Bank Failures

The bank failures earlier in the year clearly hit a nerve.  It seems like every client, employee, or even neighbor is asking me about the banks failing.  It has people unnerved.

 

"Michael, how can a bank even fail?  How does it happen so fast?" are the most common questions.  A bank fails when it mismanages the risks in lending (makes bad loans), mismanages interest rate risk (locks in mortgages for people at 3% when the market rate moves to 6%), or fails to operate with enough capital to absorb losses (too little equity in the bank).

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A bank can take years to fail or it can happen in days. 

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So what is a bank run?  A bank run occurs when depositors want funds immediately in cash.  The bank cannot do this because the bank is invested in mortgages and business loans it cannot convert immediately to cash. 

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See below.  I have created a simple example of banks and how they can fail.  By the way, the ratios are actually pretty close.  Most banks operate with about 10% equity capital (stock).  The remaining funds a bank lends out are actually money the bank borrows from customers to then lend out. 

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America operates on a system called fractional banking.  The bank does not need to have $100 million of it's own money to lend $100 million.  It only needs $100 million from somewhere.  Having $10 million in investor funds (stock) allows them to borrow the other $90 million. 

 

Most people do not realize how thin the capital in most banks actually is.

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