Bank Run at the Bailey Building & Loan

B&B: The Book, Chapter 1

This is a draft chapter for my new book version of Banking & Beyond, substantially revised from the first draft posted on this site. I am posting this in the hopes that some of you will take the time to read it, find it interesting and perhaps even send me comments or suggestions that you think might improve it. This book is intended primarily for college students new to the study of finance, but my hope is that it will also be interesting and educational for more advanced finance students and practitioners. Thank you all in advance for whatever help you can provide. And thanks for reading, as always.

Every Christmas I watch the film It’s a Wonderful Life, which never fails to restore my faith in humanity. But my favorite part of the film is not the salvation of the suicidal George Bailey by his bumbling guardian angel Clarence or the wonderful community rendition of Auld Lang Syne at the end of the film, all of which is even more uplifting if one knows the backstory of the lead actor James Stewart’s battle with PTSD following his service in World War II. No, my favorite part of the film is the bank run scene, which should perhaps be no surprise coming from someone who grew up hearing family stories of the Great Depression, who spent most of his career working in or around the banking industry, and who in the early 2000s witnessed at close hand the worldwide run on banks which we now refer to as the Global Financial Crisis, a seminal event in financial history which we will come back to in chapter three.  

In the bank run scene from It’s a Wonderful Life, which readers can easily find on YouTube (watch the 7” version, not the shorter one), we observe the panicked customers of the Bailey Building & Loan rushing en masse to withdraw their savings from the BB&L in the wake of a run on the cross-town bank. Bank runs of this sort were a not uncommon occurrence in the early 1930s (the time at which this film scene was set), when over one-third of all US banks failed and customers lost something like 20% of the total deposits then held in the nation’s banks. And so the BB&L’s customers had good reason to be concerned about the financial health of the BB&L and to run on the bank at the first sign of trouble. 

During the balance of this scene, we come to understand that the BB&L was in fact short of cash, as customers feared, but only because the bumbling Uncle Billy, who was left temporarily in charge while the bank president George Bailey was off on his honeymoon, had on the morning of the run turned over all of the BB&L’s vault cash (“every last cent”) to the cross-town bank, leaving the BB&L with insufficient funds to transact even a normal day’s customer business, let alone to meet any extraordinary customer cash withdrawals requests during a run. In the end the situation was resolved, but just barely, when George and Mary Bailey return early from their honeymoon and put up $2,000 of their own funds (worth about $40,000 in today’s dollars) to tide over the bank’s customers, acting a bit like the Fed as lender of last resort in the days before deposit insurance, another topic we will come back to later in the book (in chapter two).  

The reason I like the BB&L bank run scene so much is not only because of my background as a former banker, but because of its educational value. For the discerning viewer, this one short scene about a fictional bank run in 1930s New York State has a great deal to teach us about the business of banking and in particular about the various risks which banks must manage while taking deposits and making loans, an activity which most of us take for granted but do not really understand. If from this film clip we can figure out how the Bailey Building & Loan worked, and why it almost failed, then we will have come a long way toward understanding much of importance not only about the wave of bank failures during the 1930s but also about our contemporary financial system.

Let’s explore.

What is a bank? Each spring I teach an introductory course on financial institutions to college sophomores new to the study of finance and economics, and we spend the first day of class discussing the bank run at the Bailey Building & Loan.  My students are generally very bright individuals, but they are young and inexperienced in the ways of the world financially speaking, and to my shock and horror most of them in recent years have never seen the film It’s a Wonderful Life. Before taking my course, most of my students have at best an uncertain understanding of what we mean by the term “bank”, and for good reason. Many of them have never set foot in a bank building or branch and have not yet taken responsibility for managing their own finances, with mom and dad still paying the bills. Some of my students will be familiar with firms like PayPal and Venmo (which they may use to make payments while on campus), and possibly even with Rocket Mortgage (which their parents may have used to finance or refinance a house), all of which are financial institutions which seem to operate like banks but which are not in fact banks per se. But if I ask my students what exactly it is that makes JP Morgan Chase or Wells Fargo a bank, but not Venmo, PayPal or Rocket Mortgage, they generally do not have a clue. 

For purposes of our first day class discussion, when we talk about a “bank” we mean a specific type of bank, a depository lending bank.  Depository lending banks are financial institutions which do at least two critical things which distinguish them from other non-depository financial institutions (or ‘non-bank banks’):  they both hold customer deposits and they make customer loans. This is exactly what the Bailey Building & Loan did in 1930’s Bedford Falls, New York. It accepted deposits from customers looking for a safe place to park their cash and it made loans to some of those same customers. JP Morgan Chase and Wells Fargo do both of these things as well; they hold deposits and they make loans. In contrast, while Rocket Mortgage is a direct mortgage lender like the BB&L, it does not hold customer deposits and so it must fund its loans with other sources of financing. Venmo and PayPal are peer-to-peer payment apps, which transfer funds among users who link their bank accounts to the app provider, but they do not hold customer deposits per se and they do not generally make loans. 

Like JP Morgan and Wells Fargo, the Bailey Building & Loan was a depository lending bank which held customer deposits and made loans. But the BB&L was also a special kind of a bank, what we would today call a savings bank or a savings and loan, rather than a commercial bank or community bank. (A community bank is essentially a small commercial bank serving one or more local communities, rather than operating regionally or nationally.) The primary business of the BB&L was making home mortgage loans—loans to individual customers for the purpose of financing the purchase or construction of new homes. The BB&L appears to have competed to some extent with a more diversified cross-town commercial (or community) bank, which served not only individual customers but also business customers (including the BB&L), presumably with a broader array of depository, lending and other banking services. And the BB&L was special in that it was mutually owned, that is owned by its customers rather than by third party shareholders like the evil Mr. Potter, who took over the cross-town bank after it failed and attempted to do the same thing at the BB&L, taking advantage of its panicked customer-owners. 

And so for the purposes of the discussion that follows, when you see the term ‘bank’, I would like you to think ‘depository lending bank’, that is a bank which both holds customer deposits and makes loans. We will discuss other types of banking institutions later in this book, most notably in our chapter on the Global Financial Crisis, but depository lending banks play a very special, even unique role in our financial system, and as a result they operate and are regulated differently than other forms of non-bank financial institutions, with very different implications when they fail. And it is important that we understand how and why. 

What makes banks so special? The answer to this question may seem obvious, if only because it is hard to imagine our contemporary world without banks. Many people would probably say that banks are special because they safeguard customers’ deposits or because they make loans. But accepting customer funds for safeguarding or making loans are not activities which in and of themselves necessarily distinguish banks from other forms of non-bank financial institutions, as we have seen in the examples cited above. Instead, what makes banks truly special is that they both take deposits and make loans, and they do this in a very particular way.

Many people think that banks operate by taking the funds deposited by certain customers (depositors) and lending this money out to other customers (borrowers), effectively just moving the money from one set of customers to another, with the bank acting as a financial intermediary standing between depositors and borrowers. And this is more or less how George Bailey seems to have explained the business of banking to Tom and the other BB&L customers attempting to pull their cash from the bank. “You're thinking about this place all wrong”, he said. “Why your money’s not here. It’s in Joe’s house, and Mrs. Maitland’s and a hundred others. What do you want to do, foreclose on them?” 

George Bailey’s explanation was not wrong, but it was incomplete and potentially misleading. When the Bailey Building & Loan made a mortgage loan to Mrs. Maitland, say for $1,000, it didn’t hand her $1,000 of vault cash that had previously been deposited by Tom and the other BB&L customers. No, it simply credited Mrs. Maitland’s deposit account with $1,000 of newly available funds that she didn’t previously have. The balance of funds in the deposit accounts of Tom and the others remained unchanged and the size of the BB&L’s balance sheet increased by $1,000—with a new asset in the form of a $1,000 loan to Mrs. Maitland and an offsetting $1,000 liability representing the increased balance in Mrs. Maitland’s deposit account. The BB&L didn’t just take deposits and use these funds to make loans; it made loans in amounts far in excess of what it previously received as cash deposits and in the process of making these loans it created new deposits, seemingly out of whole cloth in a process known as fractional reserve banking, which you may have learned about (and most likely forgot) in your high school or college introductory economics course.  And this process of creating deposits by making loans is something which depository lending banks can do, but other non-bank financial institutions cannot.

This ability of banks to create deposits in the process of making loans effectively gives banks the power not only to extend credit (loans) but also to create money, funds which borrowers can use to purchase goods and services or to make investments. And it is this power to create money which gives banks such a special role in our financial system and in our economy. It also explains why widespread bank failures can be so problematic, as we saw during the 1930s and again in the 2000s. When banks fail, they stop making loans and creating deposits (money); and when banks stop extending credit and creating money, consumers stop spending, businesses stop investing, and people lose their jobs and sometimes their homes, threatening the solvency of other banks and triggering economic recession or worse. 

And this is why depository lending banks are so special. 

What is a bank run? In a classic bank run, large numbers of depositors rush to withdraw their savings from the bank all at the same time. This can take the form of depositors lining up in person to withdraw cash from the bank teller window, as we saw at the Bailey Building & Loan in the 1930s and as I witnessed in person at a branch of the Northern Rock Building Society in London sometime in 2007 or 2008. Or it can be done electronically, as we saw at Silicon Valley Bank in 2023. And the funds withdrawn need not all be customer deposits; they can be any form of funding which is repayable to the lender at any given point in time. At the BB&L, the run had two components: individual customers attempted to withdraw funds from their savings accounts, and immediately before that the cross-town bank called in a demand loan it had made previously to the BB&L (in response to which Uncle Billy turned over all of the BB&L’s vault cash, leaving the bank with insufficient cash to satisfy customer withdrawal requests.) During the Global Financial Crisis, in the fall of 2008, the investment bank Lehman Brothers suffered a fatal run which took the form of credit counterparties refusing to roll over $250 billion or so of overnight collateralized loans, and it was this withdrawal of overnight funding, not sub-prime mortgage losses or Lehman’s collapsing share price, which forced the firm to close its doors. 

One of the questions I ask my students on our first day of class is whether the depositors at the BB&L were acting irrationally in rushing to withdraw their funds from the bank. Some students answer ‘yes’, arguing that it was the fact of the run itself which jeopardized the bank’s financial viability, and had depositors not rushed to withdraw their cash the BB&L might have remained open for business indefinitely with no loss to its customers. Other students answer ‘no’, arguing that once a bank’s financial health is called into question, whatever the underlying cause, it is perfectly rational for depositors to withdraw their funds and to do so quickly, since no bank has enough cash on hand to pay off all of its depositors at one time. Unlike shareholders, depositors don’t get paid to take insolvency risk, and so it is often better for depositors to pull their funds and be safe rather than sorry, even if this means temporarily stuffing their cash under the mattress at home. 

Both of these answers have merit, of course, and this is why banks and other financial institutions go to such great lengths to manage their inherent liquidity risk, the risk of running out of cash (or other sources of liquid funds) in the event that depositors or other creditors unexpectedly withdraw their funding. 

Why are bank runs so problematic? Bank runs are of course problematic for the individual banks which experience them, and for their customers and shareholders, particularly when regulators are forced to step in and close insolvent banks. But bank runs can also be problematic for society as a whole, as we saw in the 1930s and more recently during the Global Financial Crisis in the early 2000s. And this is particularly true when bank runs impact depository lending banks, which as we have seen play a special role with respect to the extension of credit and the creation of money in our economy.

During the 1930s, the US banking crisis centered for the most part around depository lending banks, and the contraction of credit (and money) resulting from the failure of these banks played a big role in prolonging and deepening the Great Depression. In contrast, during the early 2000s the events of the global financial crisis involved not only depository lending banks but also investment banks and other non-bank financial institutions, which acted as commercial and funding counterparties to financial and non-financial institutions all over the world, creating a systemic inter-connectedness which was not only complex but also highly opaque and not well understood by regulators or by the financial institutions themselves. And during 2023, the failure of several large regional banks, most notably Silicon Valley Bank (SVB), came close to triggering a run on other regional banks across the country, many of whom were in a similar financial position to SVB, a threat that was mitigated only by a truly extraordinary policy response by the Fed and the FDIC (discussed in chapter four).  

How do banks mitigate run risk? Banks generally fail for one of two reasons: they incur large losses which deplete their equity capital and render the bank insolvent in a balance sheet or regulatory capital sense; or they experience a funding run for whatever reason and cannot come up with sufficient cash or credit to repay their currently due obligations on a timely basis, and fail for reasons of inadequate liquidity rather than insolvency per se.  In normal times, solvent banks can generally raise sufficient funds to deal with short-term liquidity issues, but there are occasionally periods when market conditions are so unsettled that liquidity simply dries up for everyone, forcing even otherwise solvent firms to the brink of failure, as we saw during the Global Financial Crisis. 

Banks can mitigate run risk by enhancing their liquidity directly—say by holding more cash on reserve or funding their operations with less liquid (ie longer-term) liabilities. But they can also enhance liquidity indirectly by increasing the amount of equity capital they hold, reducing insolvency risk directly and in the process reducing the likelihood of funding runs triggered by insolvency concerns. In order to prosper and survive, however, banks must retain the confidence of all their funding counterparties, including not just depositors but also other creditors and shareholders. And when any one of these constituencies loses confidence in the bank, it often spooks the others and sets into motion a chain of events that takes on a life of its own, sometimes resulting in the bank’s failure, as we saw with Lehman Brothers and Silicon Valley Bank.

Before we dig too much deeper into banks’ liquidity risk mitigation strategies, let’s take a quick look at deposit insurance, a topic we will come back to in chapter two. In the US, federal deposit insurance was initiated in 1934 in response to the run on thousands of banks across the country, mostly small and rural banks not unlike the BB&L. The insurance coverage offered by the Federal Deposit Insurance Corporation (FDIC) was initially quite limited in scale and scope, but the program expanded over time and proved to be largely successful in achieving its stated objective of reducing the frequency and severity of bank runs. During the 1930s, over 9000 US banks failed, but the introduction of FDIC deposit insurance in 1934 essentially staunched the run on participating banks, and from 1941-1979, the number of bank failures dropped to an average of only 5 per year (a total of 200 or so over this 40-year period).

Deposit insurance is not a panacea, however, and the FDIC does not provide the same level of run-risk protection for all banks. Community and retail banks, which serve primarily individual customers with small average deposit amounts, benefit the most from FDIC insurance, which today covers up to $250,000 per depositor (per deposit type). Commercial banks with larger concentrations of business customers holding much larger average account balances in excess of FDIC coverage limits do not benefit to the same extent, as we saw with SVB. The US has experienced several waves of bank failures over the past fifty years--most notably in the 1980s, the early 2000s and again in 2023--and in each case a common feature of those banks which suffered runs was a large concentration of uninsured deposits or a heavy reliance on non-deposit funding sources. Banks with large amounts of fully-insured deposits can also fail, of course, but the risk of runs at these banks tends to be quite low, precisely because of the FDIC insurance coverage. 

Banks manage liquidity risk in various ways, on both the asset and liability side of their balance sheets. On the asset side, the bank may elect simply to hold more cash on reserve, either in their vault (like the BB&L) or more likely on deposit at the Fed. Rather than hold more cash, however, banks will often invest excess funds in high-quality (low risk) liquid securities which pay a higher rate of interest than is available on cash, for example short-term US Treasury or government agency securities, which can also be sold or used as collateral for backup funding if needed. And sometimes banks will choose to reduce the size of their loan books, either by selling loans or letting maturing loans run off, and park the funds in more liquid securities in their investment portfolio, in an effort to reduce the risk of loan losses but also to enhance the bank’s liquidity. 

Liquidity can also be addressed on the liability side of a bank’s balance sheet, by increasing the amount of funding from longer-term sources of debt capital, for example time deposits or bond issuance. Banks maintain committed lines of credit with other financial institutions, which can be drawn upon in the event of unexpected liquidity needs, ideally in circumstances when not all financial institutions are facing similar funding pressures. And as a last resort, banks today can draw upon various forms of backstop funding provided by the Federal Reserve or the Federal Home Loan Banks, assuming the borrowing bank has sufficient amounts of eligible and unencumbered collateral and has made the necessary operational arrangements in advance. We will come back to the role of the Fed as a lender of last resort in chapter two.

And finally, banks can manage both liquidity risk and solvency risk by shifting the composition of business actives in which they engage, for example by investing in lines of business which are less capital intensive than lending, do not create run-prone deposits and/or generate non-interest (fee) income to help cover overhead costs and offset some of the earnings volatility associated with lending. 

What other risks must banks manage? We have talked at some length about liquidity risk, the risk of having insufficient cash on hand to meet unexpected funding withdrawals, as well as solvency risk, the risk of incurring losses sufficiently large to wipe out a bank’s equity capital, forcing closure of the bank by regulators. Banks face many different types of risks which can contribute to the threat of insolvency or illiquidity, including a whole host of operational, legal and reputational risks, but for our purposes let’s focus on just two of the biggest risks faced by depository lending banks: credit (or default) risk and interest rate risk.

Credit or default risk is the risk that borrowers will not repay their loans in full and on time, and that the amount ultimately realized by the bank from these loans will prove to be less than the amount owed to the bank (ie the original principal amount of the loan plus any accrued but unpaid interest). In the case of the BB&L, a small-town bank with a limited geographic footprint, a concentrated customer base and essentially just one line of business (residential mortgage loans), one can easily imagine circumstances in which not just a few but many of the BB&L’s customers would at the same time become delinquent in making payments on their loans and might eventually default, for example in the event that a major Bedford Falls employer shut its doors during the Great Depression.  In this circumstance, the value of the collateral pledged on these loans (the market price for the borrowers’ homes) might not be sufficient to repay the BB&L in full, and as a practical matter it could even be that the BB&L would be unable to liquidate much of the collateral at any price if the local economy in Bedford Falls remained depressed for a long period of time. And if the loan losses suffered by the BB&L were sufficiently large, the bank’s equity capital could be reduced to zero (or below regulatory minimums), forcing the regulators to step in and close the bank, liquidating its assets and imposing losses on the bank’s shareholders (who in this case were also its customers). And even if the credit losses were not large enough to render the BB&L insolvent from a regulatory capital perspective, public concerns about the bank’s solvency might be sufficient to spook the bank’s depositors and other funding sources, triggering a run and leading to much the same result.

Banks manage credit risk in a number of ways. The first rule of banking is “know your customer” (KYC), and banks try to avoid lending to unreliable or untrustworthy borrowers. Borrower due diligence and credit analysis helps in this regard, as does crafting loan terms which allow the bank to monitor and mitigate risk, for example by matching the amount and term of the loan to the borrower’s ability to repay and requiring collateral or guarantees to secure repayment in the event of a borrower default. Perhaps the most important thing banks can do to manage credit risk, however, is to run a diversified loan book, something which would have been difficult for the BB&L to do given its limited geographic footprint, its concentrated customer base and its single product line (residential mortgage loans). Banks with undiversified or high-risk loan books may also need to finance their businesses with more permanent capital (equity) than do lower-risk banks, using the additional equity capital provided by shareholders to absorb unexpected loan losses and mitigate the risk of insolvency. 

The other big risk we should discuss here is interest rate risk, the risk that future changes in the level of short and longer-term interest rates will impact a bank’s profitability (and thus its equity capital) in adverse or unexpected ways. Interest rate risk is a big concern for all depository lending banks, which fund their longer-term (often fixed-rate) loan books with shorter-term (floating rate) sources of funding (including deposits), and which generate profits by charging higher rates of interest on their loans (assets) than on their funding sources (liabilities), generating net interest income in the process.  And interest rate risk is particularly troublesome for residential mortgage lenders like the BB&L, due not only to the relatively long maturity of their mortgage loans but also because most US home mortgages are by law prepayable by the borrower without penalty. As a result, when the market level of interest rates increases the mortgage lender’s funding costs typically go up relatively quickly, but the rate of interest it earns on its book of long-term fixed rate loans goes up more slowly (as old loans are paid off and new loans come onto the books), squeezing the bank’s profitability. But when the market level of interest rates falls, the mortgage lender cannot capture the full benefit of any reduction in its funding costs because its borrower customers will often elect (without penalty) to refinance their old high-cost mortgage loans at the new lower market rate, either with the same or a new lender.

The principal way in which banks mitigate interest rate risk is by managing the relative duration (interest rate sensitivity) of their assets and liabilities, for example by funding short-term (or floating-rate) assets with short-term (or floating-rate) liabilities and funding longer-term (or fixed-rate) assets with longer-term (or fixed-rate) liabilities. This risk management approach is often difficult for banks to employ in the mortgage market, however, due in part to the borrower’s prepayment option noted above. And so what most mortgage lenders have done over the past several decades is to shift their business model from ‘lend and hold’, retaining the interest rate and credit risk on their books until the mortgage loans are paid off, to one of ‘underwrite and distribute’, acting more like an investment bank, which originates a mortgage loan but then quickly sells it to another investor, who bears the associated risk. Mortgage lenders do this by periodically packaging pools of their individual home mortgage loans into ‘mortgage-backed securities’ which then get sold into the capital markets, in many cases with a credit guarantee from Fannie Mae or Freddie Mac, a rather complicated process that we will come back to later in the book. 

All banks work hard to manage the various risks they run, including credit and interest rate risk as well as liquidity and solvency risk. No bank will ever be risk-free, of course, nor would they want to be. Banks get paid to take risks of various sorts, including all of those mentioned above, and banks which take relatively few risks tend to earn relatively low returns on their capital. But in taking risk and capturing the associated financial returns, banks must also prepare for eventualities that may not occur frequently but which can be catastrophic when they do.  As we saw during the 1930s and again in the early 2000s, unforeseen events can sometimes have the effect of reversing decades of accumulated profits and force even otherwise successful banks to (or beyond) the brink of failure.  And because of the importance of banks to our overall financial system, and to the real economy, this is something which bank regulators and economic policymakers would like to avoid as well.

What have we learned?  In exploring the fictional bank run at the Bailey Building & Loan, we have hopefully learned quite a bit about the business of banking, and specifically about the business of those banks we call depository lending banks. We have learned that these banks not only take customer deposits and make loans, they also create deposits in the process of making loans and thereby increase the supply of money circulating in the economy, impacting the overall level of economic activity. We have learned that banks must manage a number of risks inherent to this business, most notably credit (or default) risk and interest rate risk, and more generally liquidity and solvency risk. We have learned about some of the ways in which banks attempt to mitigate these various risks, and why this is so important to our financial system and therefore to regulators and policymakers. And in the process of discussing the fictional Bailey Building & Loan, we have also been exposed, perhaps for the first time, to a number of financial terms (highlighted in italics) and real-world events which we will discuss in more detail later in this book.