Case Study 1: Experiencing the Ultimate Liquidity Crisis

“Bank Run” is probably the most worrisome situations that the banking sector faces, and is
the ultimate liquidity crisis for the owners of the firm. It is a situation in which depositors
demand large amounts of their money from the bank. The depositors are running towards the
bank, but this situation puts the bank in the frenzy because often that money has been lent out
to businessmen as loans or invested someplace else, so the bank is running away from the
depositors. In a situation like this, not only depositors, but borrowers as well seem to lose
trust in their lending banks, as they switch to other banks that seem to be more credible.

Banks are often tied up in these liquidity crises. In 1984, The fall of Continental Illinois
National Bank of Chicago was one of the largest in modern history, with deposits totaling $10
billion lost over a 60-day period. The reason this bank was stuck in this crisis was that they
were growing their loan portfolio at a rapid rate, which meant they gave out too many loans,
many of which turned out to be bad, and relied on hot money, i.e., negotiable CDs and non-
deposit borrowings in the money market for funding rather than more stable deposits.
However, when these money market investors heard about Continental being tied up in
liquidity problems, they too pulled back their funding. Continental had to rely on government
backed loans to survive. Continental was not managing their liquidity properly. They lent out
more loans than they could handle, which probably created a duration gap, i.e., their
liabilities matured before their assets did. Also, in an attempt to grow their loan portfolio,
they were not clearly analyzing their clients and their creditworthiness, which led to many
loans being bad. What they should’ve done is, firstly, assess their borrower’s creditworthiness
properly, and given out loans according to what their deposits could allow. Moreover, they
shouldn’t have had too much reliance on money market securities for funding. Proper
liquidity management techniques, like asset-based management or cash-based management,
could have helped Continental from being victim to such a crisis.

Another similar event was seen in 2007, in Northern Rock PLC, which was a British bank,
which was said to be stuck in a crisis because of their large mortgage-backed securities. Since
the world was already in recession due to the subprime mortgage crisis, a news like this
would not be taken lightly by depositors. Hence, many ran to the bank to demand their
deposits. The Bank of England quickly stepped in as the “Lender of Last Resort”, but the
Northern Rock PLC suffered huge losses nevertheless. This situation can be seen as one
which was out of the banks control. Rumors in the market led to a bank run because of the
already sensitive issue of the mortgage-backed securities. However, banks need to be
prepared for situations like these, which is why properly liquidity management should be in
place. An asset-based management approach could have saved the bank as their funds could
be tied up in short term securities as well, and not only long-term mortgage-backed securities.
Moreover, a cash-based approach could be used to borrow from the money market before the
depositors ran towards the bank, as a way to have enough cash to handle the situation.

In short, banks need to be on top of their game when it comes to liquidity management,
because the situation of bank run could damage the financial standing of a bank at any time.

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