New Study Challenges Crypto's 'Banking Collapse' Narrative

Author: Byron Gilliam, blockworks

Compiled by: Shenchao TechFlow

Shenchao Introduction: Bitcoin supporters often treat fractional reserve banking as a Ponzi scheme, saying that when a bank run occurs, even good banks will fail. But a new study combed through a large number of bank run events and found that most runs fizzle out on their own before threatening the bank. For investors who use bank fragility as a crypto narrative, this is a rebuttal they must confront.

"You're thinking of this place all wrong, as if I had the money back in a safe." (George Bailey on fractional reserve banking)

The basic promise of banking is that everyone can get their money back at any time, as long as they don't all ask for it at the same time.

That's what George Bailey taught us.

"You're thinking of this place all wrong, as if I had the money back in a safe," he told the customers who were running on Bailey Brothers Building & Loan. "The money's not here. Your money's in Joe's house, right next to yours. And in the Kennedy house, and Mrs. Macklin's house, and a hundred others."

"You're lending them the money to build, and then, they're going to pay it back to you as best they can," he explained.

The anxious customers were not immediately reassured. George had to put up his own $2,000 to fend off the run. Even then, the bank wasn't truly saved until the end of the movie: friends and customers donated enough money to cover the $8,000 hole in the bank's balance sheet.

Austrian economist Murray Rothbard would have said let Bailey Bros. fail. "Fractional reserve banking is a scam, a Ponzi scheme, a fraud," he once wrote.

He believed banks could perpetrate this fraud because bankers like George Bailey misrepresented how they were able to make so many loans.

"Because everyone is so accustomed to thinking of banks as simply borrowing our money and lending it out," Rothbard explained in a lecture, "it is difficult to shift gears and realize that banks are actually engaged in a legalized form of counterfeiting money."

In other words, if people truly understood how fractional reserve banking works—that banks create money "out of thin air"—everyone would demand their money back at the same time. Even the best banks would fail.

This pessimistic view of banks seemed to have academic support. Economists Douglas Diamond and Philip Dybvig wrote a classic study on the fragility of fractional reserve banking: "Bank Runs, Deposit Insurance, and Liquidity."

The study formalized Rothbard's intuition: banks that fund long-term loans with demand deposits are vulnerable to being brought down by a run, even if their assets are healthy.

Thus, fears of bank failure can be self-fulfilling: "During a bank run, depositors rush to withdraw their deposits because they expect the bank to fail," the authors explained. "In fact, the sudden withdrawals force the bank to liquidate many of its assets at a loss, and it ultimately fails."

"This need not be related to the bank's fundamentals," they added. Instead, "anything that causes [depositors] to anticipate a run will lead to a run."

"Even 'healthy' banks can fail."

Diamond and Dybvig reached this troubling conclusion largely through theoretical models based on mathematics and game theory.

A new study shows that the model does not reflect reality.

Every bank run event, scraped from newspaper reports by a large language model, is recorded on a website detailing why the run started and how it was resolved.

The surprising finding is that most runs fizzle out on their own before threatening the bank. The authors found: "Runs that did not lead to bank failure outnumber those that did."

This does not match the predictions of the Diamond-Dybvig self-fulfilling model.

Even among banks with "very weak" fundamentals, only 59% failed after experiencing a run.

I suspect Rothbard would have expected that number to be 100%.

Meanwhile, banks with the strongest fundamentals "rarely failed," even when they experienced runs.

The authors' conclusion? "This pattern casts doubt on the strong view that liquidity problems alone can trigger severe financial distress."

I think that's their polite way of saying Diamond, Dybvig, Rothbard, gold bugs, and Bitcoiners are all wrong about fractional reserve banking.

Cases Pile Up

Diamond and Dybvig got at least one thing right: "Bank runs in our model are caused by shifts in expectations," they noted, "and expectations can depend on almost anything."

I randomly browsed the bank run database and found some excellent examples.

In 1910, a run on Merchants National Bank in Los Angeles was triggered when boxer Jim Jeffries visited the bank, drawing a crowd of boxing fans. A newspaper reported: "Dozens of depositors, thinking something was wrong, began cashing in their deposits. It wasn't until the boxer left that the frightened customers were reassured."

It turned out Jeffries had just come to open an account and deposit part of his championship winnings.

In 1924, a run on Metals Bank & Trust Company in Butte, Montana, was triggered when someone overheard a joking bet that the bank would not open the next day. A newspaper reported that the bank stayed open four hours past its normal closing time to meet withdrawals, "and did not stop paying depositors until it became unsafe after dark."

The joke was that the bank would indeed be closed the next day, because of Lincoln's birthday.

In 1929, a run on Bay Ridge Savings Bank in Brooklyn, New York, was triggered by a rumor that the bank president had died. Fortunately, a newspaper reported, the bank "learned of the false rumor in advance," giving it time to prepare $14 million in cash to meet withdrawals.

The truth was that the president had gone to Connecticut to have a carbuncle removed from his neck. (He survived the surgery.)

Again, this is just a random sample from the database.

But the peaceful resolution of these runs seems to refute the strongest interpretation of the Diamond-Dybvig theory: it turns out bank runs are rarely self-fulfilling.

Sometimes, though, they do happen.

In 1930, a run on Independence State Bank in Chicago was triggered by a fight two doors away. A newspaper reported: "A police patrol wagon stopped in front of the bank building after being called to a restaurant, sparking rumors that the bank was being run on." Somehow, more than $1.6 million of the bank's $5.6 million in deposits was withdrawn, which must have exhausted the bank's liquid assets, because state officials felt compelled to close the bank.

The Bank Runs website does not say whether Independence Bank's balance sheet was fundamentally sound. But the authors' research suggests that if it was, the bank would almost certainly have survived.

In many cases, surviving a run simply required a public display of cash.

For example, a run in 1907 was stopped by "a large display of bills and cash on the counter, in full view of depositors."

In 1857, an "unprofitable run" on an Alabama bank was halted when depositors saw "a Malakoff of gold and a Redan of silver" piled high on the teller's desk. (The Malakoff and the Redan were famous Russian fortresses.)

In 1924, the manager of a Brooklyn bank stopped a run by stacking bills of up to $1,000 denomination in the bank's front window, "piled carelessly in a big heap," for all to see.

Did bank customers understand that no matter how high the cash was piled, it wouldn't be enough to pay everyone if they all wanted their money at the same time?

I suspect they did.

(Byron Gilliam)

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