Read the working paper
INSEAD Working Paper 2013/23/EFE
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.