Traditional Banking Remedies

With the inherent risks of a liquidity mismatch banks started promoting the importance of a sticky depositor base as a token of long term stability. Flexible term deposits coupled with a more granular approach to customer and account type selection introduced a risk lever that, if operated prudently, minimized the risk of sudden liquidity runs.

Although, the most important introduction was deposit insurance, either private or government provided. Ferre De Graeve and Alexei Karas isolated and analyzed bank runs as Insured and Uninsured financial institutions in the 2004 Russian Banking crisis, providing one of the more profound deep dives into the nature, and outcomes of bank runs.

In their paper bank runs were defined as liquidity shocks that occur in static interest rate environments, isolating two bank groups: Insured and Uninsured. The specific events analyzed were bank runs in 2004, exhibited across the Russian Banking sector. As analyzed by De Graeve and Karas, Insurance substantially reduces the propensity of depositor withdrawals when comparing Insured to Uninsured banks. Further, the average Insured bank benefits from the supply shocks exhibited in uninsured banks by assuming a vast amount of the capital leaving the bank being run on.

From a fundamentalist approach, a good balance sheet does exhibit a smaller capital outflow. During the 2004 crisis, banks with good fundamentals suffered an average 5% capital drawdown, while banks with bad fundamentals suffered an average 6% capital drawdown. Although, irregardless of fundamentals, Insured banks witnessed a 5% inflow of capital driven by the withdrawals from the uninsured banks. As such, it's clear that depositors have no incentive to keep their capital in uninsured banks in times of stress as there is no upside and unlimited downside.

Socializing Losses

One of the primary trigger events of a bank run is rooted in the inherent need to exit first. It's a constant race to pull out capital, leaving laggards with bad debt and a total loss on deposited capital. The “leave unharmed” or “suffer a total loss” scenarios promote the sporadic and irrational withdrawals that are extremely difficult to run a deterministic model on, and subsequently hedge against.

Socialization of bad debt losses could be seen as a distant relative of the Islamic Banking system, where depositors receive an equity share in the bank's financial activities instead of a prescribed interest rate. Although this alternative does not deviate from the traditional interest based system, the accrued losses from bad debt, predominantly in force induced bank runs, would be socialized among all depositors as opposed to an all-or-none withdrawal. As such, all depositors would take a haircut on their deposits, reducing the viability of withdrawing first and further contributing to a total liquidity crunch.

The sheer existence of a socialized withdrawal system aims to suppress the likelihood of a panic or fundamentals induced bank run as the losses are inherently priced into the deposits. Introducing such a structure aims to preemptively act in times of investment distress or monetary volatility, reducing the psychological factors leading to irrational liquidity crises.

In practice, the deposits in a savings bank would effectively be floating based on the real-time marked-to-market balance sheet of the said bank. Effectively the depositors would receive a fixed or variable interest rate based on the account type chosen, and would hold an equity-type position in the bank with deposit covenants. The covenants would focus on equity value upside deviations instituting a performance-based payout for the banks, where if the equity value crosses a threshold, the excess generated above the threshold is retained by the bank. In addition, interest rate margins could also be included as a covenant to decrease the risk tolerant behavior in a performance based banking payout model.

In essence, the outcome would socialize upside and downside swings in the bank's balance sheet, attempting to limit panic driven liquidity crunches and more closely align the interests of the depositors and the bank stakeholders. Depositors are no longer incentivized to run for the gates in a perceived bank run, as the effects of the crises would be socialized in a real time deposit balance calculation.

Equity based incentivisation driven by outflow volatility

Government secured insurance has been the most evident remedy to a substantial number of panic and fundamentals induced bank runs. Although, a vast number of banks are uninsured. In particular, small regional banks that constitute the largest socio-financial effect on the population, hurting ones that need security the most.

The status quo norm of banking is fragile at its core. There is no upside in keeping one's deposits in the bank in question regardless of the severity of negative sentiment surrounding the fundamentals. A depositor receives no compensation on the perceived risk of total loss, while the bank is facing the consequences of the intentional or unintentional misinformation leading to panic withdrawals.

Misinformation, exaggerated data points or strawman-like arguments spread like wildfire on social media. In the wake of digital communications instantaneous virality, panic driven attacks could originate and have a serious liquidity effect within hours of posting. As a case in point, Twitter has been regarded as one of the leading reasons for Silicon Valley Banks' swift run on the bank.

On the other side of the spectrum, Decentralized finance has been very prolific at limiting bank runs due to the transparent nature of opened ledgers and the collective incentive alignment through decentralized ownership. Technically, traditional bank runs are outright impossible, as all assets used to issue loans are ever present and transparently stored in smart contracts. Although, sudden price shocks combined with comparatively high loan-to-value factors could lead to issues with collateral liquidations leaving the protocols and liquidity providers with bad debt.

To further alleviate bank runs and align “bank” and user incentives, DeFi has pioneered user-led ownership through native token emissions, and decentralized token launches. Emissions are collectively referred to as Pool2, Liquidity Mining, or Staking rewards, and token launches are de-facto initial public offerings.

The primary remedy that DeFi offers is twofold: Compensation for perceived risk and user-protocol alignment.

As mentioned previously, perceived or real risk in the banking sector features no compensation for the assumption of that risk to the depositor. The depositor either assumes that risk, or withdraws their capital and seeks refuge in cash, treasury notes or other banks. As an alternative, the bank could issue their stock, similar to token emissions, to the depositor in times of perceived or actual distress to compensate the depositor for the assumed risk, conversely the bank would hedge their exposure to liquidity crunches and the potential for a complete run. In addition to a reward distribution mechanism, Banks could facilitate an equity brokerage business that is fueled by a stock compensation model, developing another line of revenue for the institution.

The mentioned equity “emissions” could be modeled out to exhibit a direct relationship to downside liquidity volatility. As an example, if a bank exhibited a 20% drawdown in deposit liquidity within a 24hr period an equity issuance would be automatically distributed to depositors as a means to compensate them for the elevented perceived risk of a liquidity crunch. Alternatively, if a non-fundamental, panic induced, liquidity crunch is observed, an aggregation of online data and the virality of such data on social media could be taken as an input to the emissions model. Such a structure would cover both bank run schools of thought: Fundamental and Panic driven.

Specifically for a fundamentals driven liquidity crunch that is caused by duration mismatch, the banks buy themselves time to restructure the debt, avoiding an asset firesale. Duration mismatch is a phenomenon that is often driven by a highly volatile interest rate, as such, the acquired time gives the bank an opportunity to enter a potential interest rate reduction period. If ample equity compensation is issued to retain the deposit base, the following interest rate reduction would naturally resolve the duration gap and substantially improve the fundamentals.

In the status quo banks issue emergency fundraising notices to sell equity as a means to cover cash flow shortfalls. Although, if there is enough cash on the books to cover interest payments, whilst the distributed equity to depositors prevents a run, the emergency funding could be obsolete as there would be no requirement to sell equity at a discount to rescue the institution.

The equity distribution would not only provide a means of compensation for risk, but would also create inherent economic alignment between the depositor and the bank as the depositor is now an equity shareholder. The depositor would be less inclined to withdraw as they are compensated for the risk and are a shareholder of the bank, failure of which constitutes a drawdown in their portfolio.

Although, there is another stakeholder: a Bank equity holder who is not a depositor in the bank. The equity holder would be diluted as compensation for perceived volatility is distributed to depositors and not equity holders. This cost of dilution could be perceived as the cost of insurance against a bank run, and the cost of long term economic alignment between depositors and the institution in which they hold stock in. The economic alignment is invaluable, and would lead to long term stability of the banks core source of liquidity (deposits) and predictability of returns (short and long term investments).

With strong economic alignment, and a sticky depositor base the bank would be able to accrue outsized returns increasing equity value, compensating the equity holder for the dilution. This value loop creates an optimal and sustainable operating environment for a financial institution, where all stakeholder incentives are aligned.

The game theory of depositor-institution incentive alignment creates another shield to bank runs which, arguably, would be able to sustain bad-faith, or panic driven runs. Fundamentals driven runs are further addressed, as the economic alignment between the institution and user drives for a stickier liquidity base and promotes a healthier balance sheet.