Two Types Of Bank Failure

There are two ways for a bank to fail.  That thought was prompted by a good explanation of economic research on banking crises by Charles W. Calomiris of Columbia University.  Read it here.

Here’s the obvious way for a bank to go bankrupt: loan losses.

This bank has more debts (deposits are the bank’s debt) than assets, because of its loan losses.  This is what we think of when a bank goes under.  But there’s another way:

This bank is in fine shape.  The assets are greater than deposits, so it is solvent.  But now suppose that depositors get nervous and withdraw $15 of deposits.  The bank is supposed to provide cash immediately, but it only has $10 of cash.  Those long-term loans cannot be called in for payment; the borrowers have the right to pay according to the agreed-upon schedule.

In practice, those long-term loans might be marketable.  Our bank could try to sell them to another bank or investor.  But if financial markets are really nervous, that won’t happen.  This bank becomes illiquid, which is not the same as insolvent.  Washington Mutual was closed for reason of illiquidity, and Bear Stearns had the same problem.  We may never know how their assets would have worked out if the companies had stayed in business.

The Calomiris article has a couple of good sections:

“The picture of small depositors lining up around the block to withdraw funds has received much attention, but perhaps the more important source of market discipline was the threat of an informed (often “silent”) run by large depositors (often other banks). Banks maintained relationships with each other through inter-bank deposits and the clearing of public deposits, notes, and bankers’ bills. Banks often belonged to clearinghouses that set regulations and monitored members’ behavior. A bank that lost the trust of its fellow bankers could not long survive.”

and

“Empirical research on the banking collapses of the last two decades of the twentieth century has produced a consensus that the greater the protection offered by a country’s bank safety net, the greater the risk of a banking collapse.”

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