot bank runs are also said to be
"bubble" phenomena. One of the
most famous examples of a bubble
involved tulip bulbs in Holland during the seventeenth century. Investors
frantically bought tulip bulbs, expecting their price to rise, which in turn
caused their price to rise.s

ways in which private clearinghouses

Sunspot bank runs are like bubbles in
that they are self-fulfilling prophecies.
To determine the correct regulatory
response to this apparent market failure, one must first inquire empirically
how frequently bank failures are
caused by sunspots and then ask what
is special about banking that allows
these types of phenomena to arise.

vention of contagious

is the pre-

bank runs-a

bank failure that spreads to solvent
banks. Part II, presented

here, dis-

cusses why bank runs may be contagious and examines
protected

some of the

against widespread

bank

failures. The article concludes
federally provided

that

deposit insurance

may not be necessary in order to
protect

against such bank runs.

Determining

how often bank runs are

caused by sunspots-extraneous
events-is
difficult to do with any de·
gree of statistical accuracy. However,
we can examine whether bank failures
were the products of the same type of
deposit and withdrawal behavior during both panics and nonpanics.

Gorton tests this hypothesis for bank
failures during the u.s. National Banking Era (1863 to 1914) and shows
that the factors affecting deposits and
withdrawals were similar in periods
of widespread bank failures and in
periods when banking failures were
not widespread. His results suggest
that "banking panics during the
National Banking Era were systematic
responses by depositors to changing
perceptions of risk."!
Corroborating evidence that extraneous events did not seem to cause a
substantial number of bank failures
prior to the Great Depression is given
by Benston, et al. They show that the
average annual rate of bank failures
for the 1875 to 1919 period was 0.82
percent, versus 1.01 percent for nonfinancial firms.' If banks are like
other firms except for the possibility
of contagious bank runs, one would
expect the failure rate of banks to be
at least as great as it is for other kinds
of businesses.
Most bank runs do not seem to be of
the type pictured in textbooks (or in
the Frank Capra movie American
Madness): banks falling like dominoes, with mass hysteria as depositors
line up for blocks hoping to withdraw
their money. Instead, the evidence
indicates that bank runs have primarily been rational responses to changes
in the financial worth of a bank. Even
the recent runs on the Ohio and Maryland savings and loans seem to have
been based on market fundamentals.'
Since the evidence against contagious
bank failures is indirect, one should
not completely dismiss the possibility
that a contagion of sunspot bank runs
might arise in an unregulated environment. However, this type of bank
run does not appear to be as widespread as typically thought, so the
regulatory response to this possibility
should be tempered by our current
state of knowledge.

•

Why Bank Runs Can

Be Contagious
The possibility for extraneous events
leading to bank runs arises from two
elements of banking structure: the
first-come, first-served aspect of banking deposits, and the illiquidity of
many bank assets. The former is
necessary in order for runs to exist. If
the amount in a depositor's account
fluctuated with the market value of
the assets and liabilities of the bank
(as it does in a mutual fund), bank
runs would typically not occur. However, as discussed earlier, the threat of
bank runs imposes a necessary discipline on banks.
A bank asset is said to be illiquid if
the bank cannot sell it in a short
amount of time without incurring a
substantial loss. Illiquidity results
from the asymmetry between the
bank's perception of the value of its
assets and the market's (depositor's)
perception of the value of those
assets. This difference arises because
information that a bank learns at the
time a loan is made (such as a borrower's credit history, assets, and liabilities) and information that a bank
learns during the life of a loan (such
as timing and receipt of payments)
cannot be costlessly acquired by
other financial firms.
The fire-sale value of an asset is the
price that can be received for an asset
on short notice. Asymmetric information explains why the fire-sale value
of a government security (in which
all investors have the same information about its quality) is nearly 100
percent of its longer-run market price.
Similarly, the fire-sale value of a corporate bond is much closer to its
longer-run value than the fire-sale
value of a personal loan.
Banks will tend to first sell off assets
that might look good to purchasers
but that the banks know are of poor
quality. Because the marketplace
anticipates this, asymmetric information causes some of a bank's assets to

sell at a large discount." Therefore,
when a bank run occurs, a financially
sound but illiquid bank can conceivably become insolvent. A bank may
be forced to sell off a high-quality
asset in order to get quick cash,
which may bring a low fire-sale value
since information about the quality of
the asset is not made public.
•

Cures for Contagious

Bank Runs

The two principal methods the federal government uses to eliminate
bank runs based on extraneous
events are federal deposit insurance
and discount lending by Federal
Reserve Banks.
FDIC insurance has eliminated the
need for most depositors to run on a
bank, whether the run is caused by sunspots or by information that the bank
has become insolvent. Federal Reserve
Bank lending can minimize such runs
because the Fed stands willing to provide "adjustment" or even extended
credit to a solvent but troubled bank,
so that it does not have to liquidate
its assets at fire-sale prices.
Before the Federal Reserve Act, the
pre-1914 banking industry was organized by a system of regional clearinghouses, whose powers and functions
resembled those of a central bank. In
many ways the Federal Reserve System was simply the nationalization of
the private clearinghouses.
A study by Gorton indicates that the
New York Clearing House was also a
private deposit insurance company. It
"taxed" sound banks in order to pay
off depositors at a troubled bank.?
TIle New York Clearing House also
maintained capital requirements and
reserve requirements and required
banks to publish their balance sheet
items. In addition, it could effectively
shut down an insolvent bank.
These practices are similar to current
proposals to allow private insurance
companies or mutual insurance funds
to insure banks. Critics of this

approach argue that the insurance
companies could fail with a contagion of bank runs, as were experienced during the Great Depression.
However, branch banking, to some
extent, enables a bank to insure itself.
During the Great Depression, only
one bank in California failed, and no
banks in Canada failed-both
areas in
which branch banking was allowed.
How broad a role private insurance
could play in our banking system is
an open question. The recent crisis
with the Ohio thrifts, in particular,
seems to cast doubt on the ability of a
private insurance system to protect
against bank runs. In spring 1985,
runs occurred on thrifts insured by
the Ohio Deposit Guarantee Fund
(ODGF) after the fund was depleted
by the failure of the Home State Savings Bank.
Any viable private insurance scheme,
however, would have to give the
insurance company the right to cancel a contract or the right to close a
bank. That is, it would have to
resemble the functions of the private
clearinghouses. The ODGF did not
have the right to close its member
thrifts when they became insolvent,
however. Consequently, institutions
like Home State Savings were not
closed promptly.
Another way the New York Clearing
House helped eliminate contagious
bank runs was by suspending convertibility of deposits into specie or currency: a bank would stay open and
make payments, but temporarily
would not honor cash withdrawals.
Although suspending convertibility
was technically illegal, it was allowed
to occur on at least eight occasions
during the nineteenth and early twentieth centuries.
Gorton argues that "such accommodating behavior arose because suspension
was part of a mutually beneficial
arrangement." He maintains that by

suspending convertibility, banks signaled to depositors that further liquidation of the bank's assets was not in
their best interests." The ability to
temporarily suspend convertibility
not only helped to quell existing bank
runs, but it also reduced the chance
that a run based on extraneous
information, or sunspots, could occur.
• Bank Runs During the
Great Depression
Another lesson can be learned by
examining bank failures during the
Great Depression. With the inception
of the Federal Reserve System, suspension of convertibility did not
occur (except for the governmentimposed banking holidays). Friedman and Schwartz argue that "if the
pre-Federal Reserve banking system
had been in effect ... restriction (suspending convertibility) would have
almost certainly taken place in September 1931 and very likely would
have prevented at least the subsequent failures.?
Instead, the total suspension that
eventually took place aggravated the
situation. The haphazard ways in
which states declared banking holidays in 1932 and 1933 further worsened the runs as depositors in open
states rushed to get their money after
neighboring states imposed holidays. to
Ironically, at its inception, the Federal
Reserve System instituted a discount
window in order to prevent banking
panics. As argued earlier, discount
lending lessens the incentives for
banks to hold liquid assets, making
banks more vulnerable to runs.
Instead of lowering the discount rate
in order to provide liquidity during
the panics, the Federal Reserve raised
the discount rate in September 1931
and again in February 1933.
Although the level of discount lending increased during the Great
Depression, banks also had to dump

assets on the market to try to meet
depositors' withdrawals." The Federal Reserve System aggravated the
situation by not actively pursuing
open market operations in order to
prevent a multiple contraction of the
money supply.
•

Conclusion

Many agree that reform of the current
banking structure is overdue. To their
credit, bank regulators allowed nearly
200 insolvent banks to fail in 1987.
Unfortunately, they may not be letting
enough insolvent banks fail, and even
when regulators close a bank, the
FDIC sometimes employs a rescue
procedure that protects the "uninsured" depositors.
Although reform of the present banking system may be desirable, a growing body of evidence indicates that
many of the current financial problems
in banking are at least partly the result
of the incentive structure created by
deposit insurance and by the way
deposit insurance is administered.
Regulators contemplating reform of
the banking system should consider
the costs associated with federal deposit insurance. Left on its own, the private system provided many of the current safeguards considered necessary
for a well-functioning banking system.

-

Charles T Caristrom is an economist at the
Federal Reserve Bank of Cleveland. The
author wishes to thank Walker Todd,
james Thomson, john Scadding William
Gavin, and Mark Sniderman for their
helpful comments.
The views stated herein are those of the
author and not necessarily those of the
Federal Reserve Bank of Cleveland or of
the Board of Governors of the Federal
Reserve System.

Gorton tests this hypothesis for bank
failures during the u.s. National Banking Era (1863 to 1914) and shows
that the factors affecting deposits and
withdrawals were similar in periods
of widespread bank failures and in
periods when banking failures were
not widespread. His results suggest
that "banking panics during the
National Banking Era were systematic
responses by depositors to changing
perceptions of risk."!
Corroborating evidence that extraneous events did not seem to cause a
substantial number of bank failures
prior to the Great Depression is given
by Benston, et al. They show that the
average annual rate of bank failures
for the 1875 to 1919 period was 0.82
percent, versus 1.01 percent for nonfinancial firms.' If banks are like
other firms except for the possibility
of contagious bank runs, one would
expect the failure rate of banks to be
at least as great as it is for other kinds
of businesses.
Most bank runs do not seem to be of
the type pictured in textbooks (or in
the Frank Capra movie American
Madness): banks falling like dominoes, with mass hysteria as depositors
line up for blocks hoping to withdraw
their money. Instead, the evidence
indicates that bank runs have primarily been rational responses to changes
in the financial worth of a bank. Even
the recent runs on the Ohio and Maryland savings and loans seem to have
been based on market fundamentals.'
Since the evidence against contagious
bank failures is indirect, one should
not completely dismiss the possibility
that a contagion of sunspot bank runs
might arise in an unregulated environment. However, this type of bank
run does not appear to be as widespread as typically thought, so the
regulatory response to this possibility
should be tempered by our current
state of knowledge.

•

Why Bank Runs Can

Be Contagious
The possibility for extraneous events
leading to bank runs arises from two
elements of banking structure: the
first-come, first-served aspect of banking deposits, and the illiquidity of
many bank assets. The former is
necessary in order for runs to exist. If
the amount in a depositor's account
fluctuated with the market value of
the assets and liabilities of the bank
(as it does in a mutual fund), bank
runs would typically not occur. However, as discussed earlier, the threat of
bank runs imposes a necessary discipline on banks.
A bank asset is said to be illiquid if
the bank cannot sell it in a short
amount of time without incurring a
substantial loss. Illiquidity results
from the asymmetry between the
bank's perception of the value of its
assets and the market's (depositor's)
perception of the value of those
assets. This difference arises because
information that a bank learns at the
time a loan is made (such as a borrower's credit history, assets, and liabilities) and information that a bank
learns during the life of a loan (such
as timing and receipt of payments)
cannot be costlessly acquired by
other financial firms.
The fire-sale value of an asset is the
price that can be received for an asset
on short notice. Asymmetric information explains why the fire-sale value
of a government security (in which
all investors have the same information about its quality) is nearly 100
percent of its longer-run market price.
Similarly, the fire-sale value of a corporate bond is much closer to its
longer-run value than the fire-sale
value of a personal loan.
Banks will tend to first sell off assets
that might look good to purchasers
but that the banks know are of poor
quality. Because the marketplace
anticipates this, asymmetric information causes some of a bank's assets to

sell at a large discount." Therefore,
when a bank run occurs, a financially
sound but illiquid bank can conceivably become insolvent. A bank may
be forced to sell off a high-quality
asset in order to get quick cash,
which may bring a low fire-sale value
since information about the quality of
the asset is not made public.
•

Cures for Contagious

Bank Runs

The two principal methods the federal government uses to eliminate
bank runs based on extraneous
events are federal deposit insurance
and discount lending by Federal
Reserve Banks.
FDIC insurance has eliminated the
need for most depositors to run on a
bank, whether the run is caused by sunspots or by information that the bank
has become insolvent. Federal Reserve
Bank lending can minimize such runs
because the Fed stands willing to provide "adjustment" or even extended
credit to a solvent but troubled bank,
so that it does not have to liquidate
its assets at fire-sale prices.
Before the Federal Reserve Act, the
pre-1914 banking industry was organized by a system of regional clearinghouses, whose powers and functions
resembled those of a central bank. In
many ways the Federal Reserve System was simply the nationalization of
the private clearinghouses.
A study by Gorton indicates that the
New York Clearing House was also a
private deposit insurance company. It
"taxed" sound banks in order to pay
off depositors at a troubled bank.?
TIle New York Clearing House also
maintained capital requirements and
reserve requirements and required
banks to publish their balance sheet
items. In addition, it could effectively
shut down an insolvent bank.
These practices are similar to current
proposals to allow private insurance
companies or mutual insurance funds
to insure banks. Critics of this

approach argue that the insurance
companies could fail with a contagion of bank runs, as were experienced during the Great Depression.
However, branch banking, to some
extent, enables a bank to insure itself.
During the Great Depression, only
one bank in California failed, and no
banks in Canada failed-both
areas in
which branch banking was allowed.
How broad a role private insurance
could play in our banking system is
an open question. The recent crisis
with the Ohio thrifts, in particular,
seems to cast doubt on the ability of a
private insurance system to protect
against bank runs. In spring 1985,
runs occurred on thrifts insured by
the Ohio Deposit Guarantee Fund
(ODGF) after the fund was depleted
by the failure of the Home State Savings Bank.
Any viable private insurance scheme,
however, would have to give the
insurance company the right to cancel a contract or the right to close a
bank. That is, it would have to
resemble the functions of the private
clearinghouses. The ODGF did not
have the right to close its member
thrifts when they became insolvent,
however. Consequently, institutions
like Home State Savings were not
closed promptly.
Another way the New York Clearing
House helped eliminate contagious
bank runs was by suspending convertibility of deposits into specie or currency: a bank would stay open and
make payments, but temporarily
would not honor cash withdrawals.
Although suspending convertibility
was technically illegal, it was allowed
to occur on at least eight occasions
during the nineteenth and early twentieth centuries.
Gorton argues that "such accommodating behavior arose because suspension
was part of a mutually beneficial
arrangement." He maintains that by

suspending convertibility, banks signaled to depositors that further liquidation of the bank's assets was not in
their best interests." The ability to
temporarily suspend convertibility
not only helped to quell existing bank
runs, but it also reduced the chance
that a run based on extraneous
information, or sunspots, could occur.
• Bank Runs During the
Great Depression
Another lesson can be learned by
examining bank failures during the
Great Depression. With the inception
of the Federal Reserve System, suspension of convertibility did not
occur (except for the governmentimposed banking holidays). Friedman and Schwartz argue that "if the
pre-Federal Reserve banking system
had been in effect ... restriction (suspending convertibility) would have
almost certainly taken place in September 1931 and very likely would
have prevented at least the subsequent failures.?
Instead, the total suspension that
eventually took place aggravated the
situation. The haphazard ways in
which states declared banking holidays in 1932 and 1933 further worsened the runs as depositors in open
states rushed to get their money after
neighboring states imposed holidays. to
Ironically, at its inception, the Federal
Reserve System instituted a discount
window in order to prevent banking
panics. As argued earlier, discount
lending lessens the incentives for
banks to hold liquid assets, making
banks more vulnerable to runs.
Instead of lowering the discount rate
in order to provide liquidity during
the panics, the Federal Reserve raised
the discount rate in September 1931
and again in February 1933.
Although the level of discount lending increased during the Great
Depression, banks also had to dump

assets on the market to try to meet
depositors' withdrawals." The Federal Reserve System aggravated the
situation by not actively pursuing
open market operations in order to
prevent a multiple contraction of the
money supply.
•

Conclusion

Many agree that reform of the current
banking structure is overdue. To their
credit, bank regulators allowed nearly
200 insolvent banks to fail in 1987.
Unfortunately, they may not be letting
enough insolvent banks fail, and even
when regulators close a bank, the
FDIC sometimes employs a rescue
procedure that protects the "uninsured" depositors.
Although reform of the present banking system may be desirable, a growing body of evidence indicates that
many of the current financial problems
in banking are at least partly the result
of the incentive structure created by
deposit insurance and by the way
deposit insurance is administered.
Regulators contemplating reform of
the banking system should consider
the costs associated with federal deposit insurance. Left on its own, the private system provided many of the current safeguards considered necessary
for a well-functioning banking system.

-

Charles T Caristrom is an economist at the
Federal Reserve Bank of Cleveland. The
author wishes to thank Walker Todd,
james Thomson, john Scadding William
Gavin, and Mark Sniderman for their
helpful comments.
The views stated herein are those of the
author and not necessarily those of the
Federal Reserve Bank of Cleveland or of
the Board of Governors of the Federal
Reserve System.

February 15, 1988

•

Footnotes

1. For a formal treatment of these types of
bank runs, see Douglas W. Diamond and
Philip H. Dybvig, "Bank Runs, Deposit
Insurance, and Liquidity," journal of Political Economy, vol. 91, no. 3 (june 1983),
pp.401-419.
2. See Charles Mackay, Extraordinary
Popular Delusions and the Madness of
Crowds, London: Richard Bentley, 1841.
For a dissenting opinion to this popular
belief, see Peter Garber, "Digging for the
Roots of Tulipmania," The Wall Street
journal
January 4, 1988. He argues that
the "tulip bubble" was not a bubble but in
fact is explainable by market fundamentals.
3. See Gary Gorton, "Banking Panics and
Business Cycles," Working Paper No. 86-9,
Federal Reserve Bank of Philadelphia,
March 1986.
4. See George]. Benston, Robert A.
Eisenbeis, Paul M. Horvitz, Edward]. Kane,
and George G. Kaufman, Perspectives on
Safe and Sound Banking: Past, Present,
and Future, Cambridge, MA: The MIT
Press, 1986, p. 64.

eCONOMIC
COMMeNTORY

Learn What from the Failure and Delayed
Bailout of the ODGF?" in Merging Commercial and Investment Banking: Proceedings of A Conference on Bank Structure and Competition, Federal Reserve
Bank of Chicago, May 1987.

Federal Reserve Bank of Cleveland

6. That is, of a group of assets that seem
identical, banks will sell off the least
desirable of the assets first. In the case of a
run, the bank will want to minimize the
costs of getting quick cash and will first
sell assets with no informational problems
(such as government securities) and will
then sell highly rated corporate bonds.

Bank Runs, Deposit Insurance,
and Bank Regulation, Part II

7. See Gary Gorton, "Clearinghouses
and
the Origin of Central Banking in the United
States," journal of Economic History, vol.
45, no. 2 (june 1985), pp. 277-284.
8. See Gary Gorton, "Bank Suspension of
Convertibility," journal of Monetary Economics, vol. 15, no. 2 (March 1985), pp.
177·194.

by Charles T. Carlstrom

9. See Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the
United States, 1867·1960, Princeton, NJ:
Princeton University Press, 1963, p. 316.
10. See Benston, et aI., op. cit., p. 64.
11. See Friedman
p.318.

and Schwartz, op. cit.,

mentals-such
as the amount of solar
activity-a bank's solvency would, in

Part I, which was presented in the February 1 Economic Commentary, described some of the costs and benefits
of providing deposit insurance and
concluded that an analysis of contagious bank failures is necessary in
order to understand these benefits.

5. See]. Huston McCulloch, "The Ohio
S&L Crisis in Retrospect: Implications for
the Current Federal Deposit Insurance Crisis," and Edward Kane, "Who Should

ContagiOUS
bank failures are often
thought to be a possible consequence of a banking system without
federal deposit insurance. This article
considers whether federal deposit
insurance is necessary to prevent
these types of bank runs.

It would seem irrational for depositors to run on a solvent bank. How-

Part II continues

BULK RATE
U.S. Postage Paid
Cleveland,OH
Permit No. 385

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 4410 1

with an examination

of contagious bank runs and a discussion of how the market handled banking panics prior to the Federal
Reserve System and the Federal Deposit Insurance Corporation.
• Contagious Bank Failures
The last apparent difference between
banks and other businesses is the possibility for a rumor or a failure of
another bank to ignite bank runs and
cause the failure of financially sound
banks.
These types of bank
"sunspots" because,
believe that a bank's
on events unrelated

Material may be reprinted provided that
the source is credited. Please send copies
of reprinted materials to the editor.
Address Correction Requested:
Please send corrected mailing label to the Federal Reserve Bank of Cleveland, Research Department,

P.O. Box 6387, Cleveland, OH 44 IOI
ISSN 0428·1276

failures are termed
if depositors truly
solvency depends
to market funda-

fact, depend on the amount of solar
activity. In the typical example, a
sunspot is the failure of one bank or a
group of banks, which ignites rumors
that other banks might also fail.

-

Part I of this article, presented
1 Economic

February

described

in the

Commentary,

some of the costs and

benefits of providing federal deposit
insurance.

The major benefit of pro-

ever, because a bank's liquidity and
solvency depend in part on the number of depositors wishing to withdraw
money, it is rational for each depositor to queue up if he expects other
depositors also to stand on line.'

viding deposit insurance

Sunspot bank runs are also said to be
"bubble" phenomena. One of the
most famous examples of a bubble
involved tulip bulbs in Holland during the seventeenth century. Investors
frantically bought tulip bulbs, expecting their price to rise, which in turn
caused their price to rise.s

ways in which private clearinghouses

Sunspot bank runs are like bubbles in
that they are self-fulfilling prophecies.
To determine the correct regulatory
response to this apparent market failure, one must first inquire empirically
how frequently bank failures are
caused by sunspots and then ask what
is special about banking that allows
these types of phenomena to arise.

vention of contagious

is the pre-

bank runs-a

bank failure that spreads to solvent
banks. Part II, presented

here, dis-

cusses why bank runs may be contagious and examines
protected

some of the

against widespread

bank

failures. The article concludes
federally provided

that

deposit insurance

may not be necessary in order to
protect

against such bank runs.

Determining

how often bank runs are

caused by sunspots-extraneous
events-is
difficult to do with any de·
gree of statistical accuracy. However,
we can examine whether bank failures
were the products of the same type of
deposit and withdrawal behavior during both panics and nonpanics.