From Booms to Busts: Why Banks Collapse and How to Avoid Financial Fallout

In the recent light of Bank fails I am writing this 101 article on why banks fail and what can retail consumers do about it. As we all know Banks play a vital role in the economy by providing financial services, such as lending, deposit-taking, and investing. However, history (also recent history) has shown that banks can fail, causing severe economic consequences.

Reasons for bank failures

Poor management and governance:

Poor management and governance are one of the primary reasons for bank failures. Banks that lack effective governance and management structures are more likely to engage in risky behavior, such as lending to borrowers who cannot repay their loans. A lack of oversight and accountability can also lead to fraud and other unethical practices.

Economic downturns:

Banks are also vulnerable to economic downturns, such as recessions and depressions. During these periods, borrowers may default on their loans, causing banks to suffer losses. In severe cases, banks may become insolvent and fail.

Asset-liability mismatches:

Banks borrow money from depositors and other sources to make loans to borrowers. However, banks must ensure that they have enough liquidity to meet their obligations to depositors and other creditors. When banks make long-term loans using short-term funding, they create an asset-liability mismatch, which can lead to liquidity problems.

Regulatory failures:

Regulators are responsible for overseeing banks and ensuring that they comply with laws and regulations. When regulators fail to detect or respond to risks adequately, banks can engage in risky behavior, leading to failure.

Fraud and unethical behavior:

Banks can also fail due to fraud and other unethical behavior, such as money laundering and insider trading. When banks engage in these practices, they can suffer reputational damage and legal penalties, leading to financial losses and failure.

Rumor Mill:

A rumor mill is any type of gossip network where information or rumors are spread rapidly by word of mouth, social media, or other communication channels. When it comes to the banking system, rumors can be particularly dangerous because they can undermine confidence in the banking system, leading to a bank run. A bank run occurs when a large number of depositors withdraw their money from a bank within a short period of time. This can happen when depositors lose confidence in the bank's ability to pay out their deposits, and they fear that the bank may fail or become insolvent. The Federal Deposit Insurance Corporation (FDIC) does a good job by insuring deposits (up to a limit) and stopping the snowballing effect which could lead to a bank run.

Role of FDIC

The term FDIC is suddenly being thrown everywhere so what is it and how is it relevant? The Federal Deposit Insurance Corporation (FDIC) is an independent agency of the US government that provides insurance for deposits in banks and savings associations. The FDIC's primary role is to protect depositors by insuring their deposits in case of bank failures.

In the event of a bank failure, the FDIC takes over as the receiver of the failed bank. The FDIC is responsible for managing the assets of the failed bank, paying off depositors up to the insured limit, and resolving the failed bank's debts and other obligations.

The FDIC insures deposits up to $250,000 per depositor, per insured bank, for each account ownership category. This means that if a depositor has multiple accounts at the same bank, the total insured amount may be higher than $250,000, depending on the account ownership categories.

When the FDIC takes over a failed bank, it first tries to find another bank to take over the failed bank's deposits and assets. If no other bank is willing to do so, the FDIC may sell the assets of the failed bank and use the proceeds to pay off depositors. The FDIC may also arrange for another bank to purchase the deposits of the failed bank.

In addition to deposit insurance, the FDIC also works to promote the safety and soundness of banks and savings associations. The FDIC examines banks and savings associations to ensure they are following safe and sound banking practices and complying with laws and regulations.

But wait, it's Capitalism right? so how does FDIC make money / stay afloat? The FDIC's main source of revenue comes from the insurance premiums paid by banks and savings associations. The earnings on its investment portfolio (the insurance premiums are invested) and assessments on insured banks and savings associations are used to supplement the premiums and maintain the Deposit Insurance Fund (DIF). The FDIC's ability to generate revenue is crucial to its ability to protect depositors and maintain confidence in the banking system.

Ways to Shield Retails Consumers from Bank Runs

First of all, it's a good problem to have, and second kudos to doing well in life. If you have a large amount of cash that you want to keep safe and secure, it's a good idea to distribute it across multiple banks to stay within FDIC-insured limits. Here are some ways to distribute cash over multiple banks to ensure that your deposits are fully insured:

Open accounts at multiple banks:

One way to distribute cash over multiple banks is to open accounts at different banks. This will allow you to spread your deposits across different institutions so that each account is fully insured up to the FDIC limit. You can choose to open checking, savings, or money market accounts, depending on your needs.

Use joint accounts:

You can also distribute cash over multiple banks by using joint accounts. You can add another person, such as a spouse or family member, to the account, which will increase the insured limit to $500,000 for joint accounts. This means that you can deposit up to $500,000 in a joint account at one bank, and another $500,000 in a joint account at another bank.

Use different account ownership categories:

The FDIC insures deposits based on different account ownership categories, such as individual accounts, joint accounts, retirement accounts, and trust accounts. You can distribute cash over multiple banks by using different account ownership categories. For example, you can open an individual account at one bank, a joint account at another bank, and a retirement account at a third bank. This will allow you to fully insure your deposits at each bank up to the FDIC limit for each ownership category.

Use multiple branches of the same bank:

If you prefer to use the same bank for all your accounts, you can still distribute cash over multiple banks by using different branches of the same bank. Each branch is considered a separate insured institution, so you can open accounts at different branches to stay within the FDIC limit.

Use online banks:

Online banks often offer higher interest rates and lower fees than traditional brick-and-mortar banks. You can distribute cash over multiple online banks to take advantage of these benefits while staying within the FDIC limit. Many online banks are also part of larger banking networks, which means that you can access your money through ATMs and other services.

Conclusion:

In conclusion, banks can fail due to various reasons, such as poor management and governance, economic downturns, asset-liability mismatches, regulatory failures, fraud, and unethical behavior. It is essential for banks to have effective governance and management structures, maintain appropriate liquidity, comply with laws and regulations, and avoid engaging in risky behavior to avoid failure. Regulators also play a critical role in ensuring that banks operate in a safe and sound manner. By understanding the reasons for bank failures and taking appropriate measures, banks can reduce the risk of failure and contribute to the stability of the financial system. The FDIC plays a critical role in maintaining confidence in the banking system by protecting depositors and promoting the safety and soundness of banks and savings associations. there are several ways to distribute cash over multiple banks to stay within FDIC-insured limits. By spreading your deposits across different institutions and using different account ownership categories, you can ensure that your deposits are fully insured and protected in the event of a bank failure.

Disclaimer: The views expressed in my responses and content are my own and do not necessarily reflect the views of my employer or any organization I am affiliated with. My responses are based on my own knowledge, experience, and research and are intended for informational purposes only. Any action taken based on my responses is at the reader's discretion.