Running for the Exit: Community Cohesion and Bank Panics

as well as two anonymous reviewers and senior editor Olav Sorenson. We also thank Sahangsoon Kim, Clare Lee, Michelle Ie, Daphne Teh, and Yuhanis Yusoff for research assistance and INSEAD for financial support. A Working Paper is the author's intellectual property. It is intended as a means to promote research to interested readers. Its content should not be copied or hosted on any server without written permission from [email protected] Find more INSEAD papers at Abstract Bank panics attract scholarly interest because they reflect distrust of each bank that experiences a run as a result of diffusion of information whereby rumors about bank runs trigger additional runs elsewhere. However, the contagion of bank runs is highly selective for reasons that are unrelated to the financial strength of the individual banks. This presents a puzzle that extant theories on institutions and reputations cannot fully explain. To solve this puzzle, we turn to the characteristics of the community in which the banks operate. We develop theory on how communities with diverse affiliation structures and economic inequality have weaker community cohesion and communication, making such communities less likely to experience widespread distrust and hence bank runs. We test hypotheses on the effects of community ethnic diversity, national origin diversity, religious diversity, and wealth inequality using data from the great bank panic of 1893, and find strong community effects on bank runs. The findings suggest that the contagion of distrust in organizations following adverse events is channeled by community differences as well as organizational differences. 3 The recent turmoil in financial markets has been a reminder of how the banking system that sits at the core of modern economies is vulnerable to events involving a breakdown in trust. The economic crisis caused by undisciplined management of financial institutions undermined public trust in the banking system. Indeed, according to the Financial Trust Index (Guiso, Sapienze and Zingales forthcoming), the U.S. public's overall trust in the nation's financial system has significantly declined since the financial crisis in late 2008. Because trust in financial institutions is essential for financial intermediation, actions resulting from distrust, such as increased fund withdrawals from banks and reduced investment activity, have led to a deepening downturn in the economy, with consequences that are still unfolding. In the past, breakdowns in trust tended to occur between depositors and banks, leading to mass deposit withdrawals—often referred to as a ‗bank run' (Smith 1991; Wicker 2000). …