When you put money in a bank, it doesn't sit in the vault. Most banks keep cash on hand equal to 5 percent of their total deposits; the rest of the money is out on loan to other customers. Normally that works fine, but when the total number of withdrawals exceeds the available cash, it can trigger a "bank run."
Bank runs usually start when depositors worry the bank might fail. Depositors rush to withdraw money before the bank shuts down; the bank exhausts its cash reserves; and the bank then liquidates assets and calls in loans to find more money. If the bank can't sell enough assets to cover the withdrawals, it may have to close. Banks that do cover the run often end up financially crippled from selling assets cheap to raise money.
The stock market crash of 1929 left millions of Americans scared, which led to multiple bank runs over the next few years. Some banks shut down and depositors who hadn't withdrawn their money lost everything. In 1933, the government created the Federal Deposit Insurance Corporation; by insuring deposits, the government hoped to increase consumer confidence and discourage future runs. As of 2012, FDIC covers your losses up to $250,000 per bank if your money is in a checking account, money-market account or certificate of deposit. Other investments, such as mutual funds, aren't protected.
If the bank does fail -- whether because of a run or another reason -- usually another bank buys it or the FDIC takes it over until a buyer can be found. The FDIC may not announce the failure to avoid making the run worse: instead, the bank closes on a Friday and reopens under new ownership on Monday. The new bank takes over your insured deposits, but you may lose any deposits or investments that weren't covered. Most bank services, such as ATM withdrawals, continue without interruption.
As long as you and your fellow account holders redeposit your money in a better bank, one failure isn't a huge problem. If you start to worry that all the banks are potentially unsafe, you may not want to redeposit: Putting the money outside the country or in a wall safe may seem a better bet. When that happens on a grand scale, the entire banking system suffers as the cash dries up. The U.S. government created the FDIC precisely to prevent that kind of disaster.
A graduate of Oberlin College, Fraser Sherman began writing in 1981. Since then he's researched and written newspaper and magazine stories on city government, court cases, business, real estate and finance, the uses of new technologies and film history. Sherman has worked for more than a decade as a newspaper reporter, and his magazine articles have been published in "Newsweek," "Air & Space," "Backpacker" and "Boys' Life." Sherman is also the author of three film reference books, with a fourth currently under way.