The more information banks depositors have about an economic crisis, the less likely they are to make a run on their deposits in those banks, according to an experimental study by economists at New York University and the Federal Reserve Bank of New York. Their results also showed that the presence of insiders-those who know the quality of the bank-and the availability of deposit insurance, even if limited, can significantly mitigate the severity of bank runs. The study, On the Dynamics and Severity of Bank Runs, appears in the Journal of Financial Intermediation.
The study was co-authored by New York Universitys Andrew Schotter, a professor of economics and director NYUs Center for Experimental Social Science, and Tanju Yorulmazer, an economist at the Federal Reserve Bank of New York.
The 2007 bank run on Northern Rock in the U.K., the first bank run in the U.K. since the collapse of the City of Glasgow Bank in 1878, once again showed that crises and bank runs are an important feature of our financial landscape, the authors wrote.
To examine the factors that may dampen bank runs, in which a large number of depositors seek to withdraw their funds over fears of insolvency, the researchers ran a series of laboratory experiments in which human subjects faced a variety of conditions and then examined how fast money is withdrawn from the banking system after a hypothetical crisis has developed.
In the experiment, conducted at NYUs Center for Experimental Social Science, the researchers used groups of six subjects, or depositors, who were told they must withdraw their money during one of four time periods. In the experiment, the subjects were told that the bank promised to pay interest on deposits as long as it had the funds when depositors withdrew, meaning a depositor could earn more, through compounded interest, the longer his or her money was kept in the bank and as long as it remained solvent. If the bank did not have the required funds, then it paid each depositor who wanted to withdraw at that time an equal share of what it had available on hand while the depositors who showed up at later periods would receive nothing.
The researchers implemented a variety of experimental treatments to replicate real-world conditions. In one treatment, the high-information sequential treatment, subjects had to decide, period by period, whether to remove their funds from their bank, but were informed of how many others had removed their funds already and whether those who removed were paid their promised interest. In the low-information sequential treatment, subjects again had to decide, period by period, whether to remove their funds, but were given no information about what actions their predecessors took or whether they had been paid. These sequential treatments were also run in the presence of partial deposit insurance, in which participants were told their deposits were insured up to 20 percent or 50 percent of their value, and in a condition where there were insiders within who group of six. These insiders knew the quality of the bank in which each member of that groups funds were deposited.
The researchers found that the participants in the experiment withdrew their funds more slowly when they were informed about the previous actions of their cohorts and when there was deposit insurance-even when that insurance was only partial. In addition, money was withdrawn more slowly when there were insiders (i.e., those who knew the quality of the bank in which funds were deposited) in the experiment and when their existence, though not their identity, was known to the group. Surprisingly, when insiders exist, they tend to remove their money later. This is because they know that the outsiders will be watching to see if anyone removes his or her funds. As a result, the insiders tend to remove their funds later, resulting in a greater return due to more accrued interest.
Our experiments demonstrate that the more information laboratory economic agents can expect to learn about the crisis as it develops, the more willing they are to restrain themselves from withdrawing their funds once a crisis occurs, the authors wrote. Furthermore, our results indicate that the presence of insiders, who know the quality of the bank, significantly affects the dynamics of bank runs and helps mitigate their severity. We also show that deposit insurance, even of a limited type, can help diminish the severity of bank runs.