Bank Runs and Contagion: Why Panics Spread

This platform's Money Basics module explains how banking works in everyday life. It covers deposits, lending, and the basics of fractional reserve banking. You'll learn what happens when confidence in that system breaks down, and why a single bank's problems can quickly become everyone's problems. A bank run happens when a lot of depositors rush to withdraw their money at once, fearing the bank might fail. The dangerous part? This fear can become a reality. Banks only keep a fraction of deposits as cash since they lend most of it out. If too many people try to withdraw at the same time, even a fundamentally sound bank can run out of cash. So, the fear of failure can trigger a real liquidity crisis, even if the bank's financial health is just fine.

"Contagion" refers to how this distress spreads beyond one bank through two distinct channels. The first is direct counterparty risk: this happens when a lender or trading partner fails to meet their obligations. One bank's failure can lead to real losses for others that are financially tied to it. The second is an indirect, confidence-based channel. This is where suspicion and fear spread to banks with no direct ties to the original issue. Depositors start to wonder, "If that bank has problems, could this one too?" This fear can spread much faster than direct financial exposure.