Why Do Banks Fail?
Commercial banks are an important part of the financial system, especially for individuals’ borrowing and for the financing of small and medium-sized businesses. But there is an inherent fragility in banking because some bank assets are illiquid while the key bank liability, demand deposits, can be withdrawn at any time. Rules and regulations that attempt to address this fragility include capital ratio requirements, government oversight, and deposit insurance. Nonetheless, banks can fail, as shown by recent events. These failures highlight the importance of banks’ risk management, the role of oversight and regulation, and the threats to the overall economy from bank runs and bank fragility.
There is an inherent fragility in banking: some bank assets are illiquid while the key bank liability, demand deposits, can be withdrawn at any time.
- The business model for commercial banks is inherently fragile because of the illiquidity of bank assets as compared to their liabilities. Commercial banks accept deposits and use them to make loans and invest in financial assets. Banks only keep enough cash on hand to cover a relatively small proportion of deposits. Their demand deposits can be withdrawn at will by the bank’s depositors while many of the banks’ assets, such as loans, cannot be quickly or easily converted to cash. A bank that faces enough depositor withdrawal requests will have to find ways to convert assets – potentially very illiquid assets – into cash. Liquidation of illiquid assets is costly and banks may have to sell these assets at fire-sale prices. Depositors have an incentive to withdraw assets when banks are perceived to be troubled because the first withdrawal requests are more likely to be met than subsequent ones. In this way, a bank run can become self-amplifying as depositors race to withdraw their funds. Bank runs that lead to bank closures and cause a credit crunch contribute to overall economic weakness, and even, in the case of the Great Depression, to deep economic downturns.
- Banks can also face solvency problems. While illiquidity reflects an inability to meet short-term obligations, insolvency reflects an inability to meet longer term obligations. For example, a bank may become insolvent if it holds nonperforming loans that cannot be paid back at their full value. A bank could also become insolvent if it holds bonds and the prices of those bonds fall because of rising market interest rates (interest rates and bond prices are inversely related). Solvency problems can lead to liquidity problems if depositors’ concerns about their ability to withdraw their funds ignite a bank run.
- Bank management must weigh expected profitability against solvency and liquidity considerations. Banks’ profits come from interest received from loans and returns on other assets they hold. But these assets are illiquid and they can be risky. Managing bank risk while attempting to maximize profits requires managing, among other potential pitfalls, interest rate risks (which will manifest when interest rates rise so the value of bonds fall), credit risks (the risk that loans or bonds are not repaid in full), and risks related to deposit dynamics (particularly the risk that large numbers of depositors will decide to withdraw funds at the same time).
- Rules and regulations attempt to make banks more stable. Banks may be required to keep a certain proportion of the value of their deposits in cash – what is known as the reserve requirement. It is worth noting that reserve requirements for U.S. banks have been set to zero since 2020. Banks are also required to hold some proportion of their assets in investments that can be easily converted to cash. Large banks (currently those with more than $250 billion in assets), the so-called Systemically Important Financial Institutions (SIFIs), are subject to regular stress tests that analyze bank liquidity and solvency under alternative stress scenarios. Smaller banks can be subject to these stress tests as well, at the discretion of bank regulators. Another important rule that aids bank stability is deposit insurance – the government guarantee to backstop certain deposits in case of bank failure. The Federal Deposit Insurance Corporation (FDIC) guarantees deposits up to $250,000, although during the recent bank crisis deposits in excess of this level at closed banks have also been explicitly guaranteed. These guarantees are funded through premiums paid by banks and savings associations for deposit insurance coverage. The premiums paid by banks go into the FDIC’s Deposit Insurance Fund which had $128 billion in assets at the end of 2022. In addition to those assets, the FDIC’s guarantees are backed by the full faith and credit of the United States government. The Federal Reserve also offers “Discount window” lending that enables banks with short-term or seasonal liquidity shortages to receive collateralized loans so that banks can weather temporary liquidity strains without having to sell off illiquid assets.
- Recent bank failures reflect the challenges of bank fragility. On March 8, 2023, Silvergate Capital, a cryptocurrency-focused bank, announced it would cease operations and liquidate its assets after it suffered a bank run. Two days later, Silicon Valley Bank (SVB) failed. SVB was vulnerable because during a phase of rapid growth it moved its asset base away from loans and toward longer-term fixed-income securities whose values fell as interest rates rose. This drop in asset value coincided with a slowdown in the startup and technology business environment that increased the liquidity needs of its highly-concentrated depositor base. Additionally, an extremely high proportion of this bank’s deposits were in excess of the $250,000 FDIC insurance limits, and these large depositors tended to share business and social links, so news of panicked withdrawals traveled quickly among the banks’ depositors and ignited a run. SVB was seized by California banking regulators on March 10, 2023. Signature Bank, also experiencing a run, was shut down by federal regulators that weekend. Signature Bank also had a large share of deposits in excess of the FDIC limit of $250,000. Depositors at that bank may also have been concerned because of the bank’s heavy involvement in real estate and in cryptocurrency markets, both of which have not fared well recently.
- Policy responses to these bank failures have reflected an attempt to stem a wider crisis, but these efforts have attracted some criticism. Despite the safeguards, individual banks do fail from time to time. However, there are times when a bank’s failure can threaten the broader economy. This is the case when a bank is so large that its demise could, for example, ignite runs on other banks and lead to a larger systemic crisis. The FDIC and Federal Reserve Boards voted to insure SVB and Signature depositors above the $250,000 statutory limits because of concerns that failing to do so could cause a systemic crisis, with large depositors at other banks withdrawing funds and causing bank runs. The Federal Reserve announced a new “Bank Term Funding Program” (BTFP) that will provide additional collateralized lending to banks that come under stress – this represents an expansion of the discount window role. Insuring all deposits has been criticized because of the potential cost and because this emergency expansion of deposit insurance rewards large depositors who did not properly discipline banks with more careful monitoring. On the other hand, the shareholders and bondholders of those banks have been wiped out and executives have lost their jobs, and these losses reflect some measure of penalty for risky and lax behavior. There has also been criticism of regulators and policymakers who, it is argued, should have foreseen the problems in these banks.
What this Means:
Commercial banking is both important for the economy and inherently fragile. The fragility can be mitigated through appropriate bank management practices and good regulation and oversight. While it is too soon to understand all that contributed to the recent crisis, some themes are already apparent. Large deposits at the closed banks, far in excess of the insured FDIC limit, may have reflected a failure by bank depositors to appropriately evaluate bank risk. Bank executives failed to successfully manage the combination of interest rate risk, depositor concentration risk, and other risks that they took on. The Economic Growth, Regulatory Relief and Consumer Protection Act of 2018 increased the threshold for banks to be considered SIFIs, and therefore subject to greater regular oversight, from $50 billion in assets to $250 billion in assets. Nonetheless, regulators had the option to engage in more oversight but do not appear to have done so. There are lessons to be drawn from this – and, as is often the case, there may be a substantial cost associated with this learning.