What Happens When Banks Fail?

FDIC Insurance

FDIC insurance was implemented after the Great Depression and the subsequent runs on banks during that time period. The general idea behind FDIC insurance is that it helps promote consumer confidence in the banking establishment because if something were to happen to the bank, the FDIC would send you a check for the insured balance amount. Essentially, if something happens to the bank the FDIC will make you solvent on the insured amount of your deposits. However, before that occurs, the FDIC will try to sell both deposits and loans to a functioning and stable banking institution. Yes, FDIC Insurance is “insurance” but it also acts to bolster consumer confidence so that if anything were to happen to their money, they would be made whole. This occurs when banks

If your money is not insured you will not be eligible for the insurance on your balance and the government will not back your deposit. The same hold trues if your account balance exceeds the $250,000 insured amount. You will only receive the FDIC insured amount, anything exceeding it is not eligible to be returned to you. However, you can have multiple accounts which all have FDIC insurance for the $250,000 amount. So, this can be avoided if your funds are dispersed among different institutions.

Bank Failure

Banks fail when they become insolvent and are unable to meet their short-term payment obligations to other creditors and deposit holders or the total market value of their assets becomes less than total liabilities. This can happen even if a bank holds much more in assets than they do in liabilities. A bank can have $500 billion in assets (deposits, income generating interest payments, etc.) which generate $1 billion in monthly cash flow and $300 billion in liabilities which require $1.2 billion in payments to creditors/depositors. In this scenario, even though the bank has a net of $200 billion in assets on its books, they cannot meet their short-term obligations and are insolvent. In this case, the bank in question will have to sell off its assets and pay off its debt in order to satisfy their balance sheet. A great example of bank failure can be seen with Wachovia during the 2008 recession. Although, Wachovia was not insolvent in terms of their balance sheet, they were unable to satisfy depositors and were cash-flow insolvent. The bank and its assets were eventually purchased by Wells Fargo (Wachovia and its respective assets exceeded its liabilities so it was well worth Wells Fargo to buy the bank out). Although they had a short-term windfall in terms of cashflow, Wells Fargo undoubtedly got a good deal on the Wachovia assets.

Why Do Banks Fail?

Banks can fail for a multitude of reasons. They can fail due to insolvency, lack of liquidity –cash flow insolvency (where deposits are withdrawing their money and causes a run on the bank), a decrease in the value of assets they hold—balance sheet insolvency (where the market value of their assets falls below their liabilities), and due to a lack of consumer confidence. Even relatively healthy banks can fail in the short term, if deposits where to withdraw all their funds at the same time a bank may not have enough in reserves to make depositors whole. During the Great Recession, many banks failed because they purchased bad assets like Mortgage Backed Securities (essentially a derivative hodgepodge of risky mortgages assets which were lumped together) and when the market value of those bad assets fell, the banks liabilities exceeded its assets. In essence they owed more than they owned.

Money and banking has it’s ins and outs and this is in large part why our current fractional reserve system is setup the way it is.