A bank failure occurs when a bank is unable to meet its obligations to its depositors or other creditors because it has become insolvent or too illiquid to meet its liabilities.[1] More specifically, a bank usually fails economically when the market value of its assets declines to a value that is less than the market value of its liabilities. The insolvent bank either borrows from other solvent banks or sells its assets at a lower price than its market value to generate liquid money to pay its depositors on demand. The inability of the solvent banks to lend liquid money to the insolvent bank creates a bank panic among the depositors as more depositors try to take out cash deposits from the bank. As such, the bank is unable to fulfill the demands of all of its depositors on time. Also, a bank may be taken over by the regulating government agency if Shareholders Equity (i.e. capital ratios) are below the regulatory minimum.

The failure of a bank is generally considered to be of more importance than the failure of other types of business firms because of the interconnectedness and fragility of banking institutions. Research has shown that the market value of customers of the failed banks is adversely affected at the date of the failure announcements.[2] It is often feared that the spill over effects of a failure of one bank can quickly spread throughout the economy and possibly result in the failure of other banks, whether or not those banks were solvent at the time as the marginal depositors try to take out cash deposits from these banks to avoid from suffering losses. Thereby, the spill over effect of bank panic or systemic risk has a multiplier effect on all banks and financial institutions leading to a greater effect of bank failure in the economy. As a result, banking institutions are typically subjected to rigorous regulation, and bank failures are of major public policy concern in countries across the world.[3]

No advance notice is given to the public when a bank fails.[6] Under ideal circumstances, a bank failure can occur without customers losing access to their funds at any point. For example, in the 2008 failure of Washington Mutual the FDIC was able to broker a deal in which JP Morgan Chase bought the assets of Washington Mutual for $1.9 billion.[7] Existing customers were immediately turned into JP Morgan Chase customers, without disruption in their ability to use their ATM cards or do banking at branches.[8] Such policies are designed to discourage bank runs that might cause economic damage on a wider scale.

As aforementioned, the failure of a bank is relevant not only to the country in which it is headquartered, but for all other nations that it conducts business with. This dynamic was highlighted quite dramatically in the 2008 financial crisis, during which the failures of major bulge bracket investment banks held dire consequences for local economies throughout the broader global market. The high degree to which markets are integrated in the global economy made this a near inevitability. This interconnectedness was manifested not on a high level, with respect to deals negotiated between major companies from different parts of the world, but also to the global nature of any one company's makeup. Outsourcing is a key example of this makeup. As major banks such as Lehman Brothers and Bear Stearns failed, the employees from countries other than the United States suffered in turn.

See also