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How Banks Fail

In her book, Bull by the Horns, former chairman of the Federal Deposit Insurance Corporation Shelia Bair explains how banks fail:

A bank can essentially fail in one of two ways: It can become insolvent, meaning that the amount of capital it has is insufficient to cover its losses on its loans and other assets. That is why regulators watch each bank’s capital ratios very closely; when it dips below 2 percent, federal law requires that the regulators close the bank within ninety days, unless it can raise more capital. As we learned during the S&L crisis, insolvent institutions need to be closed quickly to minimize losses. If a failed institution is left open, the management will typically get deeper and deeper into high-risk lending in an attempt to generate fat returns to dig their way out. But those high-risk loans end up generating even more losses. That is exactly what happened during the S&L crisis, and the cleanup cost the taxpayers more than $125 billion.

A bank can also suffer a liquidity failure. That essentially means that it runs out of money to meet its obligations, including deposit withdrawals. A bank nearing insolvency will frequently fail because it runs out of cash, even though it is technically still solvent. The market anticipates that its capital base is insufficient to absorb likely losses, so creditors will try to pull out early before the failure occurs. Some creditors—such as insured depositors and those holding collateral to secure their loans—are protected in an FDIC resolution. However, unsecured creditors, including uninsured depositors, are not. So they are the first to try to pull out when it looks as though a bank is running into trouble. They want to escape whole because they know they will take a haircut if the FDIC has to take over.