Table of Contents
Introduction
A look at the advanced economies around the world will support the observation by Castiglionesi (2012), who stated that availability of credible financial institutions is significant in the evaluation of the economic development of a country. Therefore, banks play a pivotal role in each economy, as they represent the channel through which investments are induced into the economy by their role of providing financial assistance to businesses. Despite this, the history of banking across the world has been one defined by panics and bank runs.
This paper considers history in analyzing the banking experiences related to bank runs. In so doing, the essay attempts to ascertain the role that contagion plays in facilitating bank runs. This study is significant in exploring the relationship between contagion and the bank runs, hence giving indirect insights on how banking institutions can overcome the contagion threats, more so in relation to the function they play in promoting bank runs.
Discussion
According to the IMF estimates documented by Brown, Trautmann and Vlahu (2015), the recent financial market breakdowns experienced in South Korea, Japan, Indonesia and Thailand cost over 100 billion dollars. These crises, coupled with those of Mexico, Venezuela, Argentina and Brazil only replicate the sufferings of the Scandinavian countries at the beginning of the last decade of the 20th century. Indeed, these histories have been instrumental in the development of a vast field of literature on contagion and bank runs.
Bank runs, therefore, refer to the simultaneous withdrawal of deposits from a bank or financial institution by a large number of depositors. In many of the cases above, concerns raised about such banks’ solvency generated fear among the depositors. As Brown, Trautmann and Vlahu (2015) observe, such massive withdrawals often inflict the risks of default, a factor that generates even more fear. In extreme cases that the bank is declared insolvent, the bank reserves are deemed insufficient to accommodate the withdrawals of the depositors.
On the other hand, contagion is used by many financial scholars to refer to the transmission of idiosyncratic shocks across a group of financial institutions (Castiglionesi, 2012). These shocks, moreover, often begin with one bank, before being transmitted to the other banks within the banking sector. Contagion, furthermore, is designated as a systemic risk that may manifest into a common shock that affects all banks, albeit simultaneously.
Contagion, due to its notion of systemic risk, causes systemic instability that accrues from the problems in a single institution. In the process that a bank encounters bank runs, the vulnerability to the systemic risk of contagion is brought forth in the form of transforming the illiquid assets such as loans to liquid liabilities such as deposits. Besides, the excessive demands of liquid liabilities translate into bank runs when one bank fails to meet the demands of the individual depositors.
As He and Manela (2016) observe, bank runs are random events that can affect any bank. The author goes ahead to write that the commencement of bank runs in one bank triggers the risk of similar runs in other banks within the sector, hence the contagion effect. In this instance, the depositors exhibit panic that makes them withdraw their deposits devoid of the difference and similarity assessment between banks within a sector.
The variations of bank portfolios are critical in determining the nature of services offered by these banks. For instance, banks that specialize in providing mortgage loans have similar portfolio that commonly translate across the other banks with similar portfolio. Information based runs may be influenced by the failure of one such bank in the mortgage portfolio sector. In addition, the availability of information about the factors that contribute to a particular bank run may be a contributing factor to the information-based bank run in which the depositors link the failures of one bank to the possibilities of the failure in their own bank by virtue of perceived similarities.
The availability and symmetry of information is considered a significant contributor to the financial health of any sound banking sector (Vaugirard, 2007). Contagion can contribute to bank runs in situations where there is information asymmetry between the institutions and the depositors. In such instances that the depositors acquire information about the risks of the banking sector, the chances of contagious bank runs are heightened.
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Conclusion
Historically, the possibilities of contagious panics appear to depend on the banking system structures in relation to information, portfolio management and economic stability. In conclusion, this history continues to generate debates and course of studies that elaborate the relationship between the effects of a panic that encompasses a large part of the banking system and its effects on the economic activities of the banks.
- Brown, M., Trautmann, S., & Vlahu, R. (2015). Contagious Bank Runs: Experimental Evidence. SSRN Electronic Journal, 45(3). http://dx.doi.org/10.2139/ssrn.2195903
- Castiglionesi, F. (2012). Financial contagion and the role of the central bank. Journal Of Banking & Finance, 21(8), 81-101. http://dx.doi.org/10.1016/j.jbankfin.2012.03.025
- HE, Z. & MANELA, A. (2016). Information Acquisition in Rumor-Based Bank Runs. The Journal Of Finance, 71(3), 1113-1158. http://dx.doi.org/10.1111/jofi.12202
- Vaugirard, V. (2007). Informational contagion of bank runs in a third-generation crisis model. Journal Of International Money And Finance, 26(3), 403-429. http://dx.doi.org/10.1016/j.jimonfin.2006.11.005