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FRBSF

WEEKLY LETTER

July25,1986

Bank Runs
Concern over runs on banks and thrifts has led
these institutions to be singled out as "special"
intheU.S. economy.lnlast week's Letter, we
argued that banks' (i.e., all depository institutions) role as providers of payment services
might justify such concern.
Historically, significant changes in public policy
toward banks have come from widespread bank
runs. As a result of the banking panic of 1907,
for example, the Federal Reserve was established to act as the lender-of-Iast-resort to the
banking industry to help prevent runs. Some
years later, the banking panics of the 1930s led
to the creation of federal deposit insurance to
reduce depositors' fears about the safety of their
funds. In 1985, "bank holidays" for thrifts covered by state-sponsored insurers in Ohio and
Maryland again raised calls for changes, including the establishment of mandatory federal
deposit insurance for all depository institutions.
In this Letter, we examine what makes banks
vulnerable to runs, discuss current safeguards,
and suggest some alternative approaches to solving the problem of bank runs.

Liquidity
Some analysts argue that bank runs arise from
the illiquidity of bank assets compared to liabilities. In particular, banks fund longer-term
assets, many of which cannot be readily sold in
the market, with deposits that are avai lable on
demand or with relatively short notice. When a
large unexpected volume of withdrawals occurs,
a bank that cannot meet the demand with existing reserves and highly marketable assets must
try to sell less marketable assets (or borrow
against them). The result can be sizable losses
that lead to bank failures and a disruption of the
banking system and the economy in general.
Concern over the liquidity of bank liabilities and
the illiquidity of their assets served asthe foundation for legislation that gave the Federal
Reserve lender-of-Iast-resort authority when it
was established in 1913. Specifically, the legislation intended the Federal Reserve to supply

liquid reserves ("elastic" currency) to banks to
meet the public's demand to convert deposits to
currency. To do this, the Federal Reserve would
accept certain bank assets as collateral against
"discount window" loans.
The intended function of the lender-of-Iast-resort
was to reduce the cost to the banking system of
meeting unexpected deposit withdrawals. While
this may be possible, a lender-of-Iast-resort does
not necessarily eliminate the potential for bank
runs because bank runs involve more than bank
liquidity.

Risk
The existence of risk is also necessary for bank
runs to occur. When a bank incurs losses that
exceed stockholder equity, it becomes unable to
repay its obligations to depositors. As depositors
perceive the potential for such losses, they will
attempt to withdraw their funds (which are
redeemable at par or face value) before other
depositors in order to avoid any personal loss.
Losses sustained by banks result primarily from
their exposure to interest rate and credit risk,
fraud, and insider abuse. The Federal Reserve
was not intended to provide a general indemnification to bank stockholders or depositors
from losses connected with these types of bank
risk. Indeed, when it makes loans, the Federal
Reserve must require full collateral. This means
that when banks borrow at the discount window
of the Federal Reserve, their assets are discounted to reflect changes due to movements in
market interest rates and variations in asset
quality. Thus, with the lender-of-Iast-resort
providing only liquidity, depositors could
remain at substantial risk of loss and have good
reason to run on troubled banks.

III-defined property rights
A depositor's incentive to withdraw funds when
the solvency of a bank is in question comes from
being able to escape liability for losses should
the bank fail. Simply put, those depositors able
to withdraw funds before a bank is closed can
avoid losses entirely, while those that do not

FRBSF
withdraw in time bear a greater than proportional share of the losses. This uncertainty over
individual liability represents a problem of
poorly defined property rights. In effect, depositors who withdraw "early" take property away
from other depositors.
Economists have long argued that whenever
property rights are not well-defined, private markets fail to operate efficiently. It follows then that
public policy measures that remove the ambiguities regarding property rights can enhance efficiency. In the case of bank runs, this means
removing the uncertainty about who will be liable for the losses of an insolvent bank.
Deposit insurance

Uncertainty over depositor liability was virtually
eliminated with the institution of federal deposit
insurance in the 1930s despite limits on
coverage. The temporary deposit insurance plan
enacted in 1933 provided for insurance
coverage of up to $2,500, and deposit coverage
also was limited in the 1935 legislation that
authorized a permanent federal deposit insurance system.
Even with limited coverage, deposit insurance
was effective because, as Friedman and Schwartz have argued in their Monetary History of
the U.S., deposit insurance was intended to be
much broader than what was implied by the
statutes. This view is consistent with how
deposit insurance actually has been administered. Throughout most of its 50-plus year history, federal deposit insurance gave virtually all
depositors de facto coverage. With little or no
uncertainty regarding liability, depositors have
had little reason to run.
The stability of the banking system since the
1930s attests to the ability of deposit insurance
to prevent runs. In recent years, federal deposit
insurance is widely credited with keeping confidence in the banking system, even though close
to 500 banks and savings and loans have failed
since 1980. Events in Ohio and Maryland in
1985 highlighted the effectivenessof federal
deposit insurance. Federally insured institutions
were completely insulated from the turmoil created by the failure of thrifts covered by insurance systems chartered by those two states.

No panacea

Even though the federal deposit insurance system has been successful in preventing runs, the
Federal Deposit Insurance Corporation (FDIC)
briefly pursued a policy of not covering losses
for depositors with balances that exceeded the
statutory maximum (currently $100,000). This
policy was reflected in the experimental "modified payout plan" designed to put large depositors at risk. The plan was initiated in early 1984
and effectively terminated in May of that year in
the wake of the Continental Illinois Bank crisis.
In attempting to increase the risk of loss to some
depositors, the FDIC was exploring one way! to
cope with the complication that deposit insurance's success has created problems of its own.
In particular, insurance has removed the incentive for depositors to monitor the "prudence" of
banking institutions, and thereby eroded the
market discipline that would otherwise constrain
the risk-taking behavior of banks.
Moreover, under the federal deposit insurance
system as it has been administered, banks pay
the same insurance premium rates regardless of
the riskiness of their portfolios. This gives banks
an incentive to take on more risk than they
would in the absence of insurance. The cost of
this excess risk-taking is borne most immediately
by the deposit insurance funds, and ultimately
by the general taxpaying public. Thus, deposit
insurance, in solving the bank run problem by
eliminating depositor liability, creates a distortion by shifting the liability to the insurance fund
and the publ ic.
While the potential distortions to risk-taking are
widely recognized, increasing risk to large
depositors and the other so-called "market discipline" approaches (including co-insurance) do
not appear to be acceptable policy options. Regulators are concerned that shifting risk to depositors when banks still finance a sizable portion of
their assets with liquid deposits will only reintroduce the problem of bank runs.
Another perspective

The problem of bank runs and the incentive for
excessive risk-taking both result from poorly
defined property rights. Thus, both problems
could be solved simultaneously by clearly defi-

ning property rights in the event of a bank insolvency. One way to define property rights would
be to keep depositors from escaping their share
of bank losses by being the first to withdraw. To
do this, the liability connected with liquid
deposits would have to be extended for some
period beyond the time of withdrawal. That is,
both present and certain past depositors of an
individual bank would be kept at risk in the
eventthebankfailed. With the threat of an ex
post levy, a depositor would view his losses as
independent of his decision to withdraw funds
and thus would have no reason to run.
As a practical matter, a working definition of
when a depositor's liability ended - that is,
what constitutes a past depositor - would have
to be devised. Also, a government agency might
be required to enforce the ex post levies on
depositors. However, federal deposit insurance,
with its undesirable side effects on risk-taking,
would not be necessary. With well-defined
property rights, depositors would demand higher
interest rates from riskier banks and thus impose
a check on bank risk-taking.
Enforcing depositor liability for losses might be
difficult because of operational or, what is more
likely, political complications. If so, a second
solution to the property rights problem would be
to shift the liability for losses to equity holders of
banks. In other words, bank owners would have
to bear all the losses. If this could be accomplished, depositors would be protected just as
they are with full deposit insurance. Yet, since
bank equity holders would bear all potential
losses, they would have no incentive to take
excessive risks.
Under the current regulatory and legal framework, bank stockholders bear all losses only if
regulators close a troubled institution before its
net worth, measured on a market value basis,
falls below zero. Historically, regulatory agencies have tended to give problem institutions an
opportunity to regain their financial health and
have defined bank solvency in terms of book
value. Together, these practices more or less

ensure that, when an institution is finally c1qsed,
it will have negative net worth. Thus, neither
depositors nor equity holders now fully bear the
losses offailed banks.
For market discipline via equity holders to be
effective, several changes would be needed.
One is to give the regulatory agencies the power
and incentives to close depository institutions
more swiftly. Even so, it is likely that some failed
banks would have negative net worth. It may
also be desirable, therefore, to hold bank equity
holders liable for losses exceeding their original
investment. In fact, something similar to this
approach was actually in effect prior to the
1930s, when stockholders of nationally chartered banks could be held liable for losses up to
twice the amount of paid-in capital. Alternatively, if equity holders were held liable for all
losses, they would have the incentive to close
their institution before losses mounted.

Conclusion
Depositor runs are generally regarded as problems of bank liquidity. However, by itself,
providing liquidity to banks does not eliminate
the problem of runs. Banks incur losses from
exposure to various types of risk, and the liquid
nature of much of their funds gives a depositor
the means to escape the liability for losses usually borne by a debtholder.
Federal deposit insurance has been successful in
preventing runs by virtually eliminating depositor risk. But it has also created incentives for
excessive risk-taking by banks. It has done so by
shifting the liability for bank losses to the insurance fund and, ultimately, the taxpaying public,
and away from those with close ties to the bank
- its depositors and stockholders. The problem
of runs could be solved without the drawbacks
of the current insurance system by enforcing liabilities for losses more stringently so that depositors cannot avoid them merely by withdrawing
funds, or by taking steps to make sure equity
holders are held liable for all bank losses.

Frederick T. Furlong and Michael C. Keeley

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.

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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments 1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities 2
Other Secu rities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4
Total Non-Transaction Balances 6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS
Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+ )jDeficiency (-)
Borrowings
Net free reserves (+ )jNet borrowed( -)

Amount
Outstanding

Change
from

7/2/86
200,473
182,637
51,510
66,222
39,364
5,570
10,505
7,330
209,892
56,142
37,163
16,784
136,966

6/25/86
220
330
217
- 347
11
11
122
232
9,537
7,359
3,370
914
1,264

47,096

539

35,581
22,753

-

Change from 7/3/85
Dollar
PercenF

-

-

-

87
795

-

Period ended

5.4

2,425
119

Period ended

6/30/86

3.6
4.6
0.3
4.2
13.3
3.3
-12.4
7.0
3.9
11.1
20.1
18.1
0.1

2,441

-

7,075
8,087
165
2,701
4,650
182
1,497
483
8,013
5,624
6,236
2,581
191

6/16/86

123
80
43

59
15
44

1 Includes loss reserves, unearned income, excludes interbank loans
2

~U08

Excludes trading account securities

3 Excludes U.s. government and depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers

S Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annualized percent change

-

6.3

- 0.5