Banking gives people and businesses a way to save and borrow money, making it a vital component of our economy. Although banks are essential to our financial system, recent events have shown that they are also susceptible to failure. In this article, we’ll look at how the banking system functions and potential reasons for bank failure.
How the Banking System Works
Taking customer deposits and using those funds to make loans is the essence of banking. Banks generate revenue by collecting interest on deposits while charging interest on loans. The “net interest margin” is the difference between the interest rates a bank pays on deposits and the interest rates it charges on loans. Fees and commissions on various financial services, including credit cards, mortgages, and investment products, are another source of income for banks.
Government agencies, including the Federal Reserve in the United States, heavily regulate banks to ensure their safe and sound operations. Banks must maintain a minimum amount of capital, which is the cash they have set aside to cover potential losses. Periodic stress tests that simulate various economic scenarios and evaluate a bank’s resilience to financial shocks are also applied to banks.
What Causes a Bank to Fail?
Failure of a bank can result from a variety of factors. Credit risk, which happens when borrowers are unable to repay their loans, is one typical cause. Banks take risks because that’s what they do, but if too many of those bets turn out to be bad, the bank could lose a lot of money. In some circumstances, a bank may have made too many loans to a specific industry or area, making it susceptible to a downturn there.
Liquidity risk, which happens when a bank does not have enough cash on hand to meet its obligations, is another element that can cause a bank to fail. For their daily operations, banks depend on short-term funding sources like deposits and wholesale funding. The bank might be forced to sell assets or take out loans at higher interest rates in order to pay its debts if these sources of funding stop flowing.
An additional potential factor in bank failure is operational risk. This refers to risks connected to a bank’s internal operations, like fraud or technological errors. A significant operational failure at a bank may harm its reputation and cause financial losses.
The failure of a bank can also be influenced by outside variables like regulatory changes or economic downturns. Borrowers might default on their loans more frequently if the economy goes into a recession, which would put pressure on banks. Similar to the previous example, banks may find it challenging to operate profitably if regulators impose new rules or requirements that are overly onerous.
Examples of Bank Failures
Silicon Valley Bank experienced substantial growth between 2019 and 2022, resulting in significant deposits and assets. However, as the Federal Reserve raised interest rates, the bank’s investments in Treasury bonds became riskier, and customers in financial trouble began withdrawing funds. To accommodate these withdrawals, the bank sold investments at a loss, resulting in a loss of $1.8 billion and the bank’s collapse. Some believe the bank’s failure began with the rollback of the Dodd-Frank Act, which would have subjected the bank to additional oversight and rules had the threshold not been raised to $250 billion under the 2018 Economic Growth, Regulatory Relief, and Consumer Protection Act.
In recent years, there have been numerous prominent bank failures. One of the most notable was Lehman Brothers’ bankruptcy in 2008, which had a major impact on the world financial crisis. Lehman Brothers had invested a lot of money in subprime mortgages, which ultimately failed, causing huge losses and a bank run.
A German payment company called Wirecard filed for bankruptcy in 2020 after it was discovered that billions of euros were missing from its accounts. Criminal investigations and a sizable decline in investor confidence were brought on by the scandal.
Conclusion
Although it is vital to our economy, the banking system is not impervious to failure. Credit risk, liquidity risk, and operational risk are just a few of the risks that banks are exposed to and that could ultimately spell their doom. It is crucial that regulators and banks themselves take action to reduce these risks and guarantee the stability and security of the banking system.
