Bank-runs, Information Cascades, and The Great Depression
Around the late 1920s, people began to lose faith in the banking institutions. People began to withdraw funds from their accounts believing that the banks could not make good on those funds at a future date; i.e they could not withdraw the money at a future date. Furthermore, there was an information cascade in that people saw others(relatives, friends, acquaintances) choosing to withdraw their money and decided that these people had information that was unknown to them. This cascade spread and caused a phenomenon known as a bank-run. As defined by wikipedia, “A bank run (also known as a run on the bank) occurs in a fractional reserve banking system when a large number of customers withdraw their deposits from a financial institution at the same time and either demand cash or transfer those funds into government bonds, precious metals or stones, or a safer institution because they believe that the financial institution is, or might become, insolvent.” Due to the information cascade, everyone began to withdraw their funds and bank-run occurred at all major banking institutions and this lead to a banking system collapse in the United States. This was one of the major causes of the Great Depression.
The most optimal outcome for players in this system was to not take their money away from the banks such that the banks could continue to function, and the economy could heal. However, the dominant strategy for the players was to take out their money so they can mitigate their losses. As a bank-run occurred, If people chose to keep their money they would most likely lose it, because the banks were being driven to failure. This is an interesting case where an information cascade affects people’s strategies. If other clients of a bank began to lose faith in a bank, it is in one’s own best interest to also lose faith in the bank. How was this fixed?The Banking Act of 1933 instituted the FDIC which “provides deposit insurance guaranteeing the safety of a depositor’s accounts in member banks up to $250,000 for each deposit ownership category in each insured bank”. The FDIC essential prevents the formation of an information cascade, because even if a set of people began to act on the belief that a bank is failing, the insurance acts as a hurdle for others to not follow the cascade. Consequently, the FDIC can be seen an example of political policy that directly intervenes with the formation of information cascades. This raises the bigger question as to whether the government has the right to intervene in the spread of information. Another example of government policy that changes the perception of information within a network is subsidies; subsidies force citizens to favor one behavior over another because of the financial incentive associated with doing so. While I believe that the FDIC is a justifiable response in the context of the time period, I think it’s important to be aware of government policies and how it can affect how we perceive information everyday.
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