In a run fear that a bank may fail induces depositors to withdraw their money

In a run fear that a bank may fail induces depositors

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the banks. In a run, fear that a bank may fail induces depositors to withdraw their money, which in turn forces liquidation of the bank's assets. The need to liquidate hastily, or to dump assets on the market when other banks are also liquidating, may generate losses that actually do cause the bank to fail. Thus the expectation of failure, by the mechanism of the run, tends to become self-confirming.'2 An interesting question is why banks at this time relied on fixed-price demand de- posits, when alternative instruments might have reduced or prevented the problem of runs.'3 An answer is provided by Friedman and Schwartz: They pointed out that, before the establishment of the Federal Reserve in 1913, panics were usually contained by the practice of suspending convertibility of bank deposits into currency. This practice, typi- cally initiated by loose organizations of urban 7Hart describes the problems of the building-and- loans. An interesting sidelight here is the additional strain on housing lenders caused by the existence of the Postal Savings System; see Maureen O'Hara and David Easley (1979). 8According to Raymond Goldsmith (1958), commer- cial banks held 39.6 percent of the assets of all financial intermediaries, broadly defined, in 1929. See his Table 11. 9Cyril Upham and Edwin Lamke (1934, p. 247). Since smaller banks were more likely to fail, the fraction of deposits represented by suspended banks was some- what less. Eventual recovery by depositors was about 75 percent; see Friedman and Schwartz, p. 438. '0Benjamin Klebaner (1974) gives a good brief his- tory of U.S. commercial banking. ''Upham and Lamke, p. 247, report that approxi- mately 2-3 percent of all banks in operation failed in each year of the 1920's. 12Douglas Diamond and Philip Dybvig (1981) for- malize this argument. For an alternative analysis of the phenomenon of runs, see Robert Flood and Peter Garber (1981). 13For example, equity-like instruments, such as those used by modern money-market mutual funds, could have been used as the transactions medium. See Ken- neth Cone (1982). This content downloaded from 129.94.8.182 on Wed, 17 May 2017 02:12:24 UTC All use subject to
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260 THE AMERICAN ECONOMIC REVIEW JUNE 1983 banks called clearinghouses, moderated the dangers of runs by making hasty liquidation unnecessary. In conjunction with the suspen- sion of convertibility practice, the use of demand deposits created relatively little in- stability. ' However, with the advent of the Federal Reserve (according to Friedman-Schwartz), this roughly stable institutional arrangement was upset. Although the Federal Reserve in- troduced no specific injunctions against the suspension of convertibility, the clearing- houses apparently felt that the existence of the new institution relieved them of the re- sponsibility of fighting runs. Unfortunately, the Federal Reserve turned out to be unable or unwilling to assume this responsibility.
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