Failure of a bank means it can no longer pay back its depositors, but when large banks such as Washington Mutual fails, their deposits may be taken over by the FDIC and sold off to another institution.
Your insured deposits will be acquired by a new financial institution and you can continue using both debit and checking accounts; any outstanding checks or automatic payments, however, will be rejected by them. But that’s not the only way a bank’s failure will affect you and the economy, so read on and be prepared.
History of Banks Failing in America
As more headlines emerge about bank failures, investors need to remember the implications a failure may have on the overall financial system. Bank failures tend to increase during economic panics like stock market crashes and depressions like the Great Depression of the 1930s.
Although no bank can be predicted with absolute accuracy, investors can identify warning signs. Staying abreast of news related to a bank’s health such as delays in financial reports and discussions of mergers can provide useful indicators as to a bank’s potential failure.
According to this article – since 2008, when Washington Mutual with $307 billion in assets was taken over and sold off to JPMorgan Chase by regulators. Following SVB and Signature’s collapse this month, investors in federally insured banks are protected up to $250,000 per depositor by the Federal Deposit Insurance Corporation (FDIC), along with additional methods available through FDIC for recovering lost deposits.
Banks fail when their funds run dry–that is, when there is not enough cash or assets to cover total deposits as well as what they owe other banks or institutions. When this occurs, a regulating government agency may step in to take over and guarantee depositor funds using insurance premium funds; as was seen with SVB and Signature in 2023.
Banks may run into difficulties when too many of their depositors attempt to withdraw their money at once (depositor runs), creating a liquidity crisis.
Recent bank failures were caused by large loan losses from commercial real estate loans as well as weak underwriting and risk management practices. Fair value accounting has been suggested as a potential contributing factor; however, GAO analysis indicates it was not majorly influential. Acquisitions of failed banks by healthy ones did not increase market concentration locally.
Bank failure can have devastating repercussions for an economy. When banks can no longer pay their depositors and creditors, their ability to extend loans to businesses declines significantly and leads to reduced economic activity and recession.
Banks may collapse when their assets fall below the value of their liabilities, which may happen when investors withdraw their money (known as “run on the bank“) or when they cannot access sufficient credit from other financial institutions to meet their liabilities – this type of bank failure is commonly known as “illiquidity.”
Recent financial panic and financial institution failures have shown us that while our government has taken many measures to safeguard savers’ funds, no matter where they may reside in our system – trust is never fully assured if you put your faith in its hands. In most cases, though, if your financial institutions are insured by FDIC you should remain safe with accessing your funds.
Assets
Bank failure occurs when it can no longer pay its debts and run out of money to cover deposits and investors, leaving its deposits without sufficient returns to pay back creditors and investors. Sometimes this results from poor management decisions that reduce trust among depositors and investors; other times its assets simply depreciate over time, making repayment of debt more challenging for it.
Losses sustained by banks may be offset by depositors who are insured with the Federal Deposit Insurance Corporation (FDIC). When FDIC insures deposits at a failing bank, their liquidator takes responsibility for collecting and selling off its assets to use as reimbursement to cover claims against it as well as reimburse depositors who had their accounts insured up to certain limits.
Even with concerns over the stability of banking in the US, bank failure is rare. Over the last century, on average only several dozen banks failed every year on average; more recently though a few large regional banks have gone under due to increased competition or sudden rises in interest rates.
City National Bank of New Jersey fell into disarray in 2008 due to poor underwriting and lending practices, such as making risky loans to mortgage-backed securities and real estate developers without adequate controls to monitor or manage these investments, or lacking sufficient funds to cover losses on these investments.
Liabilities
Liabilities of a financial institution are its obligations to pay back its creditors and depositors, so managing these liabilities effectively are crucial to maintaining liquidity and mitigating risk. Banks must be able to quickly convert assets to cash when demand surges in times of stress; failing which, assets may not cover these liabilities in time which leads to losses on the asset side of its balance sheet leading to financial institution collapse.
In most instances, the Federal Deposit Insurance Corporation, or FDIC, assumes liability for failed banks. They compensate depositors up to the statutory maximum limit of $250,000 per insured account. Sometimes another healthy institution will agree to acquire all or some of a failed institution’s assets and liabilities without disrupting customers.
An FDIC official estimates that financial institution failure losses average 10-30%. These losses result from mismatch between assets and liabilities as well as long-term assets losing value due to rising interest rates; meaning money borrowed for investments costs more than it should – further straining balance sheets of failed banks.
Recent financial institution failures involved numerous commercial real estate loans made during periods of strong home price gains. Other contributing factors to their demise included aggressive growth strategies and lax underwriting and credit administration practices.
Professional service providers who provided legal, financial or accounting advice to a failed financial institution may face claims of negligence and/or malpractice from its clients. As such, errors and omissions (E&O) insurance could provide them with protection in case an action arises against them.
Private equity firms, hedge funds and other organizations that steered client funds towards said bank may also come under attack by similar accusations of negligence and/or malpractice.
Capital
An insolvent bank does not have enough assets and cash reserves to cover customer deposits as well as its obligations to others, leading it to search for another place to store its customers’ funds, leaving their funds unavailable and their access impaired. A failure may also have detrimental repercussions for communities and financial markets alike.
Many factors can contribute to the failure of a bank, including insufficient capitalization, poor loan quality and losses on investment securities. An unexpected rise in interest rates may cause its assets to depreciate rapidly and eventually cause it to shut its doors for good.
Some banks face greater risks of failure than others. This often applies to smaller, local banks with lower capitalization levels and greater concentration of loans to commercial real estate loans; they may also be more vulnerable to changes in the mortgage market.
Bank failures have become rarer thanks to improved regulations and deposit insurance, but occasionally large banks such as SVB in March 2023 and Signature this month, could trigger a crisis with large deposits that may lead to runs on other banks.
Regulators take great care in closely monitoring these institutions and taking preventive steps against failure. If a bank or investment company like Gold Alliance Capital becomes troubled enough, the FDIC steps in to take control and wind down operations. This often requires reaching out to all affected customers so they can move their accounts over to other banks.
GAO interviewed FDIC officials, community banking associations, and acquiring banks who reported that shared loss agreements aided in speeding the resolution of 281 of 414 bank failures during the financial crisis by relieving pressure off of deposit insurance funds.
Insured Deposits
Failure of banks may be rare, yet when they do occur they can leave consumers nervous and discombobulated. But have no fear as insured deposits are covered by the Federal Deposit Insurance Corporation (which you can read about here), making transfer easy should a different financial institution emerge in need.
The FDIC is responsible for the resolution of failing banks. Acting in its capacity as receiver, they take over a failed bank and attempt to locate an acquiring financial institution willing to purchase its assets and assume its liabilities. When this occurs, you won’t receive notice before your accounts are transferred over and eventually you’ll receive a check representing any insured deposits held within your accounts (if any).
Based on its circumstances, the FDIC may decide to liquidate a failed financial institution. This involves dissolving it and selling off its assets before disbursing payments to depositors based on how much was recovered by selling those assets. Liquidation is less desirable than other resolution strategies, since it disrupts regular banking operations for customers of the failed bank.
In most instances, the FDIC can quickly find an acquiring bank and ensure you won’t experience any disruptions in banking services as you transition to using a different financial institution. This typically takes just a few business days – your new institution will provide information regarding account transfers as well as new checks or debit cards if needed.
Bank insolvency (https://www.newyorker.com/business/what-does-insolvency-mean-for-a-bank) can arise when risky investments don’t pay off, economic conditions deteriorate and loan costs increase significantly, or when lawsuits mount against the company. Bank run, when depositors rush in to withdraw their money before it fails, also plays a significant role.
The Federal Deposit Insurance Corporation’s goal is to quickly resolve a failing bank and minimize disruption for both its customers and financial system. To accomplish this, they employ teams of accountants, asset specialists who focus on loans and investigators who investigate why banks collapsed.
