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Strictly Monetary V: Run on the bank

In Financial, Strictly Monetary: A Series on February 13, 2011 at 2:05 PM

This story was originally reported by Milton Friedman. While he was renowned for his theoretical accomplishments in economics, I admired him most for his ability to reach the general public through stories. A bank run, inspired by people demanding their money all at once, demonstrates the original purpose of the Federal Reserve and also serves to provide insights into the anatomy of crisis. While most bank run stories end poorly, this is my favourite example of how to successfully avert crisis.

After the stock market crash of 1929 the bubble had burst and bank failures all across America became increasingly frequent. Once the Bank of United States in New York fell, America’s recession had become global and much more severe. While nobody could have predicted the length and magnitude of the looming depression, George S. Eccles didn’t have any time to think about the future. In Salt Lake City, Utah, as well as its surrounding area, the general public panic hit the banking system and suddenly customers all wanted their deposits back.

Eccles was the bank manager at First Security Corp. In 1930 the Great Depression was only just picking up steam and newspapers speculated on rumours about which banks would be next to close their doors on customers. It was only a matter of time until the panic had reached the banks of Salt Lake City.

Eccles came in that morning with a plan. He knew that in order to stop a bank run, it was necessary to persuade the public to stop asking for it. It was also important to have some additional source of cash to appease demanding customers.

Eccles had summoned the entire branch staff to meet early that morning, before the bank opened. “Act as if nothing is happening and keep a smile on your face, if you can,” he said, with a chuckle.

“And never leave the window. Have every window open all day. The important thing is that we all know there will be a big line there all day, so there’s no use in hurrying, because the line won’t go away. Go back and check the signature. Take your time. And when you pay the money out, don’t pay it in hundred dollar bills. Pay it out in fives, tens, and twenties. Count it twice. Hand it out with a smile,” he said.

The staff followed Eccles instructions precisely. Even with their most revered clients, the tellers went back to check the signature, simply to mark time. Eccles tactic was enough to create the perception that the bank would remain open and in business. However, despite these stall tactics, customers continued to take out all their deposits and by lunchtime the bank was almost entirely out of cash.

Eccles immediately got on the phone with the Federal Reserve bank and asked for more cash to be delivered as soon as possible. America’s banking system stemmed from a very free, organic and decentralized environment. However, because there was no central banking authority, America’s system had traditionally been riddled with bank failures. Lending money to First Security Corp was precisely what the Fed Reserve was originally created to do, to help banks in times of crisis.

Soon, two giant sacks of money were delivered to the bank in an armored truck. Eccles brother, Marriner, who would years later be appointed by Franklin D. Roosevelt to chair the Fed Reserve, grabbed the Federal guard by the arm.

“I need you to stand up on the counter and tell these people that you’ve brought a lot of money and that there’s plenty more where this came from,” said Marriner. The guard did just that. Now that First Security had secured an additional source of cash to back up all the deposit demands, it was imperative that the other surviving bank across town stayed open as well.

Eccles called the other bank only to learn that they had run out of money. Eccles immediately arranged a temporary loan to the other bank. “We’ll never break the run on our own,” he said. “Everybody’ll keep coming to our bank until they get all their money out.” 

Had Eccles not extended this loan to the rival bank, it would have hurt his bank as well, since the panic would have sucked the money out of any bank that was open. The panic was a problem that was bigger than all of their individual concerns.

On day two, the entire branch staff congregated once again before the doors opened. The strategy would be different this time. “Pay out the money as fast as you can, in hundred dollar bills, and never let a line develop,” said Eccles. The same strategy was employed at the bank across town as it now had an additional source of cash to continue business.

The line never developed. By lunch people were in and out of the bank at a normal fashion and the bank run was over. To solve a potential banking crisis, it took additional money injected into the banking system by the Fed Reserve and cooperation among competing banks.

The problem with bank runs is that while the bank may have enough assets to pay everyone their deposits back, because they have made loans with your deposits, it is impossible to pay back all demand deposits at once. It takes time to retract its loans from one person in order to pay back a deposit to another.

That is the model to solve every banking crisis. Stop the panic and cooperate. Money creation happens when banks lend to each other, and it is destroyed when they distrust each other. It wasn’t enough that the Fed Reserve leant money to George Eccles. It was just as critical that First Security Corp leant money to the rival bank. That is the essence of money creation, banks lending to banks. The panic of the Great Depression was at the core of society. The average person had lost trust in banks. However, the financial system didn’t collapse until banks stopped lending to each other.

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  1. Here is a piece discussing how the financial system could collapse. Ultimately, everything related to collapse and crisis resembles a run on the bank. Rather than customers like you and me asking for their money, it’s institutions that lend to each other doing the same.

    http://www.bloomberg.com/news/print/2011-02-17/hedge-funds-may-pose-systemic-risk-in-crisis-u-s-report-says.html

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