On the Fundamental Reasons for Bank Fragility

O ver the course of the recent financial crisis, several large financial institutions experienced sudden, massive withdrawals of their usual funding sources. In the U.K., for example, depositors lost confidence in the bank Northern Rock and started a run of withdrawals that ended with the bank being taken into state ownership. In the United States, the investment bank Bear Stearns and the commercial bank Wachovia both experienced a rapid loss of funding and were taken over by other institutions to avoid their outright failure. This same phenomenon affected other types of institutions as well, including a large part of the money market mutual fund industry, which experienced heavy withdrawals following the failure of the Reserve Fund in September 2008. These episodes are only the most recent examples of a phenomenon that has been a recurrent theme in the history of banking. Banking panics, with massive withdrawals often leading to widespread bank failures, were a regular occurrence in the United States prior to the advent of government-sponsored deposit insurance in 1933. Developing economies have also experienced runs on their banking system, including episodes in Ecuador (1999), Argentina (2001), and Russia (2004). Observers of these episodes often claim that there is an important selffulfilling component to the behavior of depositors and/or investors. In this view, each depositor fears that the withdrawals of other depositors will cause the bank to fail and rushes to withdraw her funds before this failure occurs. Collectively, these actions validate the original belief that a wave of withdrawals will cause the bank to fail. During the height of the Panic of 1907 in the United States, J.P. Morgan was reported in the New York Times to have