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  • Two Types of Bank Failure

Economy

15 Feb 2009

Two Types of Bank Failure

  • By Bill Conerly
  • In Economy
  • 1 comment

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.

Assets Liabilities
Loans, gross value 90 Deposits 90
– loan
losses
-20
Loans, net value 70 Owners' equity 10
Cash 10
Total Assets 80 Total Liabilities 100

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:

Assets
Liabilities
Loans, long-term
90 Demand deposits 90
Cash
10 Owner's equity 10
Total Assets
100 Total Liabilities 100

 

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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    Comments

  1. RTO Trainer
    February 16, 2009

    Question: Why is the focus of “stimulous” and all the talk on increasing sales activity?
    Would not, given what you’ve shown, an increase in saving be more effective in helping these banks overcome illiquidity?
    To that end, raise interst rates now and help encourage people to save, not spend? As well as to back of the use of credit, preventing increasing the supply of long term loan obligations as well as stemming inflation now, rather than let it get wildly out of control first. There will be time for buying later I’d think.

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