A New Study Refutes the 'Bank Collapse Theory' in the Crypto Circle

Author: Byron Gilliam, blockworks

Compiled by: Shen Chao TechFlow

Shen Chao Insight: Bitcoin supporters often label fractional reserve banks as Ponzi schemes, claiming that when a bank run occurs, even good banks will fail. However, a new study has reviewed numerous bank run events and found that most runs fizzle out before they threaten the bank. This is a rebuttal that investors who view bank fragility as part of the crypto narrative must confront.

"You’re completely wrong, as if I put the money in a safe." (George Bailey on fractional reserve banking)

The fundamental promise of banking is that everyone can withdraw their money at any time, as long as they don’t all try to withdraw at the same time.

This is what George Bailey taught us.

"You’re completely wrong, as if I locked the money in a safe," he told customers of Bailey Brothers Building & Loan during a run. "The money isn’t here. Your money is in Joe’s house, right next door. It’s also at the Kennedy’s, Mrs. Macklin’s, and hundreds of other homes."

"You lent them money to build houses, and they will do their best to pay you back," he explained.

The anxious customers were not immediately reassured. George had to pull out his own $2,000 to fend off the run. Even so, the bank was only truly saved at the end of the movie: friends and customers donated enough money to fill the $8,000 hole in the bank’s balance sheet.

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

He believed that banks could perpetrate this fraud because bankers like George Bailey distorted how much they could lend out.

"Because everyone is used to thinking that banks just borrow our money and lend it out," Rothbard explained in a speech, "it’s hard to shift the mindset to realize that banks are actually doing a legalized form of counterfeiting."

In other words, if people truly understood how fractional reserve banking works, with banks "creating" money out of thin air, everyone would want to withdraw their money at the same time. Even the best banks would fail.

This pessimistic view of banks seems 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."

This study formalized Rothbard’s intuition: banks that finance long-term loans with demand deposits, even if their assets are healthy, face the risk of being brought down by a run.

Thus, concerns about bank failures can be self-fulfilling: "During a run, depositors rush to withdraw their funds because they expect the bank to fail," the authors explain. "In fact, sudden withdrawals can force banks to sell many assets at a loss, ultimately leading to failure."

"This is not necessarily related to the bank’s fundamental condition," they add. Instead, "anything that leads [depositors] to expect a run will trigger a run."

"Even 'healthy' banks can fail."

Diamond and Dybvig reached this troubling conclusion primarily relying on theoretical models based on mathematics and game theory.

A new study suggests that this model does not reflect reality.

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

The surprising finding is that most runs fizzle out before they threaten the bank. The authors found: "There are more runs that do not lead to bank failures than those that do."

This contradicts the expectations 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 expect that number to be 100%.

Meanwhile, the banks with the strongest fundamentals "rarely fail," even when faced with a run.

The authors’ conclusion? "This pattern raises doubts about a strong view: that liquidity issues alone can trigger severe financial distress."

I think they are politely saying that Diamond, Dybvig, Rothbard, gold bugs, and Bitcoin believers are all wrong about fractional reserve banking.

A Mountain of Cases {#article-toc-33693-2}

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

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

In 1910, the Merchants National Bank in Los Angeles experienced a run triggered by boxer Jim Jeffries visiting the bank, attracting a crowd of boxing fans. The newspaper reported: "Dozens of depositors thought something was wrong and began to withdraw their deposits. It wasn’t until the boxer left that the frightened customers calmed down."

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

In 1924, the Metals Bank & Trust Company in Butte, Montana, experienced a run because someone heard a joke bet: the bank wouldn’t open the next day. The newspaper reported that the bank continued to operate for four hours after normal closing time to meet withdrawals, "stopping only when it became unsafe to continue paying depositors after dark."

The joke was that the bank would indeed close the next day for Lincoln’s birthday.

In 1929, the Bay Ridge Savings Bank in Brooklyn, New York, experienced a run due to rumors that the president had died. Fortunately, the newspaper reported that the bank "was made aware of this false rumor in advance," allowing it time to prepare $14 million in cash to handle withdrawals.

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

Once again, this is just a random sampling from the database.

But these peaceful resolutions of runs seem to refute the strongest interpretation of the Diamond-Dybvig theory: it turns out that bank runs rarely self-fulfill.

However, they can happen sometimes.

In 1930, the Independence State Bank in Chicago experienced a run triggered by a fight outside the doors. The newspaper reported: "A police patrol car responded to a restaurant alarm and stopped in front of the bank building, sparking rumors that the bank was being run on." Somehow, over $1.6 million was withdrawn from the bank’s $5.6 million in deposits, which certainly depleted the bank’s liquid assets, leading state officials to feel they had to close the bank.

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

In many cases, surviving a run only required publicly displaying cash.

For example, a run in 1907 was stopped by "displaying large amounts of cash and currency at the counter for depositors to see."

In 1857, a "non-profitable run" at a bank in Alabama was halted because depositors saw a high pile of "a golden Malakov and a silver Redan" on the teller’s desk. (Malakov and Redan are famous Russian fortresses.)

In 1924, a bank manager in Brooklyn stopped a run by piling up $1,000 bills in the front window, "casually stacked in a big pile" for everyone to see.

Do bank customers understand that no matter how high the cash pile is, if everyone wants to withdraw money at the same time, that money won’t be enough to pay everyone?

I guess they do.

(Byron Gilliam)

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