Bank Failure

Article byShrestha Ghosal
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Bank Failure?

A bank failure is when a financial institution becomes incapable of meeting its financial obligations, leading to its closure by the federal or state authorities. It occurs when a bank’s liabilities exceed its assets, and it fails to fulfill the depositors’ withdrawal requests. This failure may result in the bank’s insolvency.

Bank Failure

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These failures can result from several factors, including risky lending practices, inadequate risk management, economic downturns, and sudden liquidity crises. The losses can trigger debilitating consequences, like losing depositors’ funds and disruptions in financial markets. It may lose public confidence in the banking system and affect the entire economy adversely.

Key Takeaways

  • A bank failure is a financial crisis when a bank becomes incapable of meeting its financial obligations, due to which it is closed by the state or federal authorities. It occurs when a bank’s liabilities surpass its assets significantly.
  • When a bank’s liquidity declines, it fails to meet the deposit withdrawal demands from its customers. As a result, the bank may become insolvent.
  • These failures have massive consequences on the economy. The depositors, investors, employees, and related industries are adversely affected. Such events may spread contagion worries, and the public may lose faith in the banking system.

Bank Failure Explained

A bank failure is a significant event when a financial institution cannot meet its financial obligations. As a result, the federal or state authorities close the institution, leading to its bankruptcy. It is a critical issue that can substantially impact investors, depositors, the banking industry, and the economy.

The governments and central banks may intervene during such a financial crisis to prevent failure risks and maintain financial stability. They may financially support troubled banks and allow mergers with economically healthier institutions. In extreme cases, they may undertake bailouts. These interventions aim to prevent contagion issues and protect the overall financial system.

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Causes

Some of the causes of bank failures are:

  • Banks make profits by lending money to borrowers and charging interest. However, when banks become excessively aggressive in lending practices, they may extend credit to borrowers with weak creditworthiness or invest in risky assets. If these loans or investments turn bad, it can lead to significant losses and crumble the bank’s capital reserve.
  • One of the significant causes of bank failures is that banks are exposed to various risks, including market, liquidity, credit, and operational risks. Effective risk management practices are crucial to identify, measure, and minimize these risks. If a bank fails to assess and manage its risks adequately, it can suffer severe losses during adverse market conditions.
  • During economic recessions or financial crises, the overall credit quality of borrowers may deteriorate, resulting in increased loan default rates. Moreover, falling asset prices and decreased consumer spending can reduce a bank’s revenues. Such adverse economic conditions can weaken a bank’s financial position and push it toward failure.
  • If a bank experiences a significant withdrawal of deposits or loses access to funding sources, it may face a liquidity shortage. In extreme cases, banks may be forced to sell assets at distressed prices. It would increase their financial troubles and may lead to failure.
  • Fraudulent activities or poor management decisions can significantly impact a bank’s financial health. Embezzlement and other unethical practices can lead to substantial losses, hampering the bank’s stability.
  • Failure to comply with banking regulations and standards can expose a bank to legal risks. Regulatory violations can lead to fines and reputational damage, impacting the bank’s overall performance.
  • Changes in interest rates, inflation, and exchange rates can impact a bank’s profitability and financial stability. Fluctuations in these macroeconomic factors can affect a bank’s financial position and result in its failure.

Examples

Let us study the following examples to understand this failure:

Example #1

Suppose Finance First is a bank that started granting house loans to borrowers with poor credit histories. Many such borrowers end up defaulting on their loans. As a result, the bank had to suffer significant losses. At the same time, the housing market experienced a downturn. The market witnessed a sharp decline in property prices. The bank’s assets, which are mortgages, start to lose value, whereas its liabilities, like the deposits, remain the same. With the declining capital and its inability to meet withdrawal demands, the bank faces a liquidity crisis and ultimately fails.

Example #2

On May 1, 2023, the United States authorities took control of the First Republic Bank. Afterward, the authorities sold most of the bank’s assets to JP Morgan Chase. This signified the second-biggest bank failure in the history of the US. This situation came close to the collapse of Silicon Valley Bank and Signature Bank, which spread shockwaves in the markets and sparked contagion issues. They were retail banks that individual consumers and businesses used. However, they differ from the investment banks that failed during the 2008 financial crisis.

Effects

Some of the effects of bank failure are:

  • Depositors who have money in the failed bank may lose some or all of their funds, depending on the deposit insurance coverage available in their country. This loss can severely impact individuals, families, and businesses that rely on the bank to safeguard their savings.
  • These failures can affect public trust in the banking system. Consumers may become wary, leading to a decrease in deposits and a reduction in lending activity. This decline in confidence can have a detrimental impact on the overall economy.
  • When a bank fails, it can disrupt the flow of credit to businesses and individuals. Other banks may become hesitant to lend, leading to a credit crunch that can hamper economic growth and investment.
  • Such failures can trigger volatility in financial markets. This disruption can affect asset prices, investor sentiment, and overall market stability.
  • The failures in banks can lead to layoffs and job losses for employees working in the failed institution and related businesses. This can have ripple effects on the local economy and community.
  • One of the primary effects of bank failure effects is that this failure can contribute to economic recessions or slowdowns. The disruption in credit availability, reduced consumer spending, and increased uncertainty can negatively impact economic growth.

How To Prevent?

Some ways to prevent bank failure risks are as follows:

  • Implementing and enforcing robust banking regulations that set minimum capital requirements, liquidity standards, and risk management guidelines may help prevent these failures. The authorities must periodically review and update the rules to address emerging risks and changing market conditions.
  • The government may assign regulatory agencies. They will regularly supervise banks to ensure regulation compliance and assess their financial health. They may test how well banks can withstand adverse economic conditions.
  • Banks must maintain sufficient capital levels to absorb losses and remain solvent during economic downturns or unexpected events. Higher capital helps increase a bank’s resilience to financial shocks.
  • The banks must implement robust risk management frameworks that identify, assess, and manage various risks, including credit, market, liquidity, and operational risks.
  • The bank management must maintain a diversified portfolio of assets to reduce bank failure risk. They may avoid overexposure to specific sectors, industries, or geographical regions.
  • The management may establish and maintain deposit insurance schemes to protect depositors up to a certain amount. This measure helps maintain public confidence in the banking system and ensures that depositors’ funds are safe.
  • Educating consumers about financial literacy and their rights as depositors can help mitigate these failures. The aware consumers can make informed choices and contribute to a more stable banking system.
  • The authorities must prohibit or restrict risky lending practices and speculative activities that can jeopardize a bank’s stability.

Frequently Asked Questions (FAQs)

1. How did bank failures contribute to the Great Depression?

These failures were a significant contributing factor to the Great Depression. The 1929 stock market crash led to widespread deposit withdrawals. As a result, many banks faced liquidity shortages and insolvency. The failure of numerous banks led to a severe lack of credit. It hampered businesses and caused massive job losses. The failure of the banking system further deepened the economic crisis, increasing the Great Depression’s severity.

2. Are bank failures common?

The failures are relatively uncommon compared to the total number of operating banks. The banking industry is heavily regulated, and measures are in place to prevent and minimize these failures. However, they can still occur due to economic downturns, risky lending practices, and inadequate risk management.

3. Are bank failures a sign of recession?

Bank failures can signify a recession but are not the only indicator. During economic downturns or financial crises, the borrowers’ credit quality may deteriorate, resulting in higher loan default rates. It can cause losses for banks and lead to failures. However, such failures may occur due to other factors unrelated to the recessions, including risky lending practices and insufficient risk management.

This article has been a guide to what is Bank Failure. Here, we explain it in detail its causes, effects, how to prevent it, and examples. You may also find some useful articles here –

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