Why Do Banks Collapse? An Exploration Of Bank Failures

Barely three months into 2023 and we have seen a spate of bank failures and instability in the markets. Silicon Valley Bank suddenly collapsed which was followed by Signature Bank and then Credit Suisse. Some experts comment that these events may just be the tip of the iceberg and we can expect more hidden rots in the system to be uncovered.

Bank failure is a situation where a bank is unable to fulfill its obligations to its depositors and creditors and becomes insolvent. The reasons for bank failures can be diverse, such as poor management, fraud, external factors, or economic downturns. When a bank fails, its assets are liquidated, and the proceeds are used to pay its creditors and depositors. Bank failures can lead to disruptions in the financial system and the broader economy.

The collapse of banks, even those with a significant amount of money, is not a rare occurrence. The question is why? To understand why banks fail, we need to examine the various factors that can lead to such a situation.

Excessive Risk-Taking

One reason for bank failures is the excessive risk-taking by the bank’s management. Banks make profits by taking on risks, but excessive risk-taking can also lead to massive losses. During the Great Depression, many banks engaged in high-risk lending practices, such as investing in the stock market with depositors’ money. When the stock market crashed in 1929, many banks suffered massive losses, leading to insolvency. Similarly, during the financial crisis of 2008, many banks invested in complex financial instruments that they did not fully understand, such as subprime lending and mortgage-backed securities. When the housing market crashed, many of these securities became worthless, leading to massive losses and insolvency for the banks that invested in them. Greed is not always good.

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Another factor that can lead to bank failures is inadequate risk management. Banks are required to maintain sufficient reserves to cover potential losses, but if they fail to do so, they can be vulnerable to economic shocks. During the Great Depression, many banks failed to maintain sufficient reserves, leaving them vulnerable to the economic shocks of the time. Similarly, during the financial crisis of 2008, many banks did not maintain adequate reserves to cover their potential losses from the mortgage-backed securities they invested in. If a bank has insufficient reserves to cover its liabilities and there is a sudden increase in default rates or a decline in asset values, the bank may become insolvent.

Economic Downturns

Moreover, banks may also fail due to external factors such as economic downturns, market volatility, or changes in the regulatory environment. During the Great Depression, the economic downturn was a significant factor that contributed to the failure of many banks. Similarly, during the financial crisis of 2008, the housing market crash and subsequent economic downturn played a significant role in the failure of many banks. At present, the COVID-19 pandemic and the global lockdowns exposed the cracks and weaknesses in our financial institutions and global economy; Businesses went bankrupt, there were mass layoffs, consumer demand shifted, and there were massive supply chain disruptions. Government handouts during the pandemic likely contributed to some degree of inflation that most major economies are facing now.

In times of financial crisis, banks may face significant liquidity problems as customers withdraw their deposits, leading to a run on the bank. In such situations, banks may be unable to meet their financial obligations, leading to their collapse. At present, there is global economic instability brought on by the COVID-19 pandemic, recession and inflation among countries, geopolitical tensions, and the war in Ukraine.

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Questionable Accounting Practices

Fraud and corruption can also contribute to bank failures. During the Great Depression, many banks engaged in fraudulent activities such as insider trading, which contributed to their failure. Similarly, during the financial crisis of 2008, some banks engaged in duplicitous activities such as misrepresenting the quality of the mortgage-backed securities they sold, which contributed to their failure. It is an open secret in the financial industry that some big institutions employ dubious and questionable accounting practices that can mislead those from the outside into thinking everything is going well.

The lack of effective regulation and supervision coupled with weak laws and lax enforcement on the government’s part also contributes to bank failures. Governments and regulators need to ensure that banks maintain sufficient reserves, engage in prudent risk management practices, and are subject to effective oversight. Banks, for their part, need to prioritize risk management and avoid excessive risk-taking. While bank failures cannot be completely eliminated, a strong regulatory framework and a culture of responsible risk management can minimize the risks and ensure a stable banking system.

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