Why Do Banks Fail?

Is it safe to write about the banking crises that almost was?  I try not to feed into the media frenzy when financial news is freaking people out.  Maybe we can look back now and see what happened and if you should (or should not) worry about the banking system.

First, why do banks fail?  Mainly, herd mentality. 

Unlike what you see in old westerns, banks do not keep all of client deposits in a large safe behind the teller desk.  Yes, they are required to keep some money on hand, but most of it is either:

  1. Loaned out at interest rates higher than what is paid to depositors.
  2. Invested in safe assets such as US Treasuries or Mortgage-Backed Securities in order to earn interest for the bank.

That’s how banks make money.

US Treasuries are considered the world’s safest investment.  If you buy a $1,000 bond from the US government, you will get that $1,000 back at the maturity date.  That said, prices do go up and down for buying and selling Treasuries on the secondary market prior to the bond’s maturity date.

In the case of SVB, the US Treasuries they had bought at low interest rates several years ago are worth less on the secondary market today, but would have paid back the full $1,000/bond if the bank had been able to hold until maturity.  Alas, the bank didn’t have the luxury of that time.

This is where herd mentality comes in.  Most banks fail because of a panic driven wave of sudden withdrawals.  Remember, there is no big steel safe with everybody’s money.  So, if the depositors ALL are asking for ALL of their money at the same time, the bank must:

  1. Sell their investments to free up the cash. In SVB’s case this was US government bonds that are trading less than the purchase price.
  2. Or, call in their loans which most individuals and businesses are unprepared to pay back all at once.

Bank runs and the panic they cause are almost as contagious as COVID.  This is why the government will step in and bail out depositors – not bank stockholder – even when they make the poor decision to hold more than the $250,000 per account FDIC insurance.

My belief (and it could be wrong) is the US government will not let the failure of banks get out of hand, no matter how politically unpopular the bailouts.



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