Every bank operates on a promise it cannot keep—at least not all at once. Your deposits are available on demand, but the money itself is locked in mortgages, business loans, and long-term investments that won't mature for years.

This arrangement works beautifully in normal times. Banks profit from the spread between short-term borrowing costs and long-term lending rates. Depositors enjoy liquidity and safety. Borrowers get capital for homes and businesses. Everyone wins.

But the entire system rests on a fragile assumption: that everyone won't ask for their money simultaneously. When that assumption breaks—when depositors start to doubt—the economics of banking turn against themselves with devastating speed. Understanding this vulnerability reveals why financial crises follow predictable patterns and why the response to them matters enormously.

Banks engage in what economists call maturity transformation. They accept deposits that customers can withdraw at any moment and invest those funds in loans that won't be repaid for decades. This mismatch between short-term liabilities and long-term assets is not a flaw—it's the core business model.

The profit comes from yield curves. Under normal conditions, long-term interest rates exceed short-term rates. A bank paying 2% on savings accounts while earning 6% on thirty-year mortgages captures that spread as profit. Multiply across billions in assets, and the returns are substantial.

But liquidity—the ability to convert assets to cash quickly—becomes the Achilles heel. A mortgage cannot be called in early without immense legal and practical difficulty. Even government bonds, while sellable, may trade at steep discounts if markets are stressed. The bank's assets are fundamentally illiquid compared to its liabilities.

This creates an inherent tension. The very structure that makes banking profitable makes it vulnerable to sudden withdrawals. A bank with perfectly sound assets—loans that will eventually be repaid in full—can still face collapse if too many depositors demand cash at once. Solvency and liquidity are different problems, but in a crisis, they become indistinguishable.

Takeaway

The profitable core of banking—borrowing short to lend long—contains the seeds of its own destruction. The same structure that creates value in good times becomes a trap when confidence wavers.

Imagine you're a depositor who hears rumors about your bank's stability. You know the bank is fundamentally sound—its loans are good, its management competent. But you also know that other depositors might panic. If enough of them withdraw, the bank will be forced to sell assets at fire-sale prices, potentially becoming insolvent.

Your choice becomes stark. Wait and risk losing everything if others run, or withdraw now and guarantee your own safety. The rational choice is to run—not because you distrust the bank, but because you distrust other depositors' patience.

This is the textbook coordination failure that economists Douglas Diamond and Philip Dybvig formalized in 1983. Two equilibria exist: one where everyone trusts, stays calm, and the bank survives; another where everyone panics, runs, and the bank fails. Both outcomes are self-reinforcing. Both are rational given expectations about others' behavior.

The tragedy is that individual rationality produces collective catastrophe. No single depositor causes the crisis. Each is simply protecting themselves against what others might do. Yet the aggregate effect transforms a solvent institution into a bankrupt one. The fear of failure causes the failure. Bank runs are not primarily about information or fundamentals—they're about expectations coordinating on the wrong equilibrium.

Takeaway

In a bank run, you're not betting on the bank's health—you're betting on other depositors' beliefs about each other's beliefs. Panic can be rational precisely because everyone else's rationality makes it so.

Central banks exist partly to solve this coordination problem. When Walter Bagehot articulated the doctrine in 1873, he prescribed that during crises, the central bank should lend freely, at penalty rates, against good collateral. The goal: distinguish illiquidity from insolvency.

A bank facing a run but holding sound assets needs only temporary cash to survive. The central bank provides that bridge, charging enough to discourage frivolous borrowing but ensuring genuine crises don't destroy viable institutions. The mere existence of this backstop changes expectations.

If depositors know their bank can access emergency liquidity, the incentive to run diminishes. Why panic-withdraw if the central bank will keep the bank functioning regardless? The lender of last resort doesn't primarily work by actually lending—it works by making lending unnecessary. Credible commitment prevents the crisis it promises to solve.

But the doctrine requires judgment. Lending to insolvent banks—those whose assets truly won't cover liabilities—merely delays inevitable failure while creating moral hazard. The challenge is distinguishing liquidity crises from solvency crises in real-time, under pressure, with incomplete information. Get it wrong in either direction, and the consequences compound. Too restrictive, and sound banks fail. Too generous, and failing banks are propped up at public expense.

Takeaway

The most powerful interventions prevent crises rather than resolve them. A credible commitment to provide emergency liquidity can eliminate bank runs entirely—not by spending money, but by changing beliefs.

Banking panics reveal something profound about economic systems: outcomes depend not just on fundamentals but on beliefs about beliefs. A perfectly healthy bank can die from nothing more than coordinated fear, while a shaky one might survive if confidence holds.

This insight extends beyond finance. Any system with commitment mismatches—where promises exceed immediate capacity to deliver—faces similar dynamics. Pension funds, insurance companies, even governments issuing debt all navigate versions of this tension.

The lesson for understanding economic cycles is that psychology and structure intertwine inseparably. Fragility isn't just about balance sheets—it's about the stories we tell each other about what might happen next.