Bank Failures: It's the Fundamentals, Not the Runs

When banks fail, the dramatic images of customers lining up to withdraw their deposits often dominate our perception of what went wrong. But new research from MIT economist Emil Verner suggests these bank runs are symptoms, not causes, of banking crises.

Verner's extensive empirical analysis of historical banking data reveals a different story than the conventional narrative. Rather than being victims of panic-driven runs that bring down otherwise healthy institutions, failing banks are typically already in a fundamentally weak position.

The Evidence from History

Verner and his collaborators have examined banking data across multiple time periods and geographies. In a forthcoming paper in the Quarterly Journal of Economics, they analyzed U.S. bank data from 1863 to 2024, concluding that "the primary cause of bank failures and banking crises is almost always and everywhere a deterioration of bank fundamentals."

Their research extends beyond American borders. A 2021 paper in the same journal studied banking data from 46 countries covering 1870-2016, finding that declining bank fundamentals usually preceded runs. This pattern held true across different regulatory environments, economic systems, and historical periods.

What Makes Banks Fundamentally Weak?

The research identifies several key factors that undermine bank stability:

Poor Risk Management: Banks that take excessive risks in their lending and investment portfolios leave themselves vulnerable to economic downturns.

Insufficient Capital Reserves: When banks maintain minimal assets in reserve, they lack the buffer needed to absorb losses.

Bad Portfolios: Concentrated exposure to particular sectors or asset classes can create systemic vulnerabilities.

Credit Booms in Non-Tradeable Sectors: Verner's 2024 research with economist Karsten Müller showed that financial crises are often preceded by credit booms in the "non-tradeable" sector of the economy—industries like retail or construction that don't produce easily tradeable goods. These firms rely heavily on loans secured by real estate, making them vulnerable when property values decline.

The Role of Bank Runs

This doesn't mean bank runs are irrelevant—they're still damaging events that can accelerate a bank's demise. But according to Verner's findings, runs are more accurately described as "the final spasm that brings down weak banks, rather than the causes of indiscriminate failures."

"Most banks that have been subject to runs have been pretty insolvent," Verner explains. "Runs are more the final spasm that brings down weak banks, rather than the causes of indiscriminate failures."

Policy Implications

The distinction between fundamental weakness and panic-driven failure has significant policy implications. If runs were the primary problem, providing banks with more liquidity during crises might be sufficient to prevent failures. But if the root cause is poor business practices and inadequate capitalization, more systemic policy interventions about best practices become necessary.

"When banks fail, it's usually because these banks have taken a lot of risk and have big losses," Verner notes. "It's rarely unjustified. So that means these types of liquidity interventions alone are not enough to stop a crisis."

Expanding the Historical Record

Part of Verner's contribution has been expanding the domain of known historical banking data. Working with economists Sergio Correa and Stephan Luck, he has applied large language models to historical newspaper collections, unearthing information about 3,421 runs on individual banks from 1863 to 1934. This dataset is being made freely available to other scholars, enabling more comprehensive analysis of banking crises over time.

A Historical Approach to Modern Problems

Verner's journey to this research began during his undergraduate years at the University of Copenhagen, when the 2008 financial crisis sparked his interest in understanding how financial systems fail. He found that studying history provided valuable insights into these questions.

"History is a useful laboratory to study these questions," Verner says. "Crises are rare, so historical cases add data. Changes over time, like more financial regulations and more complex investment tools, provide different settings to examine the same cause-and-effect issues."

This historical perspective has led to a fundamental shift in how we understand banking crises. Rather than viewing them as sudden, unpredictable events triggered by panic, Verner's research suggests they are the culmination of long-term deterioration in bank fundamentals.

The Path Forward

The implications extend beyond academic understanding. If banking crises are fundamentally about solvency rather than liquidity, then preventing them requires different tools than those traditionally employed. Regulators and policymakers may need to focus more on ensuring banks maintain adequate capital reserves, manage risks appropriately, and avoid excessive concentration in vulnerable sectors.

As Verner puts it: "While there is this notion that liquidity problems can arise pretty much out of nowhere, I think we are changing that emphasis by showing that financial crises happen basically because banks become insolvent. And then the bank run is that final dramatic spasm—which slightly shifts how we teach and talk about it, and perhaps think about the policy response."

This research doesn't eliminate the drama of bank runs, but it does provide a clearer understanding of what actually causes banks to fail. In the end, it's not panic in the streets that brings down banks—it's poor business practices that leave them vulnerable when economic conditions turn unfavorable.