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Bank Run - Definition and The Great Depression

Bank Run - Definition and The Great Depression

The stock market crash of October 1929 left the American public highly nervous and extremely susceptible to rumors of impending financial disaster. Consumer spending and investment began to decrease, which would in turn lead to a decline in production and employment. Another phenomenon that compounded the nation’s economic woes during the Great Depression was a wave of banking panics or “bank runs,” during which large numbers of anxious people withdrew their deposits in cash, forcing banks to liquidate loans and often leading to bank failure.

Depression and Anxiety

The Great Depression in the United States began as an ordinary recession in the summer of 1929, but became increasingly worse over the latter part of that year, continuing until 1933. At its lowest point, industrial production in the United States had declined 47 percent, real gross domestic product (GDP) had fallen 30 percent and total unemployment reached as high as 20 percent.

In the wake of the stock market crash of October 1929, people were growing increasingly anxious about the security of their money. Wealthy people were pulling their investment assets out of the economy, and consumers overall were spending less and less money. Bankruptcies were becoming more common, and peoples’ confidence in financial institutions such as banks was being rapidly eroded. Some 650 banks failed in 1929; the number would rise to more than 1,300 the following year.

The First Bank Runs

The first of four separate banking panics began in the fall of 1930, when a bank run in Nashville, Tennessee, kicked off a wave of similar incidents throughout the Southeast. During a bank run, a large number of depositors lose confidence in the security of their bank, leading them all to withdraw their funds at once. Banks typically hold only a fraction of deposits in cash at any one time, and lend out the rest to borrowers or purchase interest-bearing assets like government securities. During a bank run, a bank must quickly liquidate loans and sell its assets (often at rock-bottom prices) to come up with the necessary cash, and the losses they suffer can threaten the bank’s solvency. The bank runs of 1930 were followed by similar banking panics in the spring and fall of 1931 and the fall of 1932. In some instances, bank runs were started simply by rumors of a bank’s inability or unwillingness to pay out funds. In December 1930, the New York Times reported that a small merchant in the Bronx went to a branch of the Bank of the United States and asked to sell his stock in the institution. When told the stock was a good investment and advised not to sell, he left the bank and began spreading rumors that the bank had refused to sell his stock. Within hours, a crowd had gathered outside the bank, and that afternoon between 2,500 and 3,500 depositors withdrew a total of $2 million in funds.

From Panic to Recovery

The last wave of bank runs continued through the winter of 1932 and into 1933. By that time, Democrat Franklin D. Roosevelt had won a landslide victory in the presidential election over the Republican incumbent, Herbert Hoover. Almost immediately after taking office in early March, Roosevelt declared a national “bank holiday,” during which all banks would be closed until they were determined to be solvent through federal inspection. In combination with the bank holiday, Roosevelt called on Congress to come up with new emergency banking legislation to further aid the ailing financial institutions of America.

On March 12, 1933, Roosevelt gave the first of what would become known as the “fireside chats,” or speeches broadcast over the radio in which he addressed the American people directly. In that first fireside chat, Roosevelt spoke of the bank crisis, explaining the logic behind his closing of all banks and stating that “Your government does not intend that the history of the past few years shall be repeated. We do not want and will not have another epidemic of bank failures.” He reassured the nation that banks would be secure when they reopened, and that people could trust that they could use their money as they saw fit at any time. “I can assure you, my friends,” Roosevelt intoned, “that it is safer to keep your money in a reopened bank than it is to keep it under the mattress.”

Roosevelt’s words and actions helped to begin the process of restoring public confidence, and when the banks reopened many depositors showed up ready to deposit their currency or gold, signaling the end of the nation’s banking crisis.


A Brief History of Banking Reform After the New Deal

FDR Presidential Library and Museum / Wikimedia Commons / CC BY 2.0

  • Ph.D., Business Administration, Richard Ivey School of Business
  • M.A., Economics, University of Rochester
  • B.A., Economics and Political Science, University of Western Ontario

As president of the United States during the Great Depression, one of President Franklin D. Roosevelt's primary policy goals was to address issues in the banking industry and financial sector. FDR's New Deal legislation was his administration's answer to many of the country's grave economic and social issues of the period. Many historians categorize the primary points of focus of the legislation as the "Three R's" to stand for relief, recovery, and reform. When it came to the banking industry, FDR pushed for reform.


Bank Runs Can Cause Asset Sell-offs and Losses

Since U.S. banks use what is known as fractional reserve banking, not all customer deposits are available at banks in cash for immediate withdrawal. Instead, banks keep only a fraction of customer deposits in cash stocked in vaults and automatic teller machines (ATMs), while some assets are invested in loans and other types of investments.  

In general, most customers don’t need their money at the same time. When a large number of customers try to withdraw their money at the same time, the demand for deposits can overwhelm a bank. To meet its obligations, a bank may even be forced to sell off long-term assets.  

If a bank is forced to generate cash by selling investments, it may have to incur considerable losses since the height of a financial crisis is generally a bad time for the bank to redeem assets for cash.  


Great Depression Bank Crisis

One of the most significant aspects of the Great Depression in the United States was the erosion of confidence in the banking system. Weaknesses were apparent by 1930 and a growing wave of failures followed. As banks closed their doors, a chain reaction occurred that spread misery throughout the country. One immediate result of bank closures was the contraction of the money supply. With less money in circulation, the purchasing power of consumers was sharply reduced. Manufacturers and retail establishments attempted to entice consumers by dropping prices on their goods — a move that was largely in vain. Unable to move their merchandise, factories and stores then resorted to scaling back production and cutting the work force. By the end of 1932, more than 13 million American workers were unemployed. Anxious citizens withdrew their deposits from banks and hoarded cash and gold. By early the next year, more than 9,000 banks had failed. In early February, 1933, Louisiana needed a one-day bank holiday to allow the Hibernia Bank, which was seeing a run on its cash, enough time to bring in more currency. The governor, in order to find a reason to declare a holiday on Saturday, February 4, could only find the 16th anniversary of the severing of diplomatic relations with Germany in 1917. That was enough, and on February 3, Louisiana declared this new holiday. Of course, it halted more than just the Hibernia Bank, but it had the intended purpose. By the following Monday, the Hibernia Bank had received the necessary funds and remained open, and for that bank at least, the banking crisis was temporarily averted. The crisis, however, didn't stop. On March 14, the state of Michigan, home of the nearly prostrate auto industry, announced an eight-day holiday and in the process touched off panics in neighboring states. By Inauguration Day in March, nearly all of the nation’s banks were either closed or had at one point been closed, and of those remaining open, most were operating under special state rules designed to protect them. Outgoing Herbert Hoover blamed President-elect Franklin Roosevelt for the crisis and the deterioration of public confidence in the banks. Hoover had asked on several occasions for public declarations from Roosevelt that he would maintain balanced budgets and do all within his power to fight inflation — promises that would have meant more to the business and financial communities than to the millions of unemployed. Roosevelt refused to allow his future commitments to be pinned down, which left Hoover angry and anxious to be out of office. The bank crisis of 1933 was front and center when Franklin Roosevelt took office. On March 6, 1933, in order to keep the banking system in America from complete collapse, the President used the powers given him by the Trading with the Enemy Act of 1917 and suspended all transactions in the Federal Reserve as well as other banks and financial institutions. The bank holiday was the opening step in the New Deal. At the same time, he embargoed the export of silver, gold, and currency until March 9, at which time Congress would meet in special session. On that day, the Emergency Banking Act was passed by Congress and Roosevelt signed it. The President was given the power to recognize all insolvent banks and was provided with the means to reopen sound banks without delay. By promising unlimited Federal Reserve support for those banks that reopened, FDR effectively provided 100% deposit insurance. Deposits flooded back and within a few weeks had returned most of the money they had withdrawn during the banking crisis before the suspension. The bank holiday had served its purpose.

See other aspects of Hoover's domestic policy.


48. The Great Depression


Dorothea Lange was employed by the Farm Security Administration to document the Depression through the camera lens. Her bleak photos captured the desperation of the era, as evidenced through this portrait of an 18-year-old migrant worker and her child.

"Once I built a railroad, I made it run.
I made it race against time.
Once I built a railroad, now it's done.
Brother, can you spare a dime?"

At the end of the 1920s, the United States boasted the largest economy in the world. With the destruction wrought by World War I, Europeans struggled while Americans flourished. Upon succeeding to the Presidency, Herbert Hoover predicted that the United States would soon see the day when poverty was eliminated. Then, in a moment of apparent triumph, everything fell apart. The stock market crash of 1929 touched off a chain of events that plunged the United States into its longest, deepest economic crisis of its history.


Nine thousand banks failed during the months following the stock market crash of 1929.

It is far too simplistic to view the stock market crash as the single cause of the Great Depression. A healthy economy can recover from such a contraction. Long-term underlying causes sent the nation into a downward spiral of despair. First, American firms earned record profits during the 1920s and reinvested much of these funds into expansion. By 1929, companies had expanded to the bubble point. Workers could no longer continue to fuel further expansion, so a slowdown was inevitable. While corporate profits, skyrocketed, wages increased incrementally, which widened the distribution of wealth.

The richest one percent of Americans owned over a third of all American assets. Such wealth concentrated in the hands of a few limits economic growth. The wealthy tended to save money that might have been put back into the economy if it were spread among the middle and lower classes. Middle class Americans had already stretched their debt capacities by purchasing automobiles and household appliances on installment plans.


The unprecedented prosperity of the 1920s was suddenly gone, the Great Depression was upon the nation, and breadlines became a common sight.

There were fundamental structural weaknesses in the American economic system. Banks operated without guarantees to their customers, creating a climate of panic when times got tough. Few regulations were placed on banks and they lent money to those who speculated recklessly in stocks. Agricultural prices had already been low during the 1920s, leaving farmers unable to spark any sort of recovery. When the Depression spread across the Atlantic, Europeans bought fewer American products, worsening the slide.

When President Hoover was inaugurated, the American economy was a house of cards. Unable to provide the proper relief from hard times, his popularity decreased as more and more Americans lost their jobs. His minimalist approach to government intervention made little impact . The economy shrank with each successive year of his Presidency. As middle class Americans stood in the same soup lines previously graced only by the nation's poorest, the entire social fabric of America was forever altered.


What Were Some Solutions to the Great Depression?

President Franklin Delano Roosevelt initiated several acts that fixed the bank problems and helped the American people obtain jobs and relief during the Great Depression, according to PBS's The American Experience. These acts included the Emergency Banking Bill of 1933, the Glass-Steagall Act (FDIC), the Civil Conservation Corps, the Works Progress Administration, the Home Owners' Loan Corporation, the National Industrial Recovery Act and the Federal Emergency Relief Administration.

President Roosevelt took an active approach to solving the nation's problems by calling in all the experts and theorists he could to help brainstorm solutions to the Great Depression, PBS reports. His predecessor, Herbert Hoover, had let the Depression run its course, believing it was not the government's job to get involved.

The Emergency Banking Bill of 1933 stabilized the banking system. The Glass-Steagall Act created the FDIC, which gave bank deposits the protection of federal insurance. The Civil Conservation Corps put young men ages 17 to 23 to work in forests and national parks. They earned $30 a month, much of which was sent back to assist their families, according to the Authentic History Center.

The Works Progress Administration employed more than 8.5 million men to build roads, bridges, public buildings and parks. This program improved public property and offered jobs to those who desperately needed them. The National Industrial Recovery Act helped to regulate hours worked and to ban child labor. The Federal Emergency Relief Administration delivered money to states to create work relief programs.

The Agricultural Adjustment Act helped the farmers struggling in the Dust Bowl by paying them to reduce their crops. It also offered loans for farmers facing bankruptcy. Finally, the Home Owners' Loan Corporation helped people facing foreclosure keep their homes.


References

Allen, S, S Capkun, I Eyal et al. (2020), “Design Choices for Central Bank Digital Currency", VoxEU.org, 4 September.

BIS – Bank for International Settlements and a Group of 7 Central Banks (2020), Central bank digital currencies: foundational principles and core features, Report n°1.

ECB – European Central Bank (2020), Report on a digital euro, October.

Fernández-Villaverde, J, D Sanches, L Schilling and H Uhlig (2020), “Central bank digital currency: Central banking for all”, VoxEU.org, 25 April.

Juks, R (2018), “When a central bank digital currency meets private money: The effects of an e-krona on banks”, Sveriges Riksbank Economic Review (3): 79–99

Mersch, Y (2018), “Virtual or virtueless? The evolution of money in the digital age”, Lecture at the Official Monetary and Financial Institutions Forum, London, 8 February.


What is the definition of bank run? The current banking regulation in the United States holds that the banks and the economy should align in order to protect consumers from the impact of bank runs. Some economists believe that the runs on banks that took place between 1930 and 1933, eventually leading to the Great Depression are responsible for a lot of bank defaults. In fact, bank runs destabilize the economy and the banking system. Therefore, the Federal Reserve requires banks to keep 10% of their deposits in a Federal Reserve account to ensure enough cash in the case of a run on the bank.

Jonathan has deposited $100,000 in Bank ABC. Over the last two days, he hears rumors that the Bank is not solvent anymore, and that it may go bankrupt. So, worried about his money, Jonathan withdraws all $100,000 from his savings and checking accounts and transfers them to another bank.

On the way home, he calls his brother, and he tells him about his worries and that he has withdrawn all his money from the bank. His brother tells his wife, his parents, his in-laws, and his best friend, and they all go and withdraw their funds from the bank. Jonathan posts on Facebook that the Bank ABC may not be solvent, and he informs his 1,500 friends, who then inform their circle of people. So, at the end of the day, more than 150,000 people withdraw their funds from Bank ABC.

Although the Bank was not really facing such a major problem, the rumors and the fact that so many people have withdrawn their funds on the spot has forced the bank to give a lot of cash from its vault. So, now it cannot meet more withdraw requests. Another round of rumors that the bank is not solvent caused the bank to eventually default.


The Great Depression

The longest and deepest downturn in the history of the United States and the modern industrial economy lasted more than a decade, beginning in 1929 and ending during World War II in 1941.

In 2002, Ben Bernanke, then a member of the Federal Reserve Board of Governors, acknowledged publicly what economists have long believed. The Federal Reserve’s mistakes contributed to the “worst economic disaster in American history” (Bernanke 2002).

Bernanke, like other economic historians, characterized the Great Depression as a disaster because of its length, depth, and consequences. The Depression lasted a decade, beginning in 1929 and ending during World War II. Industrial production plummeted. Unemployment soared. Families suffered. Marriage rates fell. The contraction began in the United States and spread around the globe. The Depression was the longest and deepest downturn in the history of the United States and the modern industrial economy.

The Great Depression began in August 1929, when the economic expansion of the Roaring Twenties came to an end. A series of financial crises punctuated the contraction. These crises included a stock market crash in 1929, a series of regional banking panics in 1930 and 1931, and a series of national and international financial crises from 1931 through 1933. The downturn hit bottom in March 1933, when the commercial banking system collapsed and President Roosevelt declared a national banking holiday. 1 Sweeping reforms of the financial system accompanied the economic recovery, which was interrupted by a double-dip recession in 1937. Return to full output and employment occurred during the Second World War.

To understand Bernanke’s statement, one needs to know what he meant by “we,” “did it,” and “won’t do it again.”

By “we,” Bernanke meant the leaders of the Federal Reserve System. At the start of the Depression, the Federal Reserve’s decision-making structure was decentralized and often ineffective. Each district had a governor who set policies for his district, although some decisions required approval of the Federal Reserve Board in Washington, DC. The Board lacked the authority and tools to act on its own and struggled to coordinate policies across districts. The governors and the Board understood the need for coordination frequently corresponded concerning important issues and established procedures and programs, such as the Open Market Investment Committee, to institutionalize cooperation. When these efforts yielded consensus, monetary policy could be swift and effective. But when the governors disagreed, districts could and sometimes did pursue independent and occasionally contradictory courses of action.

The governors disagreed on many issues, because at the time and for decades thereafter, experts disagreed about the best course of action and even about the correct conceptual framework for determining optimal policy. Information about the economy became available with long and variable lags. Experts within the Federal Reserve, in the business community, and among policymakers in Washington, DC, had different perceptions of events and advocated different solutions to problems. Researchers debated these issues for decades. Consensus emerged gradually. The views in this essay reflect conclusions expressed in the writings of three recent chairmen, Paul Volcker, Alan Greenspan, and Ben Bernanke.

By “did it,” Bernanke meant that the leaders of the Federal Reserve implemented policies that they thought were in the public interest. Unintentionally, some of their decisions hurt the economy. Other policies that would have helped were not adopted.

An example of the former is the Fed’s decision to raise interest rates in 1928 and 1929. The Fed did this in an attempt to limit speculation in securities markets. This action slowed economic activity in the United States. Because the international gold standard linked interest rates and monetary policies among participating nations, the Fed’s actions triggered recessions in nations around the globe. The Fed repeated this mistake when responding to the international financial crisis in the fall of 1931. This website explores these issues in greater depth in our entries on the stock market crash of 1929 and the financial crises of 1931 through 1933.

An example of the latter is the Fed’s failure to act as a lender of last resort during the banking panics that began in the fall of 1930 and ended with the banking holiday in the winter of 1933. This website explores this issue in essays on the banking panics of 1930 to 1931, the banking acts of 1932, and the banking holiday of 1933.

One reason that Congress created the Federal Reserve, of course, was to act as a lender of last resort. Why did the Federal Reserve fail in this fundamental task? The Federal Reserve’s leaders disagreed about the best response to banking crises. Some governors subscribed to a doctrine similar to Bagehot’s dictum, which says that during financial panics, central banks should loan funds to solvent financial institutions beset by runs. Other governors subscribed to a doctrine known as real bills. This doctrine indicated that central banks should supply more funds to commercial banks during economic expansions, when individuals and firms demanded additional credit to finance production and commerce, and less during economic contractions, when demand for credit contracted. The real bills doctrine did not definitively describe what to do during banking panics, but many of its adherents considered panics to be symptoms of contractions, when central bank lending should contract. A few governors subscribed to an extreme version of the real bills doctrine labeled “liquidationist.” This doctrine indicated that during financial panics, central banks should stand aside so that troubled financial institutions would fail. This pruning of weak institutions would accelerate the evolution of a healthier economic system. Herbert Hoover’s secretary of treasury, Andrew Mellon, who served on the Federal Reserve Board, advocated this approach. These intellectual tensions and the Federal Reserve’s ineffective decision-making structure made it difficult, and at times impossible, for the Fed’s leaders to take effective action.

Among leaders of the Federal Reserve, differences of opinion also existed about whether to help and how much assistance to extend to financial institutions that did not belong to the Federal Reserve. Some leaders thought aid should only be extended to commercial banks that were members of the Federal Reserve System. Others thought member banks should receive assistance substantial enough to enable them to help their customers, including financial institutions that did not belong to the Federal Reserve, but the advisability and legality of this pass-through assistance was the subject of debate. Only a handful of leaders thought the Federal Reserve (or federal government) should directly aid commercial banks (or other financial institutions) that did not belong to the Federal Reserve. One advocate of widespread direct assistance was Eugene Meyer, governor of the Federal Reserve Board, who was instrumental in the creation of the Reconstruction Finance Corporation.

These differences of opinion contributed to the Federal Reserve’s most serious sin of omission: failure to stem the decline in the supply of money. From the fall of 1930 through the winter of 1933, the money supply fell by nearly 30 percent. The declining supply of funds reduced average prices by an equivalent amount. This deflation increased debt burdens distorted economic decision-making reduced consumption increased unemployment and forced banks, firms, and individuals into bankruptcy. The deflation stemmed from the collapse of the banking system, as explained in the essay on the banking panics of 1930 and 1931.

The Federal Reserve could have prevented deflation by preventing the collapse of the banking system or by counteracting the collapse with an expansion of the monetary base, but it failed to do so for several reasons. The economic collapse was unforeseen and unprecedented. Decision makers lacked effective mechanisms for determining what went wrong and lacked the authority to take actions sufficient to cure the economy. Some decision makers misinterpreted signals about the state of the economy, such as the nominal interest rate, because of their adherence to the real bills philosophy. Others deemed defending the gold standard by raising interests and reducing the supply of money and credit to be better for the economy than aiding ailing banks with the opposite actions.

On several occasions, the Federal Reserve did implement policies that modern monetary scholars believe could have stemmed the contraction. In the spring of 1931, the Federal Reserve began to expand the monetary base, but the expansion was insufficient to offset the deflationary effects of the banking crises. In the spring of 1932, after Congress provided the Federal Reserve with the necessary authority, the Federal Reserve expanded the monetary base aggressively. The policy appeared effective initially, but after a few months the Federal Reserve changed course. A series of political and international shocks hit the economy, and the contraction resumed. Overall, the Fed’s efforts to end the deflation and resuscitate the financial system, while well intentioned and based on the best available information, appear to have been too little and too late.

The flaws in the Federal Reserve’s structure became apparent during the initial years of the Great Depression. Congress responded by reforming the Federal Reserve and the entire financial system. Under the Hoover administration, congressional reforms culminated in the Reconstruction Finance Corporation Act and the Banking Act of 1932. Under the Roosevelt administration, reforms culminated in the Emergency Banking Act of 1933, the Banking Act of 1933 (commonly called Glass-Steagall), the Gold Reserve Act of 1934, and the Banking Act of 1935. This legislation shifted some of the Federal Reserve’s responsibilities to the Treasury Department and to new federal agencies such as the Reconstruction Finance Corporation and Federal Deposit Insurance Corporation. These agencies dominated monetary and banking policy until the 1950s.

The reforms of the 1930s, ’40s, and ’50s turned the Federal Reserve into a modern central bank. The creation of the modern intellectual framework underlying economic policy took longer and continues today. The Fed’s combination of a well-designed central bank and an effective conceptual framework enabled Bernanke to state confidently that “we won’t do it again.”

Endnotes

These business cycle dates come from the National Bureau of Economic Research. Additional materials on the Federal Reserve can be found at the website of the Federal Reserve Bank of St. Louis.


Consequences of Banking Crises

Banking crises have a range of short-term and long-term repercussions, domestically and globally, that reduce economic output and growth.

Learning Objectives

Explain consequences of banking crises on the broader economy

Key Takeaways

Key Points

  • Banks play a critical role in economic growth, primarily through investment and lending.
  • After a banking crisis, investment suffers. When banks lack liquidity to invest, growing business depending upon loans struggle to raise the capital required to execute upon their operations.
  • The fall in liquidity and investment, in turn, drives up unemployment, drives down governmental tax revenues and reduces investor and consumer confidence.
  • Imports and exports play an increasingly large role in the health of most developed economies, and as a result, the relative well-being of trade partners plays an increasingly critical role in the success of domestic economies.

Key Terms

  • Economic crisis: A period of economic slowdown characterised by declining productivity and devaluing of financial institutions often due to reckless and unsustainable money lending.
  • liquidity: The degree to which an asset can be easily converted into cash.

Banking crises have a dramatic negative effect on the overall economy, often resulting in an eventual financial and economic crisis in a given economic system. Banking crises have a range of short-term and long-term repercussions, domestically and globally, that underline the severe repercussions of irresponsible banking practices, poor governmental regulation, and bank runs. The most useful way to frame the consequences of bank crises is by observing the critical role banks play in economic growth, primarily through investment and lending.

Domestic Consequences

Within a given system, banking failures create a range of negative repercussions from an economic perspective. Banks coordinate and economy’s savings and investment: the act of pooling money to capture higher returns for everyone while simultaneously funding business dependent upon leveraging debt and equity. With this in mind, a banking crises can have a variety of averse individual and economic consequences within the system.

First and foremost, investment suffers. When banks lack liquidity to invest, businesses that depend upon loans struggle to raise the capital required to execute upon their operations. When these businesses cannot produce the capital required to operate optimally, sales decline and prices rise. The overall economic performance of any debt-dependent industries becomes less dependable, driving down consumer and investor confidence while reduce overall economic output. Banks also perform more poorly, due to the fact that they have less capital to invest and returns to acquire.

This drives down the overall economic system, both in the short term and the long term, as companies struggle to succeed. The fall in liquidity and investment drives up unemployment, drives down governmental tax revenues and reduces investor and consumer confidence (damaging equity markets, which in turn limits businesses access to capital). There is a distinctive cyclical nature to these adverse effects, as each are interconnected in a way that creates a domino effect across the domestic economic system.

Global Consequences

While these domestic consequences are expected and, in many ways, intuitive, the global dependency upon foreign trade in modern markets has exacerbated these effects. Imports and exports play an increasingly large role in the health of most developed economies, and as a result the relative well-being of trade partners plays an increasingly critical role in the success of domestic economies.


Watch the video: Ορεινό τρέξιμο στον Κάτω Όλυμπο. (December 2021).