Why Banks Can Fail Despite Having Less Risk Than Investment Funds During Crises.

Many believe that banks are safer than investment funds because they focus on safer assets such as loans or bonds, while investment funds often invest in higher-risk assets like stocks. However, the reality is that during financial crises, banks can still fail. This may seem surprising, but the reasons stem from the unique structure of banking operations and inherent systemic risks. Below are detailed explanations of why this happens.

1. Banks Operate with High Financial Leverage

Banks operate by using customer deposits to fund loans or investments. This means that the majority of a bank’s assets are financed by debt (customer deposits), while its equity (the portion actually owned by the bank) is very small—usually around 8-10% of total assets. This is known as "high financial leverage."

The Impact of High Leverage:

• When asset values decline, banks can quickly lose all their equity.
• Example: If a bank has total assets worth $1 billion but only $100 million in equity (10%), a mere 10% drop in asset value would wipe out its equity entirely, pushing the bank toward insolvency.

Why is High Leverage Dangerous?

• High financial leverage boosts returns on equity during normal conditions but dramatically increases the risk of insolvency when markets fluctuate or asset values decrease.

2. Banks’ Assets Are Illiquid

Banks often invest in long-term assets such as real estate loans or long-term bonds. However, they must meet short-term withdrawal demands from customers. This creates a mismatch between the maturity of assets and liabilities.

Risks During a Crisis:

• Under normal conditions: Not all customers withdraw their funds simultaneously, so banks have sufficient liquidity.
• During a crisis: If customers lose confidence and withdraw their funds en masse (bank run), banks cannot quickly sell their long-term assets to generate cash, leading to liquidity shortages.

Real-Life Example:

During the 1930 financial crisis, many U.S. banks collapsed because customers simultaneously withdrew their funds. Banks were unable to convert their long-term assets into cash quickly enough, even though those assets still held value.

3. Banks Heavily Rely on Customer Confidence

Banks operate on the assumption that customer deposits will remain safe and available. When customers trust the bank, it can operate smoothly. However, this trust is fragile. A rumor or unexpected event can lead to panic, causing customers to withdraw funds en masse, creating a ripple effect.

Why is Confidence Crucial?

• Confidence forms the foundation of the banking system. Without it, even a financially stable bank can face insolvency.
• Example: A small bank may encounter a crisis simply because customers react to unfounded rumors and rush to withdraw their funds.

4. Poor Risk Management or High-Risk Investments

While banks generally prioritize safety, some engage in high-risk investments to maximize profits, such as:

• Complex Derivative Securities: These financial instruments can yield high returns but carry significant risks.
• Unsecured or Real Estate Loans: When the real estate market crashes, the value of collateral declines sharply, resulting in significant losses for banks.

Real-Life Example:

Lehman Brothers, one of the world’s largest banks, collapsed in 2008 due to excessive investment in high-risk real estate loans. When property prices plummeted, the bank couldn’t absorb the losses, leading to its downfall.

5. Systemic Crises and Domino Effect

In a financial crisis, the failure of a major bank can trigger a domino effect, impacting the entire financial system. This occurs because banks often lend to each other or have strong financial interconnections.

The Domino Effect:

• When one bank fails, related banks can suffer significant financial stress, causing widespread liquidity shortages.
• Example: The 2008 global financial crisis began with the collapse of the U.S. housing market but quickly spread worldwide, leading to the bankruptcy of several major banks.

6. Regulatory Failures

Even with strict regulations, oversight failures can contribute to bank collapses. In some cases, regulations may not keep pace with the complexity of modern financial instruments or fail to address systemic risks adequately.

Why Regulations Matter:

• Proper oversight ensures that banks maintain sufficient capital and manage risks effectively.
• Lax regulations or poor enforcement can allow risky practices to go unchecked, increasing the likelihood of a crisis.

Real-Life Example:

Before the 2008 crisis, some financial institutions bypassed regulatory requirements through complex financial instruments, leading to excessive risk-taking and eventual collapse.

7. External Economic Shocks

Banks are vulnerable to sudden external shocks, such as geopolitical conflicts, pandemics, or global market downturns. These events can disrupt financial markets, reduce asset values, and increase default rates on loans.

Impact of Economic Shocks:

• A severe shock can lead to widespread defaults, particularly if businesses and individuals cannot repay loans.
• Global interconnectedness means that a crisis in one region can have far-reaching consequences for banks worldwide.

Example:

The COVID-19 pandemic caused significant economic disruptions, forcing some banks to restructure loans and increase provisions for bad debts, straining their financial stability.

Summary

Even though banks focus on safer assets compared to investment funds, they can still fail due to the following reasons:

1. High Financial Leverage: Rapid equity depletion when asset values decline.
2. Illiquid Assets: Inability to meet withdrawal demands during a crisis.
3. Reliance on Confidence: Loss of customer trust can destabilize banks.
4. High-Risk Investments: Engaging in unsafe investments increases the risk of large losses.
5. Systemic Crises: Interconnectedness among banks can lead to widespread financial disruptions.
6. Regulatory Failures: Ineffective oversight can allow excessive risk-taking.
7. External Economic Shocks: Unforeseen events can disrupt markets and increase defaults.

Key Lessons

To minimize the risk of failure, banks should:

• Comply with capital adequacy regulations like Basel III.
• Strengthen risk management and liquidity buffers.
• Adapt to evolving regulatory standards.
• Maintain customer trust through transparency and consistent operations.
• Prepare for external shocks by building resilient financial models.

Dam Van Vi - Quantitaitive Finance.