Bank runs are often described as "self-fulfilling prophecies." Why is this phrase appropriate to bank runs?

The notion of self-fulfilling prophecies is especially relevant regarding bank runs due to the psychological and behavioral dynamics at play. When word spreads that a bank might be facing financial trouble, regardless of the actual truth of the bank's status, depositors might panic. Fearing the loss of their deposited funds, they rush to withdraw their money, which can be seen as a rational response to protect assets. However, this behavioral pattern can exacerbate the bank's standing, as they typically maintain only a fraction of depositors’ funds in reserve.

A key dynamic here is trust. Banks operate on the principle that not all depositors will withdraw their funds at once. When this trust disintegrates, and customers act on the belief that a bank will collapse, these actions can indeed cause the failure they feared. Consequently, a bank run exemplifies a classic case of a self-fulfilling prophecy, where a belief triggers actions that lead to the realization of that belief.

Financial insolvency is a critical concept in understanding the gravity of bank runs. It occurs when an institution cannot meet its financial obligations as they come due, essentially running out of liquid assets and being unable to quickly convert assets to cash without significant loss. Normally, banks are considered financially sound, but this hinges on their liquidity - the ability to meet depositor demands.

In a bank run scenario, this delicate balance is tipped as the velocity and volume of withdrawals often surpass the bank's on-hand liquidity. Despite having long-term assets which, under regular circumstances, cover the value of deposits, these assets cannot be liquidated swiftly enough to satisfy the immediate demands of depositors. The rapid depletion of a bank's liquid assets during a run can push a bank from a stable financial stance into insolvency.

In financial terms, a liquidity crisis is when an otherwise solvent institution does not have enough liquid assets—cash or assets easily convertible into cash—to manage short-term financial demands. Banks typically invest their deposits into long-term loans or other illiquid assets that generate higher returns than cash reserves. While this is a standard banking practice under the fractional reserve system, it leaves banks vulnerable to sudden, unexpected demands for cash.

During a bank run, even a financially healthy bank can face a liquidity crisis. The rapid increase in cash withdrawal demands cannot be met by liquidating long-term assets quickly enough, leading to a potential suspending of cash withdrawals or even closure if the bank can't secure emergency funding to meet depositors' needs. This emphasize the critical distinction between insolvency, which is a long-term problem, and a liquidity crisis, which is inherently short-term but can lead to insolvency.

Economic panic is a widespread and sudden fear about the state of the economy or financial systems that leads to irrational and herd-like behavior by consumers and investors. In the context of bank runs, economic panic can be sparked by rumors, questionable media reports, or actual financial indicators suggesting a bank or the financial system is in trouble. This panic has a contagion effect; it starts with a few depositors and spreads, leading to more people rushing to withdraw their funds, even from solvent banks.

The psychology behind this panic is rooted in a loss of confidence and trust, causing people to prioritize their financial safety above all else. The collective actions taken in this state of fear can have dramatic consequences, including escalating a liquidity crisis into full-blown financial insolvency for the bank in question.