Why Worry About Bank Failures?

Depositors Must Retain Confidence

(Photo: flickr.com)

(Photo: flickr.com)

Depositor confidence in the banking system is vital to the working of the modern economy. Banks lend out money assuming that they are not going to face a situation where all their depositors demand to withdraw funds simultaneously. At the same time, depositors entrust their money to the bank, believing they can withdraw it when they need to do so. A hundred years ago, many people still kept their savings at home. Those who deposited money in a bank would often rush to take their money out at the first rumors of trouble. These “runs” on banks were common causes of the bank collapses these depositors feared. The establishment of the FDIC in 1913 was prompted by a financial crisis in 1907 when the US Stock Exchange fell by 50 percent. This triggered many runs on banks and trust companies.

What Happens When a Bank Fails?

As soon as a state bank is unable to pay off all its creditors, the FDIC intervenes. They try to act in a way that does not draw public attention – the last thing they want is to cause a run on the bank. Their staff of bank analysts, accountants and other financial professionals makes a detailed survey of the bank’s assets. The aim is both to reach an assessment of the bank’s value as well as uncovering the reason for its failure.

The FDIC has the authority to close a bank, or alternatively take control of its management. Generally the preferred approach is to seek a buyer who is interested in taking over the failed bank. The FDIC is willing to offer inducements to buyers of failed banks. For example, they might agree to reimburse the takeover bank for 80 percent of the losses it is going to incur through acquiring delinquent loans.

Has Depositor Confidence Been Damaged Beyond Repair?

FDIC statistics show that over a 120 banks have collapsed in 2009 and the year is still not over. Compare this with 2007, when there were just three bank collapses. The FDIC recognizes the need to address public concern over loss of deposits due to bank collapses. This is one of the prime reasons why they guarantee deposits of up to $100,000 in banks with FDIC insurance. Sheila Bair, Chairman of the FDIC, seeks to reassure Americans that the crisis is under control: “Our projection right now is bank failures will continue at a pretty good clip through 2011. Again, we’re prepared for it; we’re ready for it. The rate of healing in the economy will drive the rate of healing of the banking sector.”

Are Bank Failures Unmitigated Disasters?

To the wealthiest depositors and investors who stand to lose a considerable amount, there is no doubt that a bank collapsing is very bad news. Management and employees are also going to be concerned over the loss of jobs that is almost inevitably going to happen. However, from a macro-economic perspective, failure is not necessarily a great disaster. While the recent spate of bank collapses has certainly damaged confidence in the U.S. economy, some economists argue that over the long term there may be benefits. The disappearance of the weakest banks is viewed by these analysts as a healthy development that strengthens the economy.

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