How bank runs were a leading cause of the global financial crisis and why it could happen again.
In this podcast, you’ll learn:
- What are bank runs and what causes them.
- Why bank runs led by households and individuals are rare in the U.S.
- How a bank run led by institutions caused the financial crisis.
- What is the shadow banking system.
- How do repurchase agreements or repos work.
- Why the U.S. Government can never default on its debt.
- How collateral chains are like the used clothing market.
- Why a shortage of collateral is putting downward pressure on interest rates.
- What are the early warning signs of an institutional bank run.
Manmohan Singh article on collateral and the used clothing market. RRP and the rusting of the financial plumbing
Bank Runs and Repos: At the Heart of the Global Financial Crisis
A bank run occurs when depositors decide en masse that they want their savings back from a financial institution. Usually, this occurs because the depositors believe the financial institution’s solvency is in doubt.
Retail Bank Runs
Financial institutions don’t keep deposits sitting around. They are invested in various assets including investment securities and loans.
In the U.S. in aggregate, only 53% of FDIC-insured financial institution assets are loans. The remainder of their assets are investment securities-including government bonds-real estate and reserves held at the Federal Reserve, the U.S. central bank.
If a large percentage of a bank’s depositors demand their money, the bank would need to sell securities and seek to call-in loans. In some cases, a bank run by panicked depositors could actually lead to the bank becoming insolvent.
In 1933, the Federal Deposit Insurance Corporation (FDIC) was created in the U.S. to insure retail bank deposits. Account deposits up to $250,000 are guaranteed to be safe if a bank fails.
Consequently, bank runs led by household depositors are rare in the U.S. Bank runs by retail depositors continue to occur in other countries as they did recently in Bulgaria.
Institutional Bank Runs
What most people don’t realize is there are still bank runs in the U.S., only instead of being led by household depositors, they are led by institutions, such as businesses and institutional investors. An institutional-led bank run was at the heart of the global financial crisis that began in 2007.
Let me explain.
Institutions, such as insurance companies or manufacturers, want to protect their savings deposited at financial institutions even though they don’t qualify for FDIC insurance for deposit amounts greater than $250,000.
One way they protect their savings is by demanding the financial institution provide collateral to secure the deposit.
For example, if an institution deposited $100 million at a bank they might demand the bank give them $102 million of investment securities, such as U.S. Treasury notes, as collateral to secure the deposit.
When an institution gives (i.e. lends) money to a bank in exchange for collateral it is called a repurchase agreement (or repo, for short.) They are called repurchase agreements because the bank promises to purchase the collateral back from the depositor.
Institutions often require collateral that is worth more than the amount of money deposited in order to have some added protection in case the value of the collateral falls. This additional collateral amount is called a haircut.
Most repurchase agreements are for a term of one day, although some are longer. The agreements renew automatically, but each party can terminate at the end of the term if they so choose.
What if institutions begin to worry about a bank becoming insolvent? They could cancel the repurchase agreement or request more collateral (i.e. a larger haircut).
If institutions en masse demand more collateral or cancel their repurchase agreements and want their money back, it is equivalent to a bank run.
That is exactly what occurred in 2007 that led to the near global financial collapse.
Wall Street banks, such as Bear Stearns, Lehman Brothers, Merrill Lynch and others, funded much of their day-to-day operations using repurchase agreements.
When housing prices began to fall along with securities linked to home mortgages, institutional depositors started to worry about how much exposure the banks had to these distressed securities.
Depositors canceled their repurchase agreements or demanded more collateral.
That sent Wall Street banks scrambling to sell assets in order to raise money to give back to their depositors. With so many eager sellers and buyers reluctant, asset values, including the stock and bond markets, plunged.
Panic swept through the financial markets. Several Wall Street banks collapsed. Millions of individual investors were also hurt as their retirement accounts fell.
Borrowing and lending requires trust. When trust and confidence is replaced with fear and panic, the economic consequences can be devastating.