By Larry Wright
Introduction
Cryptocurrency markets are financial sectors that are currently under duress on account of economic and internal factors. Some important issues are still unresolved and they have the potential to increase the current bear market for cryptocurrency investors.
This article will allow the investors to learn about Bank Run which will teach them about different aspects of the DeFi market and help them gauge the investment risks.
What is a Bank Run?
A bank run is a phenomenon when investors start to withdraw large amounts of cryptocurrencies out of their banks or custodial account holders. When such an event happens, any financial enterprise can go out of commission and can face issues with keeping up with the liquidity requirements.
It is important to note that every financial enterprise deploys its client deposits in different investment ventures. However, these enterprises are under obligation by the law to always maintain a sufficient reserve to provide liquidity to their consumers.
Such an event typically happens when the consumers of a bank are worried that the bank is in danger of going out of business. Therefore, FUD spreads in the market and the consumers flock around the bank to keep withdrawing their money as soon as possible.
The withdrawn amount can become so huge that the banks have no choice but to declare bankruptcy. It is important to note that when a financial enterprise has filed for insolvency they are no more liable by the law to repay its debts.
How does a Bank Run Work?
The bank run can happen on account of several factors. In most cases, it starts with the circulation of negative news in the market. If there are rumors in the market that a particular bank or financial enterprise is unstable, it means that it can spread some unrest among the investors.
It is important to note that the value of every financial instrument is tied to its goodwill among the users. For example, the bonds issued by US Treasury are considered to be the most reliable investment in the world on account of the stability of the US government.
The same is the case with gold, diamond, and fiat currencies. If the people of a country start to lose their belief in a legal tender it will no longer hold real value. On the other hand, if the international markets declare that the value of a native currency has crashed, the users can also reciprocate it.
The same rule applies t to financial enterprises. If a dominant number of clients start to believe that the bank is about to collapse, they can start a trend to take out money resulting in a flood of withdrawals.
As a result, the financial institution would run out of liquidity to remain operational and would have no choice but to file for bankruptcy.
Most banks are regulated and protected under the Central Banking system. For example, the banks in the USA have the option to ask for massive amounts of cash to maintain their liquidity.
However, to qualify for these massive cash reserves, these banks have to submit large sums of money to the Federal Reserve as collateral. On the other hand, there are some insurance organizations for commercial banks in the USA that take over them to protect the interest of the consumers.
The Federal Deposit Insurance Corporation can jump in to take over a bank that has gone insolvent on account of a bank run. Therefore, in the modern world, the consumers of banks do not have to deal with issues like commercial banks breaking down and closing.
What are the Negative Impacts of a Bank Run?
As mentioned before, there is not a singular reason that can be always traced back to a Bank Run incident. The stability and goodwill of a financial institution can be affected on account of various macro and micro economic factors. Here are some of the most common reasons that lead to the occurrences of a Bank Run:
Negative Speculation
If there is enough bad press against a financial institution, it can lead to its breakdown eventually.
There are many cases in history where a single article or publication in a prestigious newspaper has led to the collapse of a financial enterprise. It does not mean that publication houses and journalists are enemies of the common masses.
On the contrary, investigative journalists may find some evidence of foul play in a financial enterprise and they can use the media to report it back to the public. Therefore, if there is enough plausible evidence against a particular financial enterprise, people are going to catch up and try to deal with this issue.
The printing press is largely replaced by social media websites these days. Therefore, the spread of information is much faster and if enough voices among netizens have accepted a negative image of a financial enterprise, it is going to become a reality for its consumers.
Asset Management
These days just about every other person is connected to a social media influencer. People tend to follow what these influencers are preaching with or without any plausible evidence to back their claims.
On the other hand, there are some cases where financial investigative companies can become active upon the news of financial mismanagement within a financial enterprise.
The consumers can also demand audit reports from the financial enterprise and demand explanations from the company officials at the same time.
In case, the management of an enterprise is unable to come up with a decent justification for its actions or fails to deny the rumors of financial mismanagement the trust of its clients can break leading it to a bank run and insolvency.
Economic Breakdown
There are some cases, where a financial enterprise is working without any foul play or any bad rumors. However, sudden changes in the economic background can lead to financial ruin. Take, for example, the COVID social restrictions.
During these times, most people decided to stop putting more money into the financial markets and the economic system was affected very badly.
As a result, the government had to intervene and use tactics like Quantitative Tightening to control the sharp economic decline. Under these circumstances, many companies have resorted to downsizing their employees or had to reschedule their budgets to remain operational.
In past, some economic crises created bank runs for several commercial banks such as stock market crashes and economic depressions.
Political Instability
Political stability is also a very important factor to make sure that the trust of people in financial enterprises remains intact. If the people are worried that bad political leadership is going to take over they are likely to stop trusting financial enterprises under the government anymore.
On the other hand, if the people are worried that the government is no longer going to maintain its writ in a region the trust of people can also lapse. If the government of a country is under attack, such as Ukraine the people are going to withdraw their money from the banks as soon as possible.
This situation can create an air of economic instability and increase bank run incidents for the financial enterprises in that region.
What are the After-effects of a Bank Run?
It can seem that a bank run is something that a financial enterprises can deal with and resolve over time. However, the cascading impact of a Bank Run can persist in a financial market for long durations.
Therefore, the consumers must make sure that they are aware of the following negative impacts of a Bank Run that could affect financial markets:
Regulatory Reformation
When an event such as Bank Run happens, it can lead a financial enterprise to collapse. It means that the investors and the clients can question the government that was regulating it.
It is important to note that all commercial banks and financial investment companies in a region are regulated under the rules of financial agencies. For example, all the stock exchanges and publicly listed companies in the USA are regulated by the Securities and Exchange Commission.
The job of these financial regulators is to ensure that these financial entities are operating as per the standardized laws. Furthermore, these federal agencies are also liable to conduct regular audits of the companies under their regulator compass to make sure that the interests of the investors and clients are protected.
Therefore, when such an event as a Bank run happens it is viewed as a question mark on the performance and leadership of the government regulators. The government can face greater pressure from the masses to introduce regulatory reforms to make sure that the current incident does not happen ever again.
Client Trust
When Bank Runs happen, they can flush the trust of the clients in an asset class, in a legal tender, in a government, or a financial market. For a considerable amount of time, the people would not be willing to put their trust in insolvent and crashed financial enterprises ever again. The bad publicity can also envelop some other financial enterprises for a long time.
For example, if people are burned out by a stock market crash the overall number of stock traders is going to remain low for a long duration. The governments and the responsible authorities can come forward and introduce preventive measures for the relative financial enterprise to restore the faith of the investors once again.
Economic Drawbacks
There are considerable economic drawbacks that can linger for a while after a bank run incident. When a financial enterprise fails, the people are going to stop participating in the market anymore or dissolve their positions.
They can increase buying pressure in the market which can result in massive losses for most position holders.
It can also result in margin call triggers for institutional investors that can make enterprises weaker and make cuts to keep operating.
On the other hand, retail participation can suffer from considerable collective losses. They can stop spending a lot and their buying power can dwindle.
At the same time, during bear runs investors are unable to acquire fixed assets like property, houses, and cars or take loans for business development. Until the markets have turned back to normal the economic stability is threatened.
History of Bank Runs in Financial Markets
There are some major bank runs in commercial banking history. It is important to note that history is filled with incidents where commercial banks were going out of business taking all the funds of consumers with them into the ground. The centralized government has only recently learned to make the system stable and fail-safe.
In the early years of commercial banking, there is an example of big failures that would make people say that banks should not exist in the first place. Here are some of the most talked about Bank Runs in financial markets:
Stockholm Banco
This was a bank started by the Crown of Sweden in the 17th Century. The bank failed in 1664 because it was unable to return banknote deposits of its consumers. The bank was merged with Crown and today it is still operating under the name of Riksens Standers Bank.
Gurney and Company
Gurney and Company was a limited liability company in the UK during the 19th century. When it was suffering from financial uncertainty, the Bank of England refused to grant it any aid. Therefore, it was dissolved out of existence in 1866.
Bank of Japan
Bank of Japan failed to redeem the bond issued to commercial banks in the aftermath of the Great Kanto Earthquake. Therefore, it was caught up in the Showa financial crisis that failed 37 commercial banks in Japan. This financial crisis also resulted in the resignation of PM Wakatsuki Reijiro.
Bank of Spain
The discovery of the misplacement of around 450 million Pasetas in the reserves of the Bank of Spain led to a bank run in the Espana region in 1994.
Bank Negara Malaysia
During 1997-1999 several bank runs happened in Malaysia on account of the collapse of its largest financial enterprise named MBf Finance Berhad. There was an accumulated lapse of 17 billion Ringgits that promoted the central bank or Negara Malaysia to take over eventually.
IndyMac Bank
In 2008, a mortgage lending company called IndyMac Bank hailing from the USA was captured by financial regulators. The investigation revealed that a federal agency Office of Thrift Supervision had colluded with the IndyMac to avoid regulatory compliance.
This bank run was caused by a letter from Charles E. Schumer to regulators about misconduct. It cost a loss of $9 million for FDIC and resulted in losses valued at $270 million for uninsured depositors.
Landsbanki
Landsbanki was the largest commercial bank operating in Iceland. It was put under government control using emergency takeover laws in 2008 and the state also dismissed its board of directors. The bank asked Russia to lend 3 billion in loans to remain operational.
The bank at that time also had 5 million in reserves from Briton clients. The collapse of the bank could also result in a massive economic hit for UK and Iceland at the same time.
What does Bank Run Mean for Cryptocurrency Exchanges?
The main reason that most people are concerned about Bank Runs today is the DeFi sector. FTX the second largest cryptocurrency exchange was hit by a bank run after it clashed with the Binance exchange.
The clash resulted in revealing the internal financial misconduct and mismanagement that gave rise to a bank run. FTX is now officially bankrupt and it has created a negative air of FUD in the entire cryptocurrency market.
Bank runs for DeFi are a real problem and the cryptocurrency enterprises are attempting to solve it using Proof of Reserve. The debate that whether PoR reports are authentic and reliable enough to restore the faith of investors in crypto exchanges is still not done.
Cryptocurrencies are decentralized enterprises that operate outside of centralized banking networks. The threat of bank runs can result in the intrusion of financial enterprises in the DeFi sector which could hurt its main utility and integrity.
It is up to the cryptocurrency exchanges and other enterprises in this sector to come up with solutions that are good enough to answer the concerns of investors. It is important to note that thus far most cryptocurrency exchanges such as FTX, Coinbase, and Binance are regulated enterprises.
However, there is a lack of proper regulatory clarity from both centralized and decentralized entities. If DeFi wishes to remain an independent financial market, it is going to incorporate some new ground rules that ensure the protection of its consumers.
Conclusion
Bank runs are not a new occurrence. As shown above, banks dealt with the growing pains of persisting under the threat of a bank run. However, with the introduction of FDIC in the 1930s, commercial banks become safer for the general population.
Taking a slip from the example of centralized banks, the DeFi sector also needs to come up with a framework that could eradicate the risk of bank runs and make it a secure financial market without compromising on the tenets of decentralization.