Consumer Behaviour

So far we have looked at bubbles and government lending and how they influence banking crises. This blog will look at what part consumers and popular media play in banking crises. Banking panic occurs when depositors lose faith in their bank which they believe is going to fail, putting their deposits at risk. In theory this seems irrational as most general customers have limited knowledge about the banks dealings, and most banks offer deposit insurance to reduce the risk of anyone losing their entire deposit. With this in mind it can be shown that in times of economic uncertainty, such as in the early stages of a recession, bank customers are likely to run a bank when they hear bad new about their bank from the media or other customers.

Gorton (1988) investigates the reasoning behind banking panics. He performs empirical tests to find underlying variables to explain why panics occurred. The tests looked at the variables which influenced a depositors perception of the riskiness of a bank, which is known to change depending on the state of the economy. He finds a positive relationship between banking crises and the variables which often forecast a recession, suggesting that in time of likely recession depositors are more likely to lose faith in their bank and panic.

In 2007 Northern Rock was the first bank to be subject to a run for over 150 years. The bank did not have the reserves to meet the increasing number of customer withdrawals, forcing them to liquidate assets to raise funds, and eventually making them bankrupt. What aggravated thed situation was the fact that Northern Rock had previously borrowed from the BoE to ease some of its debts, a move not uncommon in modern banks, however this information may have helped cause panic among depositors, resulting in a run on the bank.

In hindsight bank runs seem very avoidable. Fear of losing their investment is a reasonable excuse to withdraw, however I get the impression that banks runs are a case of depositors shooting themselves in the foot. When an individual is standing in a line a mile long outside a bank, do they not realise that running the bank will inevitably drain all its reserves and effectively ruin a business which they have invested in? Banks offer deposit insurance to try and avoid these situations, but if the customer is not properly informed, there is no reason to expect that they will not run to withdraw when they think they are going to lose their deposit. There is also a moral hazard issue with deposit insurance, removing the banks liability results in irresponsible banking strategies. 

Diamond and Dybvig 1983 look at banking deposit contracts, both insured and uninsured demand deposit contracts and explored ways in which banks can share risk between customers and reduce the risk of bank runs by careful management. Their findings suggest that there is a optimal contract which balances risk sharing and liquidating assets to prevent runs. These contracts also include Suspension-of Convertability clauses which prevent bank runs by allowing the bank not to return a customers deposit. This needs to be carefully managed as these precautions to avoid bank runs could lose them customers in the long run who want their deposits assured.

Gorton, G. 1988, “Banking Panics and Business Cycles”, Oxfort Economic Papers 40, pp.751-781 Diomond, D.W. & Dybvig, P.H. 1983, "Bank Runs, Deposit Insurance, and Liquidity", The Journal of Political Economy, ,pp.401-419.

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