When banks fail

Despite their rarity, bank failures can have serious ramifications for customers and society. In order to keep the economy moving, confidence in the financial system is necessary. It is difficult to achieve this when interconnected financial institutions provide products that are difficult to understand and unravel to unaware customers. This again increases the risk of contagion.

In the wake of the global financial crisis of 2007, structural weaknesses in the banking industry were revealed. These weaknesses might have remained unknown without this crisis. Some examples of banking risk include: excessive risk taking, remuneration and bonus structures based on quantity over quality, unnecessary oblique and overly complex structured products, manipulated balance sheets, insufficient loss absorbing coverage, and unclear valuations by credit rating agencies. A global economic meltdown resulted from these opaque dealings. To prevent financial institutions from going bankrupt, governments around the world sent rescue missions mostly funded by tax payers. This naturally resulted in public outrage as well as loss of trust in the financial system and its powerful protectors.

The measures taken were aimed at restoring market discipline and making sure that the taxpayers would not end up liable for a subsequent financial rescue package of the affected financial institutions if such circumstances occurred again. This policy was known as Basel III. Therefore, the minimum tier 1 capital requirement would rise incrementally to 8,5%, if the banks' capital conservation buffer was reached. To prevent future tumult, systemic banks were required to have total loss absorbing capacity equivalent to 18% of risk weighted assets in the far future.

Financial institutions have an important and crucial role to play in society. Their failure disrupts the value chains in society and they influence the flow of funds into the real economy, ensuring economic growth and, as a result, improving employment prospects. Defaults on loans and the ability to turn investment products into cash affect the availability of capital for lending. In the absence of a securitization policy and proper valuation of the loan portfolio, non-performing loans pose a challenge for financial institutions when they offer new loans.

In institution's collapse may have a domino effect or at a minimum negatively impact other entities since most financial institutions are complex and interconnected. A situation similar to that of Lehman Brothers in 2007 could spark a new global financial crisis. As a result, other financial institutions should be protected against the possibility of contagion. Bank runs, in which customers rapidly withdraw cash from their accounts, create liquidity and solvency challenges, should be avoided. Bank deposit protection schemes must be implemented that guarantee deposits, allay customer exposure, and promote trust and confidence among consumers.

In response to the financial crisis, European regulators introduced the Banking Recovery and Resolution Directive, which provided EU member states with a procedure and tools to manage their financial institutions in a way that would minimize the risk of another banking crisis or minimizing the extent of its consequences.

The aim for regulators is to orderly resolve the problems of financial institutions while simultaneously limiting damages for depositors, shareholders and other stakeholders. Regulatory solutions are divided into three main categories; a sale or closure of (a part of) the bank, the winding up of the bank, or nationalization via a bailout.

A bail out is organized by regulators and funded with tax payer money. The alternative is a bail-in where mandatory creditor participation is an institutional issue for the bank itself and its stakeholders which include account holders. The objective of a bail-in is to systematically tackle the financial challenges of the troubled bank through consolidation of its debt and to then, potentially reopen the bank under new ownership and management.

One of the consequences of a bail-in is that the creditor hierarchy determines the maximum repayment per customer group. Oftentimes, the failure of a bank is triggered by a lack of liquidity or poor risk management. When a resolution decree is announced by a regulator, it is likely that a part of the account balance or investment must be set down or converted into equity. This is to restore solvency. The pre-funded deposit guarantee scheme provides customers with immediate access to a guaranteed maximum amount. The guarantee scheme takes a priority position in an insolvency procedure, further limiting the possibility for customers to recover the surplus above the guaranteed amount.

Legal and regulatory frameworks are complex. Despite the fact that bank customers seldom learn about potential hazards, bank failures can have devastating consequences for shareholders and customers.