How It Works
It’s important to remember one thing about banks: They don’t keep your money in cash in a vault. Rather, when people deposit funds in a bank, the bank lends a portion of those funds to people who want loans for houses, cars, businesses or whatever else. Accordingly, depositing $100 into your bank account doesn’t mean there is $100 sitting in the vault.
By lending out deposits, banks make money in the form of interest. However, they must keep a portion of those deposits on hand at all times to support the day-to-day inflow and outflow of funds that depositors need.
Let’s say John Doe reads a rumor on the Internet that Bank XYZ is going to go bankrupt. Worried about the money in his checking and savings accounts there, John runs over to the bank and withdraws all of his money. He also tells his sister, his nephews and his parents, who also withdraw their money. Rumors of Bank XYZ’s demise spread over the Internet like wildfire. Soon, more people withdraw their funds or transfer them to other banks.
The rumor is not true, and Company XYZ is in fine financial health. But by this point, Bank XYZ has given out so much cash from its vault that now it really is having a hard time fulfilling the withdrawal requests from its customers. The news goes national, and every depositor of Company XYZ hears that you’d better get your money out now before there’s none left. The downward cycle continues.
Eventually, the withdrawals reach a point where Company XYZ is drained of cash, actually does become financially unstable and goes under. The run becomes a self-fulfilling prophecy.
