A bank failure is the closing of a bank by a federal or state banking regulatory agency. A bank is usually closed when it is determined that it will be unable to meet its obligations to depositors and others. The Federal Deposit Insurance Corp., which guarantees the accounts of approximately 8,500 banks and savings associations, handles the receivership and management of failed banks. When acting as the receiver of a failed bank, the FDIC assumes the task of selling and collecting the assets of the failed bank and settling its debts, including claims for deposits in excess of the insured limit. As the insurer of the bank’s deposits, the FDIC pays insurance to the depositors up to the insurance limit of the account.
In the event of a bank failure, the costs of acquiring and the failed bank and handling the disposition of its assets and liabilities comes from the FDIC deposit insurance fund. The FDIC’s deposit insurance fund consists of premiums already paid by insured banks and interest earnings on its investment portfolio of U.S. Treasury securities. No federal or state tax revenues are involved. The FDIC notifies each depositor in writing using the depositor’s address on record with the bank. This notification is mailed immediately after the bank closes.
A bank fails economically when the market value of its assets declines below the market value of its liabilities, so that the market value of its capital, its net worth, becomes negative. At such times, the bank cannot expect to pay all of its depositors in full and on time. The bank, or indeed any firm, should be resolved as quickly as possible in order to treat all depositors which are creditors from the banks perspective fairly and not allow a run by depositors holding demand and short-dated deposits. The longer an insolvent bank is permitted to operate, the more time such informed depositors have to withdraw their funds at par value and effectively strip the bank of its valuable assets. The entire loss will then be borne by less informed depositors and holders of longer-dated deposits.
Bank failures are accepted aspect of a deregulated financial marketplace. Unfortunately, bank failures are costly to their owners, customers, and some third parties. But so are the failures of other firms. To the extent that failures reflect market forces, public policies to prevent exit harm other economic agents, such as competitors and those who will benefit from entry, including consumers of banking services. Nevertheless, bank failures are widely perceived to be more damaging to the economy because of the belief that they are more likely to spill over to other banks and beyond. Thus, almost all countries have imposed special prudential regulations on banks to prevent or mitigate such adverse effects.
The protections that depositors are offered today enjoy a certain degree of protection, as long as they place their funds in Federal Deposit Insurance Corp. insured banks and similar institutions. Total protection from loss due to bank failure is not automatic, and even today, when a bank fails, its depositors can lose a significant portion of their money. Make sure to know and understand the limitations and guidelines of the protections offered by the FDIC, and take steps to ensure that bank accounts conform and will be as protected as possible. However, it is not merely the individual depositor in a failed bank that is affected by a bank failure.
Bank failures have a significant impact on the economy as a whole, as well as on the average American. That’s because a major bank failure affects other banks that that bank does business. Banks are closely intertwined financially with each other through lending to and borrowing from each other, holding deposit balances with each other, and the payments clearing system, a failure of any one bank is believed to be more likely to spill over to other banks and to do so more quickly. The collapse and failure of a bank could trigger an adverse financial repercussion and generate negative impacts such as a massive bail out cost for the failing bank and loss of confidence from the investors and depositors. A default by one bank on an obligation to another bank may adversely affect that bank’s ability to meet its obligations to other banks and so on down the chain of banks and beyond. Very often, bank failures are due to financial distress.
The main way that the individual feels the affect of bank failures is in an overall constriction of credit. The pool of funds available for financing loans is reduced, not just for the individual seeking credit, but also for businesses. That can contribute to a reduction in available jobs and a general economic malaise, particularly in the current economic situation, in which the nation, even the world, is already dealing with what has been termed a credit crisis, which developed as a part of the fall-out of the mortgage and lending melt-down.
Banks are viewed as more fragile than many industries based on the financial composition of their structure. Banks, in general, have low capital-to-assets ratios resulting in a relatively high degree of leverage. Our fractional reserve banking results in low cash on hand relative to total assets. Most banks have a very high level of short term debt which is predominantly the demand and time deposits such as money market demand accounts and certificates of deposit. These factors that are the foundation for most bank structures can set the stage for little room for losses, limited flexibility to quickly dispose of income producing assets to cover losses.
The adverse implications of this fragility are intensified by the fear that banks invest in assets that are opaque, illiquid and difficult to market, contain private information, and can change in market value abruptly and that depositors may run “irrationally” on banks, forcing unnecessarily large fire-sale losses. Thus, the greater fragility is believed to lead to greater failure.
In supervising banks for safety and soundness, the Fed relies on both on-site examinations and off-site inspection of financial and other information. The examinations focus on:
- The quality of loans that the bank has extended (that is, how likely are they to be repaid)
- The liquidity of the bank’s assets (that is, how quickly can the bank turn them into cash without losing any of their value)
- The amount of capital and other assets that the bank has in relation to the level of risk in the bank’s portfolio
- Sensitivity of the bank’s financial structure to risks
The quality of the bank’s management
Monitoring the financial conditions of banks and savings institutions is an important task of banking regulators. Predicting bank failure is a vital matter for the regulators of the while scrutinizing the weaker institutions in the banking industries. Producing an early warning system that identifies potential bank failure or high-risk banks through the traits of financial distress is a key aspect of the regulators task. Various traditional statistical models have been employed to study bank failures. However, these models do not have the capability to identify the characteristics of financial distress and thus function as black boxes.
Formulas associated with risk analysis of bank conditions use some variation of the CAMELS rating elements. This rating system is used by the three federal banking supervisors (the Federal Reserve, the FDIC, and the OCC) and other financial supervisory agencies to provide a convenient summary of bank conditions at the time of an exam. The acronym CAMELS refers to the six components of a bank’s condition that are measured by supervisory agencies. The six components include; Capital adequacy, Asset quality, Management, Earnings, Liquidity and Sensitivity to market risk. Ratings are assigned for each component in addition to the overall rating of a bank’s financial condition.
Bank supervisory agencies are responsible for monitoring the financial conditions of commercial banks and enforcing related legislation and regulatory policy. Although much of the information needed to do so can be gathered from regulatory reports, on-site examinations are needed to verify report accuracy and to gather further supervisory information. Much research has explored the value of this private information, both to the bank supervisors and to the public who monitor banks through the financial markets.
During an on-site bank exam, supervisors gather private information, such as details on problem loans, with which to evaluate a bank’s financial condition and to monitor its compliance with laws and regulatory policies. A key product of such an exam is a rating of the bank’s overall condition summarized as a CAMELS rating.
All bank exam materials are considered exceedingly confidential. This includes the CAMELS ratings. Only the bank’s senior management and the appropriate supervisory staff directly know a bank’s CAMELS rating. Regardless of market conditions, CAMELS ratings are never released by supervisory agencies, even on a lagged basis. While exam results are confidential, the public may infer such supervisory information on bank conditions based on subsequent bank actions or specific disclosures. Overall, the private supervisory information gathered during a bank exam is not disclosed to the public by supervisors.
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