Bank Runs: How a Confidence Collapse Actually Works

What is a bank run, and which side of the balance sheet does it happen on?

Picture a wedding hall that takes bookings a year ahead. The hall has taken deposits from forty households for dates spread across the next twelve months, and it has spent most of that money already, on the kitchen, on the generator, on the extension at the back. Nothing has gone wrong. The bookings are real, the dates are real, the extension is half built and worth what it cost. Then, one Tuesday, eleven households ring up and ask for their booking money back by Friday. The hall is not a bad business. The hall simply does not have the money in that shape on that day.

A bank run is that Tuesday, and it happens entirely on the funding side of the balance sheet. On the morning a run begins, nothing whatever has happened to the advancesThe banking word for the money a bank has lent out, sitting on its balance sheet as an asset. Deciding who to lend to, and what to charge them, is set out under credit appraisal.. The borrowers have not stopped paying. No instalment has been missed. The people who funded those advances want their money now, and a deposit is repayable on demand while a loan is not collectable on demand.

A run runs in the direction most descriptions get backwards. The asset side does not move first. Cash can come from nowhere else, so the asset side gets dragged in second.

What can leave the bank, and how fast can it go?

Net interest margin sorts the funding side by what each line earns and what it costs. A run sorts the same lines by how quickly each one can walk out of the door.

Suvarna Commercial Bank Limited, an invented commercial bank, is funded by deposits of Rs 1,92,000 crore, other liabilities and borrowings of Rs 24,000 crore, and net worthWhat is left of a bank's assets once every claim on it other than its own shareholders' has been met. On this balance sheet it is Rs 24,000 crore. of Rs 24,000 crore. A balance sheet has two sides of the same size, so those three lines add to the Rs 2,40,000 crore of total assets. Within the deposits, current and savings balancesMoney held in accounts a customer can draw on at any time, as against money placed with the bank for a fixed period. are 42.0 per cent of deposits, or Rs 80,640 crore. The remaining Rs 1,11,360 crore sits in term depositsMoney handed over on the understanding that it stays put until an agreed date, at a rate fixed when it is handed over..

Each of those three lines has a different speed setting. Being able to leave today is exactly what a current or savings account is for, so those balances can leave today. Term deposits are contracted to a date. The date slows them but does not nail them down, and a depositor who wants out will usually take the penalty and go. Other liabilities and borrowings roll off as they mature, or simply are not renewed. Not being renewed is the same thing arriving more politely. The funding side has a speed setting and the asset side does not have one at all.

What can the bank turn into cash, and at what cost?

The asset side takes the same order. Cash, and the balances the bank holds at the central bank, are already cash: nothing has to happen to them. Cash and central bank balances sit inside the Rs 36,000 crore of assets that are neither advances nor investments. The record does not break that Rs 36,000 crore down, so how much of it is cash cannot be stated. A split guessed at here would sit on the screen looking every bit as solid as one that had been counted.

Investments of Rs 60,000 crore can be sold, and being sellable is the point of holding them. A large sale made into a short window goes at the price that window offers rather than the price the book carries, and the difference between those two prices is what turns a liquidity problem into a solvency one.

Advances of Rs 1,44,000 crore meet none of a withdrawal, today or any other day. A performing borrower has agreed an instalment scheduleThe dated list of payments a borrower has agreed to make. Who gets lent to, on what terms and at what price is set out under loan pricing. and owes what falls due on it. Today, that is a small fraction of the loan and usually nothing at all. The bank cannot ring a borrower and ask for the balance back because a queue has formed at a branch. So the largest asset the bank holds is the one it cannot use at exactly the moment it most wants cash, and that is not a defect in the loan book. Being uncallable is what makes a loan a loan.

Why does a tenth of the funding reach a third of the sellable book?

The whole mechanism turns on a single step of arithmetic, and it is the step readers skip. The outflow is 10.0 per cent of deposits. Deposits are Rs 1,92,000 crore, so the outflow is Rs 19,200 crore. Measured against total assets of Rs 2,40,000 crore, Rs 19,200 crore is 8.0 per cent, and 8.0 per cent sounds like very little. Measured against the Rs 60,000 crore investment book, the only large block that can actually be sold, the same Rs 19,200 crore is 32.0 per cent.

Nothing has changed except the denominator, and the whole difference in feeling between those two numbers comes from choosing it. Net interest margin insists on the same discipline: a share without its base named in the same sentence is not a fact, it is a mood. Stated in full, Rs 19,200 crore is 8.0 per cent of total assets and 32.0 per cent of the investment book, and it is the second reading that describes what the treasury desk has to do on Friday morning.

Where does a liquidity problem turn into a solvency one?

Everything so far has been about speed. Now put a price on it. LiquidityBeing able to meet a claim at the moment it falls due. The question is one of timing, not of whether the money exists at all. and solvency are two different questions and a run is the machine that turns the first into the second.

The everyday version first. A household needs to raise money by Friday and has a scooter worth about Rs 60,000/- on a normal week. Sold by Friday, into whatever buyers happen to be around, it goes for Rs 36,000/-. The household did not become poorer because the scooter changed. The household became poorer because Friday was the deadline. Neither price is a mistake anyone made. The gap between them is the price of speed, and it is real money.

Do the same on the bank. Suppose Suvarna Commercial Bank Limited has to convert its whole Rs 60,000 crore investment book in a short window and realises Rs 36,000 crore, sixty paise in the rupee. The shortfall of Rs 24,000 crore is 40.0 per cent of the Rs 60,000 crore carrying valueThe amount at which an asset sits in the accounts before anything has been sold. and 10.0 per cent of total assets of Rs 2,40,000 crore, and it is exactly the Rs 24,000 crore of net worth. A loss that existed only as a price on a screen becomes a loss that exists in the accounts the moment the asset is sold, and once realised losses equal net worth the bank that could have paid everyone slowly cannot pay everyone at all.

There is a second turn of the screw inside that arithmetic, and it is the part almost nobody works through. At sixty paise in the rupee, raising cash consumes more of the book than the cash it raises. Rs 32,000 crore realising sixty paise in the rupee produces Rs 19,200 crore, so meeting the Rs 19,200 crore outflow means selling investments carried at Rs 32,000 crore. The shortfall booked on that one sale is Rs 12,800 crore, or 53.33 per cent of net worth. The bank raised a tenth of its deposits and spent more than half its net worth doing it.

Why is joining the queue the sensible thing to do?

A run feeds itself from here on, and the reason has nothing to do with anybody behaving badly. A bank pays in the order people arrive. A depositor who believes the people around them are going to withdraw also believes the bank will be selling assets into a falling window to pay them, and that the money will be scarcer behind them in the queue than in front of them. Given that belief, withdrawing is the correct move rather than a panicked one, and nothing in the reasoning requires anyone to be wrong about the bank.

Hold on to what that means. A person standing in a queue to protect a salary account is not a fool and has not made an error. The depositor is doing arithmetic on the information available, and the arithmetic comes out the way it comes out. The belief that others will withdraw is enough on its own, and that is precisely why a run is a mechanism and not a character failing.

Bank Run vs Market Panic: which of the two has a counterparty?

A run and a panic get used as if they were the same weather, and they are not the same kind of event at all. The comparison only means something once both halves are built, so define each one fully before putting them side by side.

A bank run is a demand for repayment made to one institution by the people who funded it. A run has a counterpartyThe other side of an obligation: the party who owes the payment, or the party owed it., namely the bank, and one question settles it: can that bank pay what is asked when it is asked? Somebody has to hand over money for it to end.

A market panic is a fall in the price of claims that trade. Nobody is asked to redeem anything, no institution is required for it to happen, and there is no counter across which a demand is made. A panic is settled when the price finds a level that buyers will meet, and that can happen with no institution taking any action whatsoever.

So the two differences that matter are that a run has a counterparty and a panic does not, and that a run is stopped by paying while a panic is stopped by the price finding a level. A week of sharply falling prices in traded claims, with nobody asked to repay anything, is a panic. A week like that is not a run, however alarming the screen looks.

What actually stops a run once it has started?

The honest answer is short and it has exactly two items in it. Either the bank pays everyone who asks, until people stop asking because asking has stopped feeling necessary. Or somebody credible stands behind the bank, and asking stops being necessary before the paying has to happen. There is no third exit inside the balance sheet. What sits outside the bank therefore matters as much as anything inside it.

Four arrangements outside the bank decide how a run ends. The liquidity a bank must carry in advance and the assets that may be counted towards it, the deposit coverProtection attached to a deposit and set outside the bank. The reach of that protection and its ceiling are set by the Deposit Insurance and Credit Guarantee Corporation. sitting beneath a depositor, the facilities a bank may draw on when its funding walks, and whether any part of the cash reserve requirement may be drawn down while it does, are every one of them set by the Reserve Bank of India, and they get revised. A figure of that kind does not go gently out of date on the day of a revision. The figure becomes false, and a figure that can become false belongs to the source rather than to memory.

The rows below are drawn and named, left empty, with the address printed inside each one. Filling them from the source takes ten minutes, and what goes in will be right on the day it is entered.

What can a bank prepare for, and what can it never prepare for?

Three things a bank can do in advance, and they are all real. The bank can hold more of its assets in a form that sells quickly. Assets that sell quickly earn less, so that choice costs income. The bank can also lengthen its funding, paying more for money that has agreed to stay. And it can spread its depositors, leaving no small group able to move a large part of the book. A food stall serving one office building lives or dies with that building. A stall on a crossing where four streets meet does not.

A bank holding enough to pay every depositor at once would not be lending, and lending is the thing a bank exists to do. No bank can hold that much. The mismatch between funding that can leave and assets that cannot be recalled is the service being provided, not a fault in how the place is run. Every commercial bank has it. Rukmini Finance Limited, an invented lender that takes no deposits at all, funds itself in the market instead. Market funding changes what its vulnerability looks like rather than removing one.

What does somebody reading a bank actually do with all this?

Three people use the mechanism differently, and none of them uses it to score a bank.

A treasury desk inside a lender uses it forwards. The desk looks at the funding stack sorted by speed, the way the first figure above sorts it, and asks what would have to be converted if a given share of it walked in a given number of days. The calculator above does the same arithmetic, and run against real internal numbers the answer is a plan for which assets get sold in which order rather than a verdict on the bank.

An analyst reading a bank from outside uses it as a question rather than a ratio. Given a funding side that is 80.0 per cent deposits, of which 42.0 per cent is current and savings balances, and an asset side where 60.0 per cent is advances that cannot be recalled, how much of this balance sheet can be converted inside a week and at what distance from carrying value? Nobody can answer that from a published statement alone, and the honest analyst says so instead of inventing the missing split.

A household uses it for one thing only: to stop reading a queue as a verdict on the people in it. Withdrawing is a reasonable response to a belief about others rather than a lapse, and that is most of what a household needs. The protection sitting beneath a deposit is a separate matter with a separate source, named in the row for it above.