Was the Panic over Banking Runs Justified?

Federal authorities overreacted to banking runs in the financial crisis, says Vern McKinley, a research fellow at the Independent Institute in a CATO Institute Policy Analysis.

Bank runs are a consistent fear during times of crisis, and the 2007-2009 financial crisis prompted those same concerns. The idea is simple: financial turmoil leads institutions to announce losses, sparking panic among customers who race to the bank to withdraw their funds. And because banking institutions generally have invested most of their assets, these withdrawals threaten their viability. Fearing the worst, the government jumps in to intervene to save the institution, insisting on a bailout that will prevent a larger, systemic crisis.

After the 2007-2009 crisis, the Financial Crisis Inquiry Commission discovered 10 bank runs at individual institutions, from Countrywide Financial to Washington Mutual to Bear Stearns to Wachovia. McKinley’s concern is that federal regulators stepped in, unnecessarily, to prevent a systemic crisis that was not going to occur.

• For example, McKinley looks at Wachovia and Citibank — banks at which federal regulators intervened “before they had determined the extent of the debilitation that would result from a run.”
• Regulators acted early, and unnecessarily.
• Wachovia, he says, had enough liquidity to last an extended period of time.
• And as for Citibank, authorities seemed to have “assumed” that the institution was systemic, without any real analysis.
• The poorly managed bank should have been deemed a problem institution, but instead, it continued to receive federal dollars.

Moreover, there was no evidence that bank withdrawals were exiting the banking system entirely. In fact, total bank deposits actually increased during the crisis period, suggesting that withdrawals were simply being moved to what were seen as stronger, healthier institutions.

In responding to bank runs, regulators should allow the unhealthy institutions to fail. Poorly managed institutions should sink or swim on their own. Allowing failure is the only way to ensure that these unhealthy institutions will never again operate.

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