Why Do Bank Runs Happen?

A problem arises, though: Can this all work when savers who do not have immediate liquidity needs withdraw their money simply because they think others will do the same? Plainly, no. The bank won't have all the cash because — and this is the idea — it parked the funds in the long-gestation projects. Also, should the bank call in the outstanding loans it made to the borrowers, those borrowers couldn't return the money quickly because it was tied up in those illiquid assets, ones that, if liquidated, would yield little value. (Think about "half a factory"; how much would you pay for that?!)

If this is the case, why put both functions under one roof? First, absent a run, this "banking" arrangement benefits everyone involved: The depositor who needs to withdraw early can actually enjoy part of the benefits that come from longer-maturity projects. There is risk sharing among depositors. Maturity transformation has social value. Two additional reasons are that first, banks can better monitor their borrowers and use this information to extend credit more cheaply, readily, and flexibly than more arms-length financing arrangements. Second, the inherent fragility of financing the long-term projects with deposits that can be withdrawn at a moment's notice may limit risk-taking in a bank's borrowing and lending practices.

Diamond and Dybvig's model suggests value to deposit insurance, something that many societies have long instituted. Once in place, there'd be no reason to fear a run — so long as "most" of a bank's deposits were indeed insured. Currently, the Federal Deposit Insurance Corporation insures individual deposits up to $250,000 per person per bank unless the government grants the failed bank an exemption that guarantees all their deposits.

But if savers with more than $250,000 deposited at smaller community banks feared that their money wouldn't be insured (or might simply become temporarily unavailable as the bank was wound down), what then? Run risk would remain, especially in the plausible case that they decide to move their money to larger banks they view as "too big to fail." (There is some evidence of this trend in recent months, although it has leveled off.) Unfortunately, if these depositors fled, the smaller banks would no longer be able to intermediate between savers and borrowers. That means tighter credit for those that rely on those banks for their long-term investment needs. And that would be problematic for the wider economy, given that the roughly 4,700 community banks across the country provide roughly 36 percent of all small business loans, and where smaller banks do a large share of all commercial real estate lending.