There are two ways for a bank to go bust:
Firstly, for some reason the bank may end up owing more than it owns or is owed. In accounting terminology, this means its assets are worth less than its liabilities. When banks create money they increase their assets and liabilities by an equal amount, meaning that an insolvent bank would still be insolvent, even if it creates more money.
Secondly, a bank may become insolvent if it cannot make the payments to other banks when it settles up at the end of each day, even though its assets may be worth more than its liabilities. This is known as cash flow insolvency, or a ‘lack of liquidity’. Banks can create the kind of money that businesses and the public use, but they can’t create the type of money that they use to pay other banks. If they run out of this type of money, then they must borrow it, either from other banks, or from the central bank. But if no-one is willing to lend to them, then they have a serious problem.
This article explains how banks can go bust in more detail.
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Posted in: 2. The Current Monetary System