Banks can Prevent Bank Runs by operating more like Bond Funds

The story of financial crises is an old and oft-repeated one. Bank runs have been occurring since the time of the renaissance, were a key factor in the great depression, and its variants have necessitated billions of dollars in bailouts in the past decade after the subprime crisis. Is this really inevitable? Is this really something that we simply need to accept and live with? I will be making the argument here that this is not the case.

Bank runs, and its derivative financial crises, all share one common root. A fundamental cause revealing the cracks in the system’s foundations. The dependency on public sentiment.

To put it simply, our banking system of present simply cannot function without people’s confidence. Even if the bank operations and balance sheet are perfectly sound, if enough people believe that they are in trouble and start withdrawing their money, these rumours and misguided fears will promptly turn into reality.

To understand why this is true, consider what actually happens at a bank. Joe deposits $100 at his bank, in order to safeguard his money. The bank however, is not providing a simple service of safeguarding this money. It is also investing the money. The bank approves Mark for a mortgage, and lends him $80 to be repaid over the next 20 years. The bank now no longer has the full $100 that Joe deposits. It has only $20, and the other $80 is pawned away as a speculative long-term investment.

Now at this point, you may be wondering what would happen if Joe were to return the following week, and withdraw his $100. The bank no longer has it. It has only $20 of Joe’s money available. Thankfully, the bank is exceedingly clever, and has a solution for this. Joe is not the only depositor at the bank. So too are Alison, Adam and Amanda. So when Joe tries to withdraw his $100, the bank gives him back his original $20, together with $80 that actually belongs to Alison, Adam and Amanda. Over time, this $80 will be repaid by Mark through his mortgage payments, and Alison, Adam & Amanda will never even know the difference.

99% of the time, the system works exceedingly well. There are only 2 problems:

  1. What would the bank do if Mark defaults on his loan and does not pay back his $80?
  2. What would the bank do if Alison and Amanda also tried to withdraw their money the next day?

First, let’s consider case 1. The bank has 4 depositors, and using their pooled money, it had made a $80 loan to Mark. If Mark now defaults, the reasonable outcome should be for all 4 depositors to lose $20 each. However, that’s not how banks work. Losses are never accrued to the depositors, and banks simply return the entire balance to customers in a first-come-first-serve manner. The first 3 people to withdraw their money will get back their full $100, and the last person to do so will end up with only the $20 that’s remaining. Hence the term “bank run.” People are literally racing against each other to be the first few lucky ones, and not be the last one holding an empty bag.

Now let’s consider case 2. The bank has 4 depositors, with deposits totaling $400. Out of this $400, $250 has been loaned out as mortgages, and only $150 is sitting in the bank as cash. All the loans made are perfectly healthy, and the bank is receiving all payments as scheduled. Everything seems to be going fine.

However, a rumor starts that loans are being defaulted on. Most of the depositors know the rumor to be false, but Adam believes it and withdraws his entire $100. After all, he doesn’t want to be the one holding an empty bag if the rumor is true. Amanda knows that Adam withdrew his money, and that there is only only $50 remaining in the bank, so she rushes to the bank as well and withdraws the full $50. Alison and Joe, the only ones who were “responsible” and didn’t fall for false rumors, are now unable to withdraw anything from the bank because all the cash is completely gone. Despite their prudence, and also because of it, it will now be many years before they can ever recover their money.

These two cases perfectly illustrate why bank runs happen:

During bad times, it devolves into a winner-takes-all and loser-gets-nothing situation, which leaves everyone scrambling to withdraw their money and not be one of the losers.

And even during good times: uncertainty, fear, rumors and the mere threat of the above, can all send people similarly rushing to the bank, creating the very problem that was rumored to exist. Even a bank that is doing everything right can still collapse as a result of baseless fears.

2023 update: Sound hard to believe? Sounds like something that would only happen in a bygone era? Think again. America’s 16th largest bank has now collapsed in just 48 hours, due to public hysteria over a 1% loss:

On Wednesday, Silicon Valley Bank was a well-capitalized institution seeking to raise some capital. Within 48 hours, a panic induced by the very venture capital community that SVB had served and nurtured ended the bank’s 40-year-run… The company’s downward spiral began late Wednesday … with news that it needed to raise $2.25 billion to shore up its balance sheet. What followed was the rapid collapse of a highly-respected bank.

“This was a hysteria-induced bank run caused by VCs,” Ryan Falvey, a fintech investor of Restive Ventures, told CNBC. “This is going to go down as one of the ultimate cases of an industry cutting its nose off to spite its face.”

As startup clients withdrew deposits… SVB found itself short on capital. It had been forced to sell all of its available-for-sale bonds at a $1.8 billion loss… The sudden need for fresh capital … sparked another wave of deposit withdrawals Thursday as VCs instructed their portfolio companies to move funds … The concern: a bank run at SVB could pose an existential threat to startups who couldn’t tap their deposits.

Prominent funds including Union Square Ventures and Coatue Management blasted emails to their entire rosters of startups in recent days, instructing them to pull funds out of SVB on concerns of a bank run. Social media only heightened the panic, he noted. “When you say, `Hey, get your deposits out, this thing is gonna fail,” that’s like yelling fire in a crowded theater,” Falvey said. “It’s a self-fulfilling prophecy.”

Falvey … said that his analysis of SVB’s mid-quarter update gave him confidence. The bank was well capitalized and could make all depositors whole, he said. He even counseled his portfolio companies to keep their funds at SVB as rumors swirled. Now, thanks to the bank run that ended in SVB’s seizure, those who remained with SVB face an uncertain timeline for retrieving their money. … The lion’s share of deposits held by SVB were uninsured, and its unclear when they will free up.

So let’s recap what happened:

  1. SVB suffered a temporary 1% loss, relative to its total assets, due to various market events
  2. Despite this, the bank was still well capitalized and could make depositors whole under normal circumstances, as long as people carried on as normal
  3. The people who realized this responsibly did nothing, and left their money in the bank
  4. Others feared a bank run, and hence pulled their money out, and told others to pull their money out
  5. The very fears of a bank run caused a bank run, causing the bank to collapse
  6. The people who were the very first to panic, and caused the bank run, were able to get their money out successfully and suffered no losses
  7. The people who kept a calm head and acted to prevent a bank run, are now at risk of losing almost all their money. Definitely temporarily, perhaps permanently

And this problem wasn’t limited to SVB and its depositors. There was a real danger of the entire nation’s financial system disintegrating:

Was backstopping two banks’ depositors enough to stop an exodus from other small- and medium-size banks? They told the president that the crisis at SVB threatened to engulf banks across the country—which could endanger the ability of small businesses to make payroll… Ms. Brainard and others made the case that depositors at other midsize banks like SVB could pull out their deposits on Monday, precipitating a bank run across the country that could endanger billions in deposits… Officials at the Fed monitored real-time data showing a growing pile of withdrawal requests… By Saturday, the regulators were seeing signs of large deposit outflows from fewer than 20 midsize banks.

Every person reading this has learnt a very valuable lesson: the next time there is any reason for panic at all, no matter how minor or unfounded, you should strive to be the very first person to panic and withdraw all your money. Your actions will ironically cause the very thing you were worried about: a total system collapse with tremendous collateral damage. But this is the only way for you to protect yourself.

For centuries, governments have tried to fix the problem by sweet talking people, whispering sweet nothings, and providing artificial government backed “guarantees” that promise more than they can ever deliver during a real panic. Consider for example, that the FDIC is responsible for insuring $9294 Billion worth of bank deposits, but it has only $25 Billion in its coffers to make good on this promise.

To put it generously, these “solutions” are mere hacks; temporary bandaids hiding the real problem. Any system of guaranteed fixed-deposits backed by speculative investments, is inherently an unstable one. Especially when the deposits can be withdrawn at any time, but the investments are tied up for a longer period of time. It’s fundamentally predicated on the idea of “borrowing from Paul to pay Peter.” It may seem great during periods of calm. But during times of trouble, the bank’s guaranteed deposits simply do not line up with their assets, and no amount of sweet talking or confidence building can make up for this mismatch.

As an alternative, consider, how bond-funds and bond-ETFs work. These funds have been remarkably stable for decades. Despite lacking the type of guarantees provided by the FDIC, bond funds have never experienced any form of “bank run”. The reason for this is simple: If some of the loans in their portfolio go bad, the loss is immediately borne out by everyone invested into the fund. It doesn’t matter how early or late you are in withdrawing, everyone loses the same relatively small amount. The fund’s liabilities to their investors, are always perfectly matched by their assets. This is what gives people the confidence to remain invested and stay with the fund, even while a select few panic and rush for the exits.

Even better, those who panic-sell will incur significant losses due to firesale prices (especially with bond ETFs), while calmer heads can mitigate their losses as markets eventually stabilize. This gives people a very real incentive to remain calm and sit tight even during turbulent times. Contrast this with today’s banks, where bank runs are in fact the rational response to times of panic.

The problem with banks is that they promise more than they can deliver. They know it, the government knows it, and their customers certainly know it as well. But things don’t have to be this way. Let’s imagine an alternative banking system, that’s built on solid fundamentals and transparency.

If consumers want their money held for safekeeping in a risk-free, liquid manner, in checking accounts, it should be locked away in a metaphorical vault, and left to gather dust. It can still be accessible at any time using debit cards, checks, or bank withdrawals. But it should never be invested or loaned out to anyone. Your money should literally be sitting there, untouched by anyone else, waiting for you to withdraw it anytime you choose. In return, the same way you pay the postal service for delivering your mail, you would also pay the bank some fees for storing and safeguarding your money.

If consumers instead want to loan their money out and earn interest in the process, through savings accounts, the money can be placed into one of many possible ETFs or mutual funds, with the disclaimer that all profits and losses will be immediately and equally accrued to all fund-investors. Customers wanting safe investments can choose money market funds or short-term government bonds, while more aggressive customers can choose funds that invest in longer-term corporate bonds, mortgage-backed securities, or business loans. Each customer will be able to choose their desired fund, based on the amount of risk they want to take on, and the corresponding amount of interest they would like to earn.

2023 update: If trusting internet bloggers isn’t your thing, consider a very similar proposal floated in the WSJ in the aftermath of the SVB banking crisis:

Checking accounts would be held with “narrow banks” that look very like a government money-market fund, holding nothing riskier than short-term T-bills and making their money from transaction fees, not borrowing short and lending long. The rest of the banking system would be replaced by funds that take only term deposits, matching the maturity of deposits with loans. The financial system would have significantly less flexibility but would need far fewer regulators and no deposit insurance.

As an individual, you can even put the above into practice right now. Keep only a small amount of money in your bank’s checking or savings account – enough to cover the next 1 month of expenses. Keep the rest of your money in a brokerage account such as Schwab or ETrade, where you can invest the money in the various funds discussed above. This way, your assets will be immune to bank runs. Though this will be of little consolation when your employer goes bankrupt and the economy enters a severe recession as a result of widespread bank runs. Hence why we need systemic fixes as well.

The above discussion has so far been concentrated on banks, but the same principle can be generalized to other financial systems as well. Any form of fixed guarantees, backed by speculative long-term investments, fundamentally leads to an unstable situation. As long as such systems exist, guarantees are bound to be broken, and panics are bound to occur.

The subprime crisis of 2008 has been an ominous precursor to bigger and more dangerous possibilities that await us. Whenever we’re dealing with unstable systems, it’s only a matter of time before a loose spark blows everything up. Let’s learn from 2008, and not repeat our mistakes all over again.

Related links:

Silicon Valley Bank, America’s 16th largest bank, collapsed in 2023 in just 48 hours

WSJ: Why relying on government deposit guarantees is problematic

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