What Causes Bank Failures (and a Bank Alternative)

6 mins
Jon Green
April 18, 2023

Bank failures occur when banks have more debt than assets. Often, customers can panic, potentially causing a total collapse.

The March 2023 bank failures of Silicon Valley Bank (SVB) and Signature Bank had the public rattled. Most of us remember the chaos of the Washington Mutual Bank failure in 2008, the largest bank failure in U.S. history. With the collapse of the New Republic Bank in May, the second-largest failure in history, followed by plunging stock at both PacWest and Western Alliance, anxiety around bank stability is volatile.

The good news is that the recent bank failures are unlikely to trigger a complete systemic collapse.

To understand why, it’s important to look at what causes a bank to fail and the specific circumstances around the recent failures. Then we can look at whether or not more banks will crash, how these crises could affect your portfolio, and whether there are alternatives to storing all your money in the bank.

What are bank failures?

A bank failure occurs when a bank’s liabilities outweigh its deposits. Why is this a problem? Banks make money by lending out depositors cash, but when there is more debt than available cash, banks can’t return money to their customers. If a bank does not have enough liquid assets to match the gap in value, the bank fails.

Typically, but not always, these banks are bought by a solvent bank.

So, if this problem can be solved, what’s the issue?

The problem with bank failures is that they can trigger a bank panic. A bank panic is when depositors attempt to take all their funds immediately out of the bank, thus making an already financially precarious situation worse. As depositors take money out of the bank, the bank’s assets continue to shrink, and it may be unable to recover.

And since banks function by loaning your money to others, it’s possible that the bank will run out of its reserves during a mass withdrawal. 

In many cases, a bank run becomes a self-fulfilling prophecy and ultimately causes the bank’s collapse.  

Did a bank failure cause the Great Depression?

Well, yes and no.

There were a number of factors that ultimately triggered the Great Depression, bank failures being one of them.

The commercial banking system in the United States during the 1920s was largely unregulated. Half of the banks were not affiliated with the Federal Reserve and operated on their own terms. 

Furthermore, many of these banks floated checks, a practice in which two banks counted the same check. In order words, if a customer from Bank A wrote a check for $10 to a business operating in Bank B, both banks would count the $10 as part of their reserves. The problem here is that the reserves resided in only one bank. 

Finally, most banks simply did not have the mechanisms to tap into cash quickly during an emergency. 

And many Americans had experienced bank failures before. Between 1920-1929, 600 banks failed per year on average. 

So, when more banks began to fail in 1930, the bank panics began. As depositors withdrew their money, more and more banks suspended services or closed completely. The number of failed banks shot up to 1,350 and doubled in 1931. 

After the bank panic peak in 1933, the government implemented a number of measures to prevent a similar systemic failure from happening. By this time, over 14,000 banks had failed.

As you can imagine, the suspension of so many financial institutions certainly played a part in the overall economic crisis. But it wasn’t the sole cause. 

That said, frequent or significant bank failures can indicate instability in the financial system. In 2007 and with the recent 2023 bank failures, the government investigates the cause of the failure to determine whether deeper, systemic issues could affect the overall economy.

Why did Silicon Valley Bank and Signature Banks fail?

Silicon Valley Bank and Signature Bank failed because they didn’t have enough assets to cover their debts.

In the case of SVB, the bank failed to diversify its customer base. Most of its depositors were technology startups or early-stage companies. Many of these customers make regular, large withdrawals to fund their businesses, thus reducing SVB’s total assets.

At the same time, most of the bank’s long-term assets were tied up in low-risk bonds with long maturity timelines. And this was another significant problem. These bonds have lost significant value due to the rising interest rates. 

Silicon Valley Bank triggered the failure when it sold its long-term bonds at a loss after its recent decision to issue new shares resulted in a mass exodus of debtors. It needed to increase liquidity, but the decision ultimately increased the overall panic of a bank failure, and more customers withdrew their funds.

The consequent SVB failure triggered another bank panic, this time at Signature Bank. While this commercial bank was more diversified, many of its clients were in the cryptocurrency sector. In addition, the bank had a high number of uninsured deposits. 

The First Republic Bank Failure and the Consequences of its Buyout

Similar to the SVB and Signature failures, First Republic Bank crashed due to low liquidity. This bank focused its business strategy on high-worth individuals, with an emphasis on loans and mortgages. First Republic gave preferential rates to these high-net-worth customers, and they did take out larger loans than the average American.

As a result, when interest rates began to rise, the loan book started to lose value. It would be difficult to sell off these assets without taking heavy losses -- which is what happened.

Now, JPMorgan Chase cut a deal with the FDIC to buy the bank almost immediately. Depositors, thankfully, would have their funds protected.

But another group of investors were not so lucky.

Investors holding First Republic bank debt, its preferred stocks, and its common stock were completely wiped out. They would get nothing. Nada. Zilch.

The main reason investors choose to include these assets in their portfolio is that products like bank debt and preferred stock offer better and more consistent dividends. But with the FDIC decision to allow JPMorgan not to pay back these investors, they are setting a troubling precedent. And they made investing in banks riskier than ever.

Will more banks crash?

Both First Republic, SVB, and Signature Bank’s short-term instability turned into collapse due to investor emotional responses and low liquidity. The resulting banks and mass withdrawals exacerbated underlying problems within the sector. 

And because bank runs are largely emotional, fear-based reactions, it can be impossible to determine when the next bank failure will occur.

But it’s unlikely that the entire banking system will be at risk.

The Federal Deposit Insurance Company (FDIC) was quick to respond to the crisis by expanding coverage above the $250,000 insurance limit and setting up short-term lending as a resource for other struggling banks.

At the same time, most banks are far more diversified than the two that failed. While all banks are affected by consumer confidence and economic instability, there are safeguards in place to prevent a complete system meltdown. 

How will bank failures affect my portfolio?

Without looking at your specific investments, it is impossible to say how your portfolio will be affected. But there are some potential consequences:

  1. Volatile stock prices. The stock market has already experienced significant volatility for the past couple of years. But bank panics typically affect investor confidence. As a result, investors may dump riskier assets, like stocks, in favor of more stable investments. This can cause the stock market to experience significant price drops, especially during the days immediately after a bank run.
  2. Potentially lower mortgage rates. Bank failures may result in the Federal Reserve tempering its interest rate hikes. This, however, is less certain. With inflation still well above the pre-pandemic average, it’s unlikely that the Federal Reserve will begin reducing rates. 
  3. Further credit tightening. Banks, especially if the interest rate hikes continue, may be more selective when providing loans or issuing credit. As a result, personal and commercial customers may have to rely on their own savings. 
  4. Changes to bank fees. The FDIC insurance is funded by its bank member. If additional fees are levied to replenish the government funds, this could lead to higher bank fees for consumers. This could further strain living expenses and reduce potential savings. 

If you have invested in bank preferred stock, bonds, and other similar instruments, you may want to review these assets.

Are there alternatives to banks?

Most investors believe that they must either have their money in a bank or under their mattresses. But there is another alternative.

Brokerage checking accounts often work just as well as a bank, for those who still feel anxious about bank failures.

Your brokerage account is where you purchase stocks, bonds, and other assets. Some examples are TD Ameritrade, Schwaab, Vanguard, and Fidelity. However, your brokerage account can also act as checking account. Unlike banks, brokerage accounts don’t lend your money out. And they are FDIC insured.

Every brokerage firm may offer different services. But many support:

In some cases, you may even earn interest by keeping your money deposited in your brokerage checking account. A checking account through TD Ameritrade, now Schwaab, also reimburses ATM withdrawal fees. 

Even if you don’t want to move all your money out of the bank, it may bring you peace of mind to keep a small emergency fund in a separate brokerage account. 

The biggest drawback is that you do everything yourself—there’s no bank teller. For Millennials and Gen Z investors who grew up in a largely digital landscape, this may not matter so much. But if you enjoy going to the bank to take out cash or asking for advice, you don’t need to shift to a brokerage checking account. But if you want a backup option, community banks and credit unions may be a good choice.

Want a second opinion?

Want some feedback
on your retirement plan? We can help.

With over 40+ years of experience in the financial sector, and as a licensed fiduciary, founder Jon Green can help you look over your retirement plan and understand whether you are on track.

You can book a complimentary session
or call me at +1 (828) 884-8840.

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