Keep depositors ‘in the know’ to avoid bank runs

NYU (US)—Healthy relationships thrive on communication, including the relationship between a bank and its depositors. A recent study by economists at New York University and the Federal Reserve Bank of New York suggests that the best way to avoid a bank run during a financial crisis is to keep depositors informed.

Even in the face of a bank run, the researchers found there is a way to mitigate the severity. The presence of “insiders”—those who know the quality of the bank—and the availability of deposit insurance are key.

“The 2007 bank run on Northern Rock in the U.K., the first bank run in the U.K. since the collapse of the City of Glasgow Bank in 1878, once again showed that crises and bank runs are an important feature of our financial landscape,” according to study coauthors Andrew Schotter, a professor of economics and director NYU’s Center for Experimental Social Science, and Tanju Yorulmazer, an economist at the Federal Reserve Bank of New York.

To learn more about factors that might dampen a bank run and forestall a massive frenzy of withdrawals, the economists studied groups of six participants, or “depositors,” who were told they must withdraw their money during one of four time periods. In the experiment, the depositors were told that the bank promised to pay interest on deposits as long as it had the funds when depositors withdrew, meaning a depositor could earn more, through compounded interest, the longer his or her money was kept in the bank and as long as it remained solvent. If the bank did not have the required funds, then it paid each depositor who wanted to withdraw at that time an equal share of what it had available on hand while the depositors who showed up at later periods would receive nothing.

The researchers implemented a variety of experimental treatments to replicate real-world conditions and found that participants withdrew their funds more slowly when they were informed about the previous actions of their cohorts and when there was deposit insurance—even when that insurance was only partial. In addition, money was withdrawn more slowly when there were insiders (i.e., those who knew the quality of the bank in which funds were deposited) in the experiment and when their existence, though not their identity, was known to the group.

Surprisingly, when insiders exist, they tend to remove their money later because they know that the outsiders will be watching their reaction. As a result, the insiders tend to remove their funds later, resulting in a greater return due to more accrued interest.

“Our results indicate that the presence of insiders, who know the quality of the bank, significantly affects the dynamics of bank runs and helps mitigate their severity,” the researchers write. “We also show that deposit insurance, even of a limited type, can help diminish the severity.”

New York University news: