Bank failure
Encyclopedia
A bank failure occurs when a bank
is unable to meet its obligations to its depositors or other creditor
s because it has become insolvent or too illiquid to meet its liabilities. More specifically, a bank usually fails economically when the market value
of its asset
s declines to a value that is less than the market value of its liabilities. The insolvent bank either borrows from other solvent
banks or sells its assets at a lower price than its market value to generate liquid money to pay its depositors on demand. The inability of the solvent banks to lend liquid money to the insolvent bank creates a bank panic among the depositors as more depositors try to take out cash deposits from the bank. As such, the bank is unable to fulfill the demands of all of its depositors on time. Also, a bank may be taken over by the regulating government agency if Shareholders Equity (i.e. capital ratios) are below the regulatory minimum.
The failure of a bank is generally considered to be of more importance than the failure of other types of business firms because of the interconnectedness and fragility of banking institutions. It is often feared that the spill over effects of a failure of one bank can quickly spread throughout the economy and possibly result in the failure of other banks, whether or not those banks were solvent
at the time as the marginal depositors try to take out cash deposits from these banks to avoid from suffering losses. Thereby, the spill over effect of bank panic has a multiplier
effect on all banks and financial institutions leading to a greater effect of bank failure in the economy. As a result, banking institutions are typically subjected to rigorous regulation
, and bank failures are of major public policy
concern in countries across the world.
In the United States, deposits in savings and checking accounts are backed by the FDIC
. Currently, each account owner is insured up to $250,000 in the event of a bank failure. When a bank fails, in addition to insuring the deposits, the FDIC acts as the receiver of the failed bank, taking control of the bank's assets and deciding how to settle its debts.
No advance notice is given to the public when a bank fails. Under ideal circumstances, a bank failure can occur without customers losing access to their funds at any point. For example, in the 2008 failure of Washington Mutual
the FDIC was able to broker a deal in which JP Morgan Chase bought the assets of Washington Mutual for $1.9 billion. Existing customers were immediately turned into JP Morgan Chase customers, without disruption in their ability to use their ATM
cards or do banking at branches. Such policies are designed to discourage bank run
s that might cause economic damage on a wider scale.
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
is unable to meet its obligations to its depositors or other creditor
Creditor
A creditor is a party that has a claim to the services of a second party. It is a person or institution to whom money is owed. The first party, in general, has provided some property or service to the second party under the assumption that the second party will return an equivalent property or...
s because it has become insolvent or too illiquid to meet its liabilities. More specifically, a bank usually fails economically when the market value
Market value
Market value is the price at which an asset would trade in a competitive auction setting. Market value is often used interchangeably with open market value, fair value or fair market value, although these terms have distinct definitions in different standards, and may differ in some...
of its asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s declines to a value that is less than the market value of its liabilities. The insolvent bank either borrows from other solvent
Solvent
A solvent is a liquid, solid, or gas that dissolves another solid, liquid, or gaseous solute, resulting in a solution that is soluble in a certain volume of solvent at a specified temperature...
banks or sells its assets at a lower price than its market value to generate liquid money to pay its depositors on demand. The inability of the solvent banks to lend liquid money to the insolvent bank creates a bank panic among the depositors as more depositors try to take out cash deposits from the bank. As such, the bank is unable to fulfill the demands of all of its depositors on time. Also, a bank may be taken over by the regulating government agency if Shareholders Equity (i.e. capital ratios) are below the regulatory minimum.
The failure of a bank is generally considered to be of more importance than the failure of other types of business firms because of the interconnectedness and fragility of banking institutions. It is often feared that the spill over effects of a failure of one bank can quickly spread throughout the economy and possibly result in the failure of other banks, whether or not those banks were solvent
Solvency
Solvency, in finance or business, is the degree to which the current assets of an individual or entity exceed the current liabilities of that individual or entity. Solvency can also be described as the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term...
at the time as the marginal depositors try to take out cash deposits from these banks to avoid from suffering losses. Thereby, the spill over effect of bank panic has a multiplier
Multiplier
The term multiplier may refer to:In electrical engineering:* Binary multiplier, a digital circuit to perform rapid multiplication of two numbers in binary representation* Analog multiplier, a device that multiplies two analog signals...
effect on all banks and financial institutions leading to a greater effect of bank failure in the economy. As a result, banking institutions are typically subjected to rigorous regulation
Regulation
Regulation is administrative legislation that constitutes or constrains rights and allocates responsibilities. It can be distinguished from primary legislation on the one hand and judge-made law on the other...
, and bank failures are of major public policy
Public policy
Public policy as government action is generally the principled guide to action taken by the administrative or executive branches of the state with regard to a class of issues in a manner consistent with law and institutional customs. In general, the foundation is the pertinent national and...
concern in countries across the world.
In the United States, deposits in savings and checking accounts are backed by the FDIC
Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation is a United States government corporation created by the Glass–Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. , the FDIC insures deposits at...
. Currently, each account owner is insured up to $250,000 in the event of a bank failure. When a bank fails, in addition to insuring the deposits, the FDIC acts as the receiver of the failed bank, taking control of the bank's assets and deciding how to settle its debts.
No advance notice is given to the public when a bank fails. Under ideal circumstances, a bank failure can occur without customers losing access to their funds at any point. For example, in the 2008 failure of Washington Mutual
Washington Mutual
Washington Mutual, Inc. , abbreviated to WaMu, was a savings bank holding company and the former owner of Washington Mutual Bank, which was the United States' largest savings and loan association until its collapse in 2008....
the FDIC was able to broker a deal in which JP Morgan Chase bought the assets of Washington Mutual for $1.9 billion. Existing customers were immediately turned into JP Morgan Chase customers, without disruption in their ability to use their ATM
Automated teller machine
An automated teller machine or automatic teller machine, also known as a Cashpoint , cash machine or sometimes a hole in the wall in British English, is a computerised telecommunications device that provides the clients of a financial institution with access to financial transactions in a public...
cards or do banking at branches. Such policies are designed to discourage bank run
Bank run
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...
s that might cause economic damage on a wider scale.
See also
- List of acquired or bankrupt United States banks in the late 2000s financial crisis
- List of bank failures in the United States (2008–present)
- List of largest U.S. bank failures
- Too Big to FailToo Big to FailToo Big to Fail is a television drama film in the United States broadcast on HBO on May 23, 2011. It is based on the non-fiction book Too Big to Fail by Andrew Ross Sorkin. The TV film was directed by Curtis Hanson...
- Volcker RuleVolcker RuleThe Volcker Rule is a specific section of the Dodd–Frank Wall Street Reform and Consumer Protection Act originally proposed by American economist and former United States Federal Reserve Chairman Paul Volcker to restrict United States banks from making certain kinds of speculative investments that...