How Banks Fail

4/11/2023

There has been a lot of talk about bank failings after the Silicon Valley Bank became insolvent on March 10^th, with plenty of speculation about other banks failing.  All this financial chatter sounds alarming, but what does all of this mean for you, and what causes a bank to fail?

Let’s get some definitions down first.

Insolvent: A bank, or any company, can become insolvent when it can’t pay its debts when they are due.

Bank Failure: When a bank becomes insolvent, it can be forced to close by a federal or state regulator, overseen by a banking commissioner.

Default: This is a failure to fulfill an obligation, especially to repay a loan. If a bank is unable to fulfill their obligations to their clients and depositors, they will be said to be in default.

Bank Run: A bank run often starts when there is either rumor or hard evidence that a bank is struggling to remain solvent.  Clients may decide to withdraw their funds from that bank to a ‘safer’ or more solvent bank. When an increasing number of clients remove their funds in a short period of time, the probability of that bank defaulting increases. In turn the fear and speculation grows, causing more clients to withdraw their funds, only worsening the situation for the bank.

FDIC: The Federal Deposit Insurance Corporation was created in 1933 in response to the Great Depression and acts to insure a bank client’s deposits within certain parameters. The FDIC protects deposits for up to $250,000 per depositor, per account. For example, if you have a joint account with your spouse, the FDIC will insure you up to $500,000 in that single account.  However, not all deposits are covered.

FDIC deposit insurance covers: checking accounts, negotiable order of withdrawal (NOW) accounts, savings accounts, money market accounts, certificates of deposit, and money orders. The FDIC will not cover stocks, bonds, mutual funds, life insurance policies, annuities, safe deposit boxes, or their contents, U.S. Treasury bills, bonds, or notes, crypto currency.

Bond Market: The bond market is the buying and selling of various debts issued by corporations and governments. These bonds are used to raise funds for growth opportunities. In return, the government or corporation promises to repay the original investment amount, plus interest.

Venture Capital: money invested in a project in which there is a substantial element of risk, typically a new or expanding business such as the tech industry.

Deposit Insurance Fund: The Deposit Insurance Fund (DIF) is a private insurance provider that ensures the deposits of bank customers are covered by the FDIC. The money in this fund is set aside by banks to pay back the money lost due to the failure of a financial institution.

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What happens when a bank fails?

Bank failures can be difficult to predict. When a bank fails, the FDIC takes control and will most likely sell it to another more stable bank. When this happens, bank customers may not experience any significant change.  They will receive new checks and banking cards representing the new bank; however their deposits will be intact. The FDIC may appoint a ‘Bridge Bank’ to oversee the continued running of the failed bank while a buyer bank is found.

 How Silicon Valley Bank failed

The failure of Silicon Valley Bank on March 10^th, 2023 was the second largest bank failure in the United States. The failure was the culmination of a series of events that ended in a bank run. Silicon Valley had investments in the bond market. The value of these bonds dropped as the Federal Reserve increased interest rates. As long as Silicone Valley Bank kept those bonds to their maturity date, they would have recovered this loss in value.

Silicon Valley Bank altered their investment strategy in 2021 to favor longer term investments with larger payouts.  Unfortunately, they did not correctly balance these longer-term investments with short-term investments that could be liquidated quickly in a time of need.  

Many Silicon Valley Bank customers were in the tech industry. As federal interest rates rose and fresh venture capital became scarce, clients began to withdraw their funds. The bank was unable to meet the demand with cash on hand and were forced to liquidate some of their bonds at a loss to protect their longer-term investments. News of the sale of the bonds at a loss caused a panic in clients and the subsequent bank run.  The bank collapsed in 48 hours.

Protections Against Bank Failures

The Federal Reserve requires banks to keep around 10% of their liabilities in cash reserves. Unfortunately, this requirement was suspended during the COVID-19 pandemic and has yet to be reinstated.

The FDIC may sometimes provide reimbursement beyond its $250,000 account coverage limits. For example, in the recent failing of Silicon Valley Bank, the FDIC used funds from the Deposit Insurance Fund to fully reimburse customers. The money paid to bank customers did not come from federal tax revenue, but from this fund.

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If you are concerned about losing money if your bank fails, keep only up to the FDIC insured limit of $250,000, in a bank account. Deposit further funds into an account at a different FDIC insured bank. If you are a couple, you are covered up to $500,000 per joint account.  As the sole owner of several accounts at one bank, you will only be covered for $250,000 as the value of all of your accounts will be combined.  Any amount in excess of $250,000 will not be covered.

If you do have funds over $250,000 in a failed bank, you will most likely get your money back, but it will take some time. You may also lose a small percentage of those funds in excess of the insured amount, but will recoup most of your money.

Nearly all banks are FDIC insured. You can look for the FDIC logo at bank teller windows or the entrance to your branch. Note that while the FDIC covers banks, credit union customers are similarly protected under the National Credit Union Administration.

 

 

 

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