Modern Financial Systems: Theory and Applications

CHAPTER 20

Bank Runs and Systemic Risk

This chapter examines performance and stability issues associated with bank operations. It first shows how bank portfolio structures pose a trade-off for both bank and system stability. It next considers policies for reducing the likelihood of speculative bank runs, examining the roles of lender of last resort, deposit insurance, and information production. Finally, the chapter considers how system risks differ from the risk of individual bank operations, and sketches policies for dealing with them.

This chapter discusses why bank runs and bank failures occur, and the risks that these phenomena can present. The chapter also considers how simultaneous runs on several banks can amount to a bank panic, examines the system risks that a panic can present, and offers some comments for dealing with system risks.³⁵⁵

Financial history reports episodes of banking instability in several countries, indicating that bank runs and bank failures are not uncommon features of a financial system. For example, England witnessed many bank failures before the Bank of England was established as a state bank³⁵⁶ in 1946. Similarly, there were almost 100 failures of United States banks in the late 1930s and early 1940s, although between the 1940s and the 1980s failures³⁵⁷ were relatively rare. The difference in U.S. failure rates was attributed to both a changed environment and a stronger regulatory framework. However U.S. regulatory revisions did not prove adequate ...