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Banking crisis on checkable deposits

Question:

Some developing countries have suffered banking crises in which depositors lost part or all of their deposits (in some countries there is no deposit insurance). This type of crisis decreases depositors' confidence in the banking system. What would be the effect of a rumor about a banking crisis on checkable deposits in such a country? What would be the effect of on reserves and the monetary base?

Answer:

The depositors of the country under consideration have faced this kind of crisis in the past, as mentioned in the question. Therefore, their confidence level in the banking system is not very high due to past experiences.

Now suppose there is a rumor that one or two banks are facing crisis on the checkable deposit accounts. This will probably lead to a bank run. A bank run happens when the depositors lose trust in the banking system and all the depositors line up at the same time to withdraw their deposits. In this case also, a rumor will lead all the depositors to try and withdraw all their deposits. Under this scenario, all the banks which do not have enough excess reserves will fail. Even the banks with sufficient reserves will be in troubled waters as paying back the entire deposits is simply not possible for a bank in one go, as most of the assets of the banks lie as loans, which cannot be called back at a such a short notice.

The central bank of the country will step in to control the situation by lending to the banks in order to meet their deposits obligations. This will mean that one hand the bank reserves deplete and on the other, their liabilities vis-à-vis the central banks decrease. Also, since the banks' excess fall steeply, as discussed above. So overall, there would be a steep fall in the monetary base. 

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