No doubt you’ve heard of a “bank run”. Where customers of a bank panic about whether the bank can pay out their deposits. Northern Rock is the posterchild. Here in the UK, at least.
That sort of thing wasn’t supposed to happen in a modern sophisticated financial system. Let alone in Britain…
But I don’t want to relive the panic of 2008 today. Instead, I want to explore why bank runs can happen in the first place.
What makes banks so fragile? Why don’t other industries experience the same sort of panics as banks do?
Given our economy is so overexposed to finance and banking, it’s an important question for us to ask. So, let’s dig in…
You’ve never heard of a “book run”, have you?
You’ve never seen mass queues outside of a storage company as customers panic about whether the garden furniture they deposited last autumn has evaporated.
Why not? What is it about banking that lends itself to panics? How can people’s deposits just disappear?
And why do banks have their own dedicated bailout and rescue institution in the form of a central bank? We have the Bank of England ready to save banks. That’s its job – emergency lending in times of crisis.
But you don’t hear about supermarkets or farmers being rescued by an institution that can print money to save their industry, do you? What makes banks so special? And why do they need such a huge rescue apparatus standing at the ready?
Last but not least, you have bank deposit guarantees – another support for the banking system designed to prevent a bank run. Governments don’t provide insurance on your home and contents, car, or gold in a safety deposit box, do they? But they do guarantee your bank deposits, up to a certain amount. Why do bank deposits get this special treatment?
The most remarkable thing is that banks still manage to experience panics, bank runs and crises, despite all these rescues and guarantees standing at the ready.
I mean, if someone printed money for you whenever you needed it, and if the taxpayer bailed you out when you lost money, and you still went bust every few years, there must be something seriously wrong with you…
Why you’re not supposed to talk about bank runs
The answer to all this is surprisingly simple. But it’s so shocking that “the mind is repelled”, as one famous economist put it.
Motor tycoon Henry Ford put it better: “It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”
In other words, the banking system relies on your ignorance of it. Just to function as it does. But why?
Well, when banks get into trouble, they don’t just struggle. They blow up spectacularly. And often take the rest of the banking system with them. And then the economy. And, in some cases, the government itself ends up in financial strife.
I first came to know about Nigel Farage because he described how this process would unfold in Europe. In rousing speeches, he told the European Parliament what they were in for – a European sovereign debt crisis. As always, he was shrugged off and laughed at. Until he was proven right.
But back to our real topic – exposing why banks are so fragile. You see, banking is so high risk that it needs rescues and government support to survive. That’s why we have central banks and deposit guarantees. To stop the crisis from spreading through the banking system.
But that still doesn’t explain why.
Banking is a confidence game
Banks are so inherently risky for a simple reason. Banking is a just a confidence game. If you disagree, consider that banking has to be legalised by government legislation, and licensed too. Because the same activity would be highly dubious if anyone else did it in any other industry.
Let me prove it.
When you deposit your belongings with a storage company, is that company allowed to lend out what you keep there? Of course not! It’s yours, not theirs. They are just a storage company where you deposit your belongings. They must keep them on hand.
If you agree to keep someone’s money deposited in your safe, but then lend out that money at interest, you’ve committed a fraud, right? Unless you have a banking licence, that is…
Banks can lend out your money when you deposit it with them. This creates the inherent problem. Banks can lend out the money which depositors deposit at the bank. Which means it isn’t there if those depositors want it.
Why is this possible? Because a bank deposit is in fact not a deposit. It is in, legally speaking, a loan to the bank.
The savings interest you (used to) earn on your deposits is the giveaway. You’re lending to the bank and earning interest for it. Calling the loan a deposit is tantamount to a scam as far as I’m concerned.
Whatever you want to call it, a bank deposit is actually a very short-term loan – one so short term that you can end the loan and demand your money back at any time. That’s known as “payable on demand”.
A bank run is when so many depositors want their money out at the same time that the banks’ meagre reserves of physical cash are emptied. And banks default on the loans which their “depositors” made to them. That is when a banking crisis begins. Because the failure to pay depositors is a default on a loan.
Let’s take a step back to highlight the problem. If all the customers of a storage company show up at the same time, the storage company would be able to allow each customer to get their belongings, right? Because those belongings are all merely kept in storage, not lent out to some other customer.
Do you see the difference?
Now that you understand the nature of the problem, let’s get back to our original question. What makes banks and the banking system so fragile?
Well, the only thing stopping all depositors from rushing down to the bank to get their money out is confidence. They believe in the system. They assume the banks have their money on hand, ready for withdrawal. Enough of their money to pay out on demanded deposits.
This means that all it takes for the banking system to go bust – to default on the loans which its “depositors” made to the bank – is a loss of confidence. That’s it. A mood swing in the economy. A bad headline. A slip of the tongue from some official.
Then the bank run begins. People suddenly realise that the bank doesn’t have enough of their money to pay out on all deposits. And only the first people to withdraw their money escape with all of it.
Next minute, the cascade which played out in 2008 is back.
All this is a simplification of how the banking system works, by the way. But it also makes clear just how fragile a key part of our national economy is. Banking is a confidence game in the sense that the game is up if people merely lose confidence in it.
If enough people want their money out, a crisis begins. That’s all it takes, unlike in any other industry.
What made 2008 so bad was that banks lost confidence in each other too. Not only did depositors want their money out, banks stopped trusting each other too. And, especially in the UK, banks rely on lending to each other to avoid a crisis.
Now let me ask you an important question. In the next financial crisis, your first instinct might be to sell your investments and have your money “safely in the bank” instead.
But when you do, I want you to remember what happened in Mary Poppins, if you can.
Within minutes of the board of the directors of the Fidelity Fiduciary Bank singing about keeping tuppence “safely in the bank”, Michael Banks starts a major banking panic merely by being misunderstood by another depositor of the bank. People think the bank has refused to pay out his deposit, even though he never actually made one.
That’s all it takes to trigger a banking panic. A misunderstanding. A loss of confidence.
So, do you trust the banks with your money?
Editor, Fortune & Freedom