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How Banks Become Insolvent

How Banks Become Insolvent and The Importance of Lender of Last Resort and Deposit Insurance

If banks can create money, then how do they become insolvent (i.e. fail)? Can’t they just create more money to cover their losses? The following explains how banks make loans, and the differences between the type of money created by the central bank and money created by commercial banks.

Insolvency can be defined as the inability to pay one’s debts. This usually happens for one of two reasons:

  1. This usually happens for one of two reasons: The bank cannot pay its debts as they fall due, even though its assets may be worth more than its liabilities.
  2. This is known as cash flow insolvency, or a ‘lack of liquidity.’ The bank ends up owing more than it owns or is owed to them. In accounting terminology, this means its assets are worth less than its liabilities.

Cash Flow Insolvency / Becoming ‘Illiquid’

The following example shows how a bank could become insolvent due to a bank run if it did not have access to lender of last resort funds.

Step 1: Initially the bank is in a financially healthy position as shown by its balance sheet – its assets are worth more than its liabilities. Even if some customers do default on their loans, there is a large buffer of shareholder equity to protect depositors from any losses.

Step 2: For whatever reason (perhaps due to a panic caused by some news) people start to withdraw their money from the bank. Customers request cash withdrawals or ask the banks to make a transfer on their behalf to other banks. Banks hold a small amount of physical cash, relative to their total deposits, so this can quickly run out. They also hold an amount of reserves at the central bank, which can be electronically paid to other banks to ‘settle’ a customer’s electronic transfer of funds.

The effect of these cash or electronic transfers, away from the bank, is to simultaneously reduce the bank’s liquid assets and its liabilities (in the form of customer deposits). These withdrawals can continue until the bank runs out of cash and central bank reserves.

At this point, the bank may have some bonds, shares, or other liquid assets, which it would be able to sell quickly to raise additional cash and central bank reserves in order to continue re-paying customers. However, once these ‘liquid assets’ have been depleted, the bank would no longer be able to meet the demand for withdrawals. It could no longer make cash or electronic payments on behalf of its customers:

At this point the bank is still technically solvent; however, it would be unable to facilitate any further withdrawals as it has literally run out of cash (and cash’s electronic equivalent, central bank reserves). If the bank were unable to borrow additional cash or reserves from other banks or the Federal Reserve, the only way left for it to raise funds would be to sell off its illiquid assets, that is its loan book.

Herein lies the problem. The bank needs cash or central bank reserves quickly (i.e. today). But any bank or investor considering buying it’s illiquid assets is going to want to know about the quality of those assets (will the loans actually be repaid?). It takes time – weeks or even months – to go through millions or billions of dollars-worth of loans to assess their quality. If the bank really has to sell in a hurry, the only way to convince the current buyer to buy a collection of assets that the buyer hasn’t been able to asses is to offer a significant discount. The illiquid bank would likely be forced to settle for a fraction of its loans’ true worth.

For example, a bank may value its loan book at $1 billion. However, it might only receive $800 million if it’s forced to sell quickly. If shareholder equity is less than $200 million then this would make the bank insolvent.

The Importance of Lender of Last Resort

Now of course in our current banking system the above scenario would never happen. If, hypothetically, there were a run on a bank, the bank might simply be able to borrow the reserves necessary to redeem its deposits from the interbank lending market. But, if for some reason other banks were worried that the bank might be in danger of insolvency and unable to repay those loans, the bank might not be able to access the interbank lending market. In this case, the bank could simply go to the discount window at the Fed for emergency liquidity assistance. As long as the bank can put up collateral of adequate quality (decent quality loans), the bank can turn its illiquid assets (its loan portfolio) into liquid assets (reserves). This allows the bank to meet its obligations to its depositors, as long as the value of the bank’s assets are worth more than the value of its liabilities.

Normal Insolvency

The following example shows how a bank can become insolvent due to customers defaulting on their loans. (This can happen in our system)

Step 1: Initially the bank is in a financially healthy position as shown by the simplified balance sheet below. In this balance sheet, the assets are larger than its liabilities, which means that there is a buffer of ‘shareholder equity’ (shown on the right).

Shareholder equity is simply the gap between total assets and total liabilities that are owed to non-shareholders. It can be calculated by asking, "If we sold all the assets of the bank, and used the proceeds to pay off all the liabilities, what would be left over for the shareholders"? In other words:

Assets – Liabilities = Shareholder Equity.

In the situation shown above, the shareholder equity is positive, and the bank is solvent (its assets are greater than its liabilities).

Step 2: Some of the customers the bank has granted loans to default on their loans. Initially this is not a problem – the bank can absorb loan defaults up to the value of its shareholder equity without depositors suffering any losses (although the shareholders will lose the value of their equity). However, suppose that more and more of the banks’ borrowers either tell the bank that they are no longer able to repay their loans, or simply fail to pay on time for a number of months. The bank may now decide that these loans are ‘under-performing’ or completely worthless and would then ‘write down’ the loans, by giving them a new value, which may even be zero (if the bank does not expect to get any money back from the borrowers).

Step 3: If it becomes certain that the bad loans won’t be repaid, they can be removed from the balance sheet, as shown in the updated balance sheet below.

Now, with the bad loans having wiped out the shareholders equity, the assets of the bank are now worth less than its liabilities. This means that even if the bank sold all its assets, it would still be unable to repay all its depositors. The bank is now insolvent.

After Insolvency and the Need for Deposit Insurance

For a bank, being insolvent means it cannot repay its depositors, because its liabilities are greater than its assets. The effect that a bank has on the economy if it becomes insolvent depends on whether the deposits are insured.

In a country without deposit insurance, an insolvent bank would not be able to repay people their deposits in full. In the event of an insolvency depositors would have to get in line with other bank creditors to reclaim whatever money they could from the bank. So for every $1.00 the bank owed to customers it might only pay 90 cents or even less. However, this is not the end of the story. The failure of one bank could lead people to worry about the financial position of other banks. Furthermore the insolvent bank would have certainly owed money to other banks, as would its customers. This can lead to a domino effect – a bankruptcy at one bank can lead to a ‘cascade’ of defaults and bankruptcies, crippling the economy.

Because of the potentially devastating impacts of a wave of bank failures, governments seek to avoid them at all costs. In addition to providing lender of last resort liquidity assistance to banks, the government also backs deposit insurance. By ensuring deposits are safe, this makes it so there is no reason for depositors to panic and withdraw their deposits, which means there is no longer any reason for bank runs to occur. This further helps stabilize the banking system.

In the US we adopted our national deposit insurance scheme (FDIC) in 1933 in response to the Great Depression. Its purpose was to prevent the kind of bank runs that contributed to the Depression from ever happening again. In a country with deposit insurance an insolvent bank will have its assets seized and sold off. Depositors are then fully reimbursed using the funds raised and FDIC funds from insurance premiums paid by the banks into the system. If necessary, the Treasury can lend to FDIC to make up any shortfall.

The Problem With Lender of Last Resort and Deposit Insurance

The problem with lender of last resort and deposit insurance is that they prop up the banks’ ability to create safe, par-convertible ($1 in deposits=$1 in cash) deposits, which function as substitutes for publicly-created money. This ability of the banks allows them to create most of our money supply through their lending, crowding out the space for public money creation and creating the laundry list of problems described in detail in our issues section.