The Evolution Of The Bank Run

Claudio Grass, Going Postal
Image by Gerd Altmann from Pixabay

There are numerous and wide-ranging reasons why someone may choose to invest in physical precious metals. A deep understanding of monetary history provides plenty of solid arguments, and so do the mounting geopolitical risks, the spiking probability of a recession and the long-term goal of many conservative investors to safeguard their financial self-determination. For me, while all of these reasons are important, there is also another argument that I find especially powerful and extremely relevant today. The vulnerability of the current banking system itself is a risk that is often overlooked or dismissed, as most mainstream investors, having short memories and a narrow attention span, tend to believe blindly in the banking sector’s ability to protect and preserve their assets and their savings.

A clear and present danger

For most people, the very idea of a bank run is quaint and anachronistic. It conjures up black-and-white images of 1929, and it harks back to the old fears of the analog times. Today, they think, these risks are a distant memory and nothing for the modern investor, or bank customer, to seriously worry about. We have sophisticated systems in place, strict regulations in the banking sector and computers that cut out emotional impulses and smoothly control everything. Surely, banks are safer than ever. And yet, nothing could be further from the truth. Bank runs, far from being a thing of the past, still present a very real risk. Customer confidence can collapse as easily and as rapidly as it did a century ago. Any bank’s creditworthiness and reputation can come under fire and mass withdrawals can cripple any financial institution.

The most recent example of this came out of China in early November and Yichuan Rural Commercial Bank learned this lesson the hard way. A rumor that originated from an obscure social media account and then spread like wildfire cast serious doubts on the bank’s solvency. Panic escalated quickly and within hours of the original post, over 1,000 customers had physically queued up to withdraw their money from the bank. By the next morning, local Chinese authorities had to intervene, with over 30 billion yuan ($4.3 billion) of liquidity injections, to restore confidence. At one branch of the bank, staff even resorted to putting piles of cash on display, just to reassure customers and creditors.

The following week, a similar scenario played out once more, this time at Yingkou Coastal Bank, in northern Liaoning province. In this second bank run in less than two weeks, liquidity fears once again drove customers to line up for mass withdrawals. Arguably, events like this can be seen as just the tip of the iceberg for China’s highly vulnerable banking sector. Earlier this year, the Chinese government had to proceed with a rare government seizure of Baoshang Bank, a move that sparked serious concerns and caused a spike in borrowing costs. As a result, the PBoC itself had to step in and inject 250 billion yuan ($36 billion) into the country’s financial system. Saddled with a huge burden of nonperforming, toxic loans, in recent months, especially smaller, rural banks have also been plagued by an escalating public confidence crisis. So far, the state has provided implicit and explicit support to the lenders, with backstops and interventions, which only provides more fuel for the widespread fears that many banks are likely unable to survive on their own.

However, this risk is not contained within China alone. In late October, we saw similar issues plague banks in Lebanon. Amid widespread protests and prolonged demonstrations against the government, fears of a bank run spiked rapidly. As a result, the country’s banks remained closed for almost half of last month. Several instances have been documented of bank staff intimidated by customers demanding access to their cash, while the probability of capital controls or even a “haircut” on deposits are further fueling public anger. Despite the assurances offered by the Governor of the Lebanese Central Bank that there will be no restrictions to the free flow of money, since reopening, many Lebanese banks have imposed their own forms of capital controls. Some have placed limits on US dollar withdrawals, others prohibited clients from transferring large amounts abroad. Chaotic scenes have been taking place in bank branches all over the country, as faith in the banking sector has been severely shaken.

Lessons from the recent past

If the situation in Lebanon sounds eerily familiar, it is perhaps because it heavily resembles the situation that Greece faced, in the weeks before capital controls were formally and officially imposed. The severe economic crisis that crippled the country, brought back the ghost of “Grexit” and lead to massive protests in the streets, eventually escalated in 2015 and threatened the entire banking sector. The political and economic uncertainty of that time caused millions of Greeks to take their deposits out of the banking system and store it at home, in safes and mattresses. In 2015 alone, deposits in the country’s banks declined by 40 billion euros. After negotiations between the Greek government and its creditors took a particularly wrong turn, long queues were formed outside most bank branches, with citizens lining up since dawn to withdraw their money. Much like in Lebanon, the initial response was to temporarily close the banks, in order to prevent a complete systemic collapse caused by public panic. The government then proceeded to impose capital controls on citizens’ deposits, limiting their withdrawals to 60 euros a day. The chaos that ensued thereafter was widely covered by international media and the impacts of the policy, which only officially ended in September of 2019, are still felt to this day.

Of course, that’s nothing compared to the case of Cyprus. In 2013, after a financial crisis had hit the island and liquidity fears surrounded its banks, the government went a step further, even beyond bank closures and capital controls. The Cypriot government, with no notice, authorized a “haircut”, or “one-time tax” on bank deposits over 100,000 euros, in a bail-in attempt to prop up the country’s distressed banking sector. This confiscation, which was a key requirement by international creditors for a 10-billion-euro bailout package, had a severe impact on savers and investors who had trusted the island’s banking system. After billions were taken from their accounts, 51 of the people who lost funds pursued a legal case for compensation. The case went all the way to General Court of the European Union, were the depositors argued that the bail-in had violated their right to property. In 2018, their case was dismissed by the court, which in its judgment found that the haircut did “not constitute a disproportionate and intolerable interference impairing the very substance of the appellants’ right to property”. Many analysts have argued that the Cypriot case established a strong precedent and a new blueprint on how far governments can go to deal with financial and banking crises, while the legal verdict further legitimized the approach.

No economy is immune to public panic

The risk of a bank run is also present in much more stable economies and a harsh crisis is not necessary to trigger it. A prime and fairly recent example of this can be found in the mass withdrawals Home Capital faced in 2017, in Canada. The lender, based in Toronto, offered uninsured mortgages to borrowers who had been rejected by traditional banks and it came under fire by Ontario Securities Commission that accused the company of violating securities laws and misleading shareholders. As a result of the accusations, Home Capital faced a run on deposits and saw its share price collapse, by over 70%. According to Reuters, “investors withdrew more than 90 percent of funds from the mortgage lender’s high-interest savings accounts.” In order to stay afloat, the company had to secure emergency credit lines with exorbitant interest rates and to sell off large parts of its business. Earnings took a serious hit, compounding the damage that was inflicted on investors by the collapse of the stock price.

A similar scenario unfolded in May 2019 in the UK. This time the target was Metro Bank, a lender that’s been mired in controversy since the beginning of the year, after the revelation of a £1.7 billion ($2.2 billion) accounting error that seriously understated the risk levels of its loans. As a result, the bank’s shares took a nosedive of nearly 40% and faced great challenges in raising fresh funds. In the weeks that followed, there were considerable deposit outflows from large business customers. However, the bank run started in earnest with a rumor that originated in a popular messaging app and quickly spread through social media. The fear of the bank’s imminent collapse, although unsubstantiated, drove hundreds of customers to form long queues at many of the bank’s branches to withdraw their deposits. Interestingly, according to reporting by the Guardian, “the majority of customers queuing were primarily interested in accessing items stored in safety deposit boxes rather than cash in their accounts”, such as jewelry and gold.

The modern bank run and its far-reaching implications

The observant reader will be quick to identify the common thread in all these cases. Unlike the bombastic bank collapses of the past century, today’s bank runs do not usually result in the same type of losses for the bank customer as they used to. Mechanisms have been established to provide emergency liquidity and various regulations have helped shore up public confidence in banks.

In most developed nations, bank deposits, up to a certain amount, are insured, which goes some way into assuaging the public’s fears in the event of a financial meltdown, thereby making bank runs a less explosive affair. What’s more, the actual consequences of a bank facing insolvency are very different today. Governments are much more eager to step in and depositors are much less likely to simply lose everything. This might sound like we’re much safer now than ever before, yet when one thinks about it for a moment and carefully considers many of the cases we looked at above, the real risk quickly becomes apparent.

Due to this relatively new trend of swift and decisive government intervention, it is true that the customers of a single distressed bank are unlikely to lose everything, but bail outs and liquidity injections of taxpayer money mean that their losses are covered by everyone else. What is even more ominous is that the extensive powers that governments have bestowed upon themselves over the banking sector might give them the ability to support and stop lenders from collapsing, but they also give them access to their customers deposits. As we saw in the case of Cyprus, this power can be used to simply take what they need to pay their bills.

As faith in financial institutions and in the banking sector wanes, especially since the 2008 crisis, the system’s defense against possible bank runs has been significantly bolstered. The approach now is proactive and the threat of a bank run can be squashed, most of the time, by closing the banks and by imposing capital controls. So far, even though it deeply damages the banks’ credibility and undermines public trust, this response has been effective in the short term in preventing flash crashes. Of course, for the “receiving end” of these measures, the consequences have varied greatly, from mere inconvenience to existential threat. Capital controls have placed countless bank customers, cash-reliant pensioners and entire households in impossible positions. As access to their accounts was severely limited, many struggled to meet their financial obligations, to pay their bills or cover emergency expenses. For businesses it was even worse. Unable to withdraw or to transfer abroad the amounts needed for daily operations without special permission for the government, numerous business owners faced serious difficulties in paying their suppliers and employees on time. Then they, in turn, struggled to pay for their own daily needs and to make ends meet, thereby creating a vicious cycle of illiquidity. In more ways than one, these limitations on the free flow of money effectively pass on the liquidity crunch from the bank to the wider economy.

However, all these mechanisms heavily rely on depositors trusting the banking system. Despite the newly extended government powers and despite the normalization of once unthinkable practices such as the “bail-in”, responsible savers and investors still have the option to “opt out”, by storing at least part of their assets in a safe jurisdiction and outside the banking system. Physical precious metals offer the best possible protection in this regard, as they not only serve as a solid insurance against the banking sector’s vulnerabilities, but also offer a strong defense against the monetary and inflation risks, that usually accompany aggressive interventionism.

Claudio Grass, Hünenberg See, Switzerland 2019

This article has been published in the Newsroom of pro aurum, the leading precious metals company in Europe with an independent subsidiary in Switzerland.

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