1. Suppose you are a depositor at First Street Bank. You hear a rumor that the bank has suffered serious losses on its loans. Every depositor knows that the rumor isn’t true, but each thinks that most other depositors believe the rumor. Why, in the absence of deposit insurance, could this lead to a bank run? How does deposit insurance change the situation?
Even though you know that the rumor about the bank is not true, you are concerned about other depositors pulling their money out of the bank. And you know that if enough other depositors pull their money out, the bank will fail. In that case, it is rational for you to pull your money out before the bank fails. All depositors will think like this, so even if they all know that the rumor is false, they may still rationally pull their money out, leading to a bank run. Deposit insurance leads depositors to worry less about the possibility of a bank run. Even if a bank fails, the FDIC will currently pay each depositor up to $250,000 per account. This will make you much less likely to pull your money out in response to a rumor. Since other depositors will think the same, there will be no bank run.