What Happens When Banks Go Bankrupt?

Learn what happens when banks go bankrupt and how to prevent a financial crisis.

What Happens When Banks Go Bankrupt?
Photo by Jezael Melgoza / Unsplash

Have you ever wondered what happens when banks go bankrupt? How does it affect the economy, the financial system, and your money? And how can we prevent a bank failure from causing a financial crisis?

In this blog post, I will explain these questions in a simple and engaging way, using examples and stories from real-life cases. I will also share some insights from Mr Klaas Knot, the president of the Netherlands Bank, who gave a speech about this topic at the Flairs conference in Amsterdam on September 29, 2023.

By the end of this post, you will learn:

  • Why banks can go bankrupt and why it is a problem
  • How governments and central banks have improved their tools to deal with bank failures
  • What are the challenges and opportunities for making banks more resilient and resolvable

Let’s get started!

Why Banks Can Go Bankrupt and Why It Is a Problem

Banks are special businesses that provide essential services to the economy. They take deposits from savers and lend money to borrowers. They also facilitate payments, manage risks, and offer financial advice.

But banks are also vulnerable to risks. They can make bad lending decisions, suffer from fraud or mismanagement, or face unexpected shocks from the market or the environment. These risks can cause banks to lose money and become insolvent, which means that they have more liabilities than assets.

When a bank becomes insolvent, it can go bankrupt.

This means that it stops operating and its assets are sold to pay off its creditors. The word bankruptcy comes from the Italian ‘banca rotta’, which literally means 'broken bank’. In Renaissance Italy, there was a tradition of smashing a banker’s bench if he defaulted on payment.

Bankruptcy is not always a bad thing. It is part of a healthy, dynamic, and competitive market system. It allows inefficient or unprofitable businesses to exit the market and free up resources for more productive ones. It also creates incentives for businesses to be prudent and responsible.

However, bankruptcy can be a big problem when it involves banks. This is because banks are interconnected and play a vital role in the economy. A bank failure can have negative consequences for other banks, financial markets, businesses, households, and governments. These consequences are called spillovers or externalities.

For example, when a bank fails, it can cause:

  • Contagion: Other banks that have lent money to or borrowed money from the failing bank may also face losses or liquidity problems. This can create a domino effect that spreads through the banking system.
  • Panic: Depositors and investors may lose confidence in the banking system and withdraw their money or sell their assets. This can create a run on the banks or a fire sale of assets that worsens the situation.
  • Disruption: The failing bank may stop providing essential services to its customers and counterparties. This can disrupt the payment system, the credit supply, and the financial intermediation that supports the real economy.

These spillovers can threaten financial stability, which is the ability of the financial system to function smoothly and efficiently in normal times and in times of stress. Financial stability is important for economic growth, welfare, and social cohesion.

How Governments and Central Banks Have Improved Their Tools to Deal with Bank Failures

To prevent bank failures from causing financial instability, governments and central banks have developed various tools to deal with them. These tools can be classified into three lines of defence:

  • First line of defence: Prudential regulation and supervision. This involves setting rules and standards for banks to follow in order to ensure their safety and soundness. For example, banks are required to hold enough capital and liquidity to absorb losses and meet their obligations. They are also subject to regular inspections and audits by regulators and supervisors who monitor their performance and compliance.
  • Second line of defence: Emergency liquidity assistance. This involves providing temporary funding to solvent but illiquid banks that face liquidity problems due to market disruptions or panic. For example, central banks can act as lenders of last resort by offering loans or buying assets from troubled banks at preferential terms.
  • Third line of defence: Resolution. This involves taking over and restructuring insolvent or failing banks in an orderly way that minimizes spillovers and preserves essential public functions. For example, resolution authorities can use various instruments such as bail-in (imposing losses on shareholders and creditors), bridge bank (transferring good assets and liabilities to a new entity), or sale of business (selling parts or all of the bank to another buyer).

These tools have been improved and strengthened after the Global Financial Crisis of 2007-2009, which exposed the weaknesses and gaps in the existing framework. The crisis showed that many banks were too big, too complex, or too interconnected to fail, meaning that their failure would have systemic consequences that could not be tolerated. The crisis also showed that many governments and central banks were not prepared or equipped to deal with such failures in an effective and efficient way.

As a result, the G20 and the Financial Stability Board, which are international bodies that coordinate financial policies and standards, launched a series of reforms to address the too-big-to-fail problem and to enhance the resilience and resolvability of banks. These reforms include:

  • Higher capital and liquidity requirements. Banks are required to hold more and better quality capital and liquidity to withstand shocks and stress. For example, the Basel III framework, which is a set of global standards for bank regulation, has increased the minimum capital ratio from 8% to 10.5% and introduced a leverage ratio of 3% and two liquidity ratios of 100% and 110%.
  • Recovery and resolution planning. Banks are required to prepare plans for how they would restore their financial health or resolve their failure in an orderly way. These plans are reviewed and assessed by regulators and supervisors who can also impose measures to improve their resolvability. For example, banks may be asked to simplify their structure, reduce their interconnections, or issue more bail-enable debt.
  • Resolution framework. A legal and operational framework has been established to enable resolution authorities to intervene in and resolve failing banks without using public funds or disrupting financial stability. This framework includes powers, instruments, authorities, funding arrangements, and cross-border cooperation mechanisms. For example, the European Union has created a Single Resolution Mechanism, which is a centralized system for resolving banks in the euro area.

These reforms have made significant progress in making banks more resilient and resolvable. They have also reduced the implicit subsidy and moral hazard that too-big-to-fail banks enjoy from the expectation of public support.

What Are the Challenges and Opportunities for Making Banks More Resilient and Resolvable

Despite the progress made so far, there are still challenges and opportunities for making banks more resilient and resolvable. These include:

  • Testing the effectiveness of resolution. While resolution has been applied to some small or medium-sized banks in recent years, it has not yet been tested on a large or complex bank that poses systemic risks. There are still uncertainties and difficulties in implementing resolution in practice, especially in a cross-border context. For example, there may be legal or operational obstacles, coordination problems, or political pressures that hinder resolution.
  • Adapting to changing circumstances. The banking sector is constantly evolving due to technological innovations, market developments, regulatory changes, and environmental factors. These changes may create new risks or opportunities for banks that require adjustments in their business models, risk management, or resolution strategies. For example, digitalization may increase cyber risks or competition for banks, while climate change may affect their asset quality or funding sources.
  • Balancing trade-offs. There are trade-offs involved in making banks more resilient and resolvable. For example, higher capital requirements may reduce the probability of failure but also lower the profitability or lending capacity of banks. Similarly, bail-in may reduce the cost of resolution but also increase the risk of contagion or panic among creditors. These trade-offs need to be carefully weighed and calibrated to achieve an optimal outcome.

These challenges and opportunities call for continuous monitoring, evaluation, and improvement of the tools and practices for dealing with bank failures. They also call for close cooperation and dialogue among all stakeholders involved: governments, central banks, supervisors, resolution authorities, banks, creditors, customers, and society at large.

I hope you have found this post informative and interesting. If you want to learn more about this topic, you can read the speech by Mr Klaas Knot at the Flairs conference here.

Here are five bullet points that summarize the main points of this post:

  • Banks can go bankrupt due to various risks that cause them to become insolvent
  • Bank failures can threaten financial stability due to spillovers such as contagion, panic, or disruption
  • Governments and central banks have improved their tools to deal with bank failures by strengthening prudential regulation and supervision, emergency liquidity assistance, and resolution
  • The effectiveness of resolution has not yet been tested on a large or complex bank that poses systemic risks
  • The banking sector is constantly evolving due to technological innovations, market developments, regulatory changes, and environmental factors
  • There are trade-offs involved in making banks more resilient and resolvable

I hope this post has helped you understand the complex world of banking and finance a little better. Remember, knowledge is power. The more you know about how banks work and how they can fail, the better prepared you will be to make informed decisions about your money and your future.

Thank you for reading. If you have any questions or comments, please feel free to leave them below. I look forward to hearing from you!

Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.

Want to be part of a community of informed and engaged individuals? Follow us on social media @Facebook, @Linkedin and @Twitter  

Subscribe on LinkedIn

Don’t be left behind! Sign up for FinFormed and start growing!