How do Banks Become Insolvent?

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How do banks become insolvent  and the importance of deposit insurance

If banks can create money, then how do they become insolvent? After all surely they can just create more money to cover their losses? In what follows it will help to have an understanding of how banks make loans and the differences between the type of money created by the central bank, and money created by commercial (or ‘high-street’) banks.

Insolvency can be defined as the inability to pay ones debts. This usually happens for one of two reasons. 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.

Secondly, a bank may become insolvent if it cannot pay its debts as they fall due, even though its assets may be worth more than its liabilities. This is known as cash flow insolvency, or a ‘lack of liquidity’.

Normal insolvency 

The following example shows how a bank can become insolvent due customers defaulting on their loans.

Step 1: Initially the bank is in a financially healthy position as shown by the simplified balance sheet below. In this balance sheet, the assets are larger than its liabilities, which means that there is a larger buffer of ‘shareholder equity’ (shown on the right).

Shareholder equity is simply the gap between total assets and total liabilities that are owed to non-shareholders. It can be calculated by asking, “If we sold all the assets of the bank, and used the proceeds to pay off all the liabilities, what would be left over for the shareholders?”. In other words:

Assets – Liabilities = Shareholder Equity.

In the situation shown above, the shareholder equity is positive, and the bank is solvent (its assets are greater than its liabilities).

Step 2: Some of the customers the bank has granted loans to default on their loans. Initially this is not a problem – the bank can absorb loan defaults up to the value of its shareholder equity without depositors suffering any losses (although the shareholders will lose the value of their equity). However, suppose that more and more of the banks’ borrowers either tell the bank that they are no longer able to repay their loans, or simply fail to pay on time for a number of months. The bank may now decide that these loans are ‘under-performing’ or completely worthless and would then ‘write down’ the loans, by giving them a new value, which may even be zero (if the bank does not expect to get any money back from the borrowers).

Step 3: If it becomes certain that the bad loans won’t be repaid, they can be removed from the balance sheet, as shown in the updated balance sheet below.

Now, with the bad loans having wiped out the shareholders equity, the assets of the bank are now worth less than its liabilities. This means that even if the bank sold all its assets, it would still be unable to repay all its depositors. The bank is now insolvent. To see the different scenarios that may occur next click here, or keep reading to discover how a bank may become insolvent as a result of a bank run.

Cash flow  insolvency / becoming ‘illiquid’

The following example shows how a bank can become insolvent due to a bank run.

Step 1: Initially the bank is in a financially healthy position as shown by its balance sheet – its assets are worth more than its liabilities. Even if some customers do default on their loans, there is a large buffer of shareholder equity to protect depositors from any losses.

Step 2: For whatever reason (perhaps due to a panic caused by some news) people start to withdraw their money from the bank. Customers can request cash withdrawals, or can ask the banks to make a transfer on their behalf to other banks. Banks hold a small amount of physical cash, relative to their total deposits, so this can quickly run out. They also hold an amount of reserves at the central bank, which can be electronically paid across to other banks to ‘settle’ a customer’s electronic transfer.

The effect of these cash or electronic transfers away from the bank is to simultaneously reduce the bank’s liquid assets and its liabilities (in the form of customer deposits). These withdrawals can continue until the bank runs out of cash and central bank reserves.

At this point, the bank may have some bonds, shares etc, which it will be able to sell quickly to raise additional cash and central bank reserves, in order to continue repaying customers. However, once these ‘liquid assets’ have been depleted, the bank will no longer be able to meet the demand for withdrawals. It can no longer make cash or electronic payments on behalf of its customers:

At this point the bank is still technically solvent; however, it will be unable to facilitate any further withdrawals as it has literally run out of cash (and cash’s electronic equivalent, central bank reserves). If the bank is unable to borrow additional cash or reserves from other banks or the Bank of England, the only way left for it to raise funds will be to sell off its illiquid assets, i.e. its loan book.

Herein lies the problem. The bank needs cash or central bank reserves quickly (i.e. today). But any bank or investor considering buying it’s illiquid assets is going to want to know about the quality of those assets (will the loans actually be repaid?). It takes time – weeks or even months – to go through millions or billions of pounds-worth of loans to assess their quality. If the bank really has to sell in a hurry, the only way to convince the current buyer to buy a collection of assets that the buyer hasn’t been able to asses is to offer a significant discount.  The illiquid bank will likely be forced to settle for a fraction of its true worth.

For example, a bank may value its loan book at £1 billion. However, it might only receive £800 million if it’s forced to sell quickly. If share holder equity is less than £200 million then this will make the bank insolvent:

After insolvency and the need for deposit insurance 

For a bank, being insolvent means it cannot repay its depositors, because its liabilities are greater than its assets. The effect that a bank has if it becomes insolvent depends upon the availability of deposit insurance.

In a country without deposit insurance an insolvent bank would not be able to repay people deposits in full. In the event of an insolvency depositors would have to queue up with other bank creditors to reclaim whatever money they could from the bank. So for every £1.00 the bank owed to customers it might only pay 90p or even less.

However, this is not the end of the story. The failure of one bank could lead people to worry about the financial position of other banks. Furthermore the insolvent bank would have certainly owed money to other banks, as would its customers. This can lead to a domino effect – a bankruptcy at one bank can lead to a ‘cascade’ of defaults, bank runs and insolvencies as people panic.

One way a bank can raise funds quickly in the event of a bank run is to sell assets. However, if ‘distressed selling’ occurs on a large enough scale it may lead to a debt deflation. The American economist Irving Fisher saw debt deflation as one of the key causes of the great depression. In Fishers formulation, the process proceeds as follows:

(1) Debt liquidation leads to distress setting and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation … cause[ing] (3) A fall in the level of prices … [as a result] there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor … lead[ing] to (7) Pessimism and loss of confidence, which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation. The above eight changes cause (9) Complicated disturbances in the rates of interest…

Irving Fisher (1933), 'The debt deflation theory of great depressions'

Because of the negative impacts of debt deflation governments seek to avoid it at all costs. One way they may do so is by providing deposit insurance to depositors. The first system of deposit insurance was established in America in response to the Great depression. Its purpose was to prevent the bank runs that contributed to the Depression from ever happening again. In a country with deposit insurance an insolvent bank will have its assets seized and sold off. The depositors are then fully reimbursed using the funds raised, with the taxpayer making up any shortfall. The idea is that because depositors know their money is safe no matter what, they will not bother withdrawing their deposits if there is a panic. This is intended to prevent bank runs spreading and the mass sell off of assets that may spark a debt deflation.

The  problem with deposit insurance.

In a system without deposit insurance depositors have a big incentive to monitor their banks behaviour, to ensure they do not act in a manner which may endanger their solvency. (If the government didn’t promise to repay your money in the case that your bank fails, would you not be a little more concerned about how the bank uses your money?). In a system with deposit insurance this incentive is removed. Economists call this moral hazard. Moral hazard is when the provision of insurance changes the behaviour of those who receive the insurance in a undesirable way. For example, if you have contents insurance on your house you may be less careful about securing it against burglary than you otherwise might be.

Deposit insurance removes depositors incentive to monitor bank lending decisions because they are guaranteed to receive their money back. Instead, depositors are incentivised by the interest rate offered. Of course, those banks offering the highest interest rate will be those taking the greatest risks, and so banks are incentivised to finance the highest risk, highest return projects.

While higher interest rates may seem to benefit depositors due to higher returns (but not taxpayers – due to greater risks leading to more financial crisis and bailouts) it reality they do not. Instead of offering a higher rate of interest the private bank can offer a lower rate, because the deposit is risk free. This results in a subsidy to the banking sector – the value of which reached over £100bn in 2008.

So despite the fact that deposit insurance is intended to increase the stability of the banking system by preventing bank runs it may in fact make it more dangerous by encouraging risky behaviour from banks:

The U.S. Savings & Loan crisis of the 1980s has been widely attributed to the moral hazard created by a combination of generous deposit insurance, financial liberalization, and regulatory failure… Thus, according to economic theory, while deposit insurance may increase bank stability by reducing self-fulfilling or information-driven depositor runs, it may decrease bank stability by encouraging risk-taking on the part of banks.

Asli Demirgüç-Kunt and Enrica Detragiache, World Bank, Development Research Group, and International Monetary Fund, Research Department.

Demirgüç-Kunt and Detragiache go on to empirically test whether deposit insurance makes financial crisis more or less likely:

Having analyzed empirical evidence for a large panel of countries for 1980-97, this study finds that explicit deposit insurance tends to be detrimental to bank stability, the more so where bank interest rates have been deregulated and where the institutional environment is weak. We interpret the latter result to mean that, where institutions are good it is more likely that an effective system of prudential regulation and supervision is in place to offset the lack of market discipline created by deposit insurance.

Asli Demirgüç-Kunt and Enrica Detragiache, World Bank, Development Research Group, and International Monetary Fund, Research Department.


For more details see:WDMCF2

Where Does Money Come From?

A guide to the UK Monetary and Banking System

Written By: Josh Ryan-Collins, Tony Greenham, Richard Werner & Andrew Jackson

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  • Lyndon

    According to the following two quotes from the article, it seems that bank loans depend on previous funding from shareholders and/or depositors, and are therefore not creating money when they create loans. After all, why would either group have to take a loss if loans granted ‘out of thin air are not repaid’? Granting a loan out of thin air implies new funds, not funding from shareholders or depositors….

    “Some of the customers the bank has granted loans to default on their
    loans. Initially this is not a problem – the bank can absorb loan
    defaults up to the value of its shareholder equity without depositors
    suffering any losses (although the shareholders will lose the value of
    their equity).”

    “Now, with the bad loans having wiped out the shareholders equity, the
    assets of the bank are now worth less that its liabilities.”

    • Kyle

      Creating a loan is a balance sheet expansion. Loan is added to Assets, Deposit (newly created money) is added to Liabilities.
      If this doesn’t clear it up, go (re-)watch PM’s videos that explain bank loan operations. Good luck.

    • db

      Bingo. Well done mate you are exactly right. These people, whilst saying nothing actually incorrect (especially in the ‘technical’ section) leave the less bright with the impression that loans are magicked out of thin air. Banks technically create ‘broad’ money, but this is just another name for credit. Banks work exactly the way you thought they did and don’t let any of these guys tell you otherwise.

      • Tom Bayley

        The ‘less bright’ would be bank apologists such as yourself, I feel. Yes, banks create credit. And that’s what 97% of the money supply is made of. You may disagree but I think everybody in the nation needs to know that, because we have all been hurt by this excessive lending. Excessive, wouldn’t you agree? Or are you really suggesting there was some kind of prudent restriction in place? Clearly there was not. Which brings us to PM’s illuminating point that banks are not restricted from lending by being in possession of sufficient deposits or reserves. It’s trivially easy to understand why this is the case for a single bank, and not much harder to understand for a system of interconnected banks all expanding credit at a similar rate.

      • Barney Rubble

        Have you seen the Bank of England Bulletin Q1 2014?

        “Banks work exactly the way you thought they did and don’t let any of these guys tell you otherwise.”

        Tell that to them!

    • Rasmus

      But funding from sharreholder is credit money in itself. Thats the point. You would never be able to attract any funding at all if someone hadn’t taken out a loan somewhere in the system, at a earlier time. It all happens in time. The point is that in reality shareholder equity and deposit is the same kind of money. It come to existence in the same way, but legally its treated different. So off cause it wouldn’t be possible for all banks to be insolvent at the same time. If a bank get insolvent it means that some of it deposits is created in another bank earlier in time, and the loan that created it still exist as an asset at another bank.

  • Vincent Cate

    You start out with, “If banks can create money, then how do they become insolvent?”. But then you don’t talk about the “creating money” again. There are people (MMT and MR) who seem to think banks have some magical ability to make money. I have tried to explain what really goes on and gotten pushback on my blog. They seem to feel it is only regulations that keep the banks magical power in check.

    http://howfiatdies.blogspot.com/2013/08/honest-banking.html

    • db1

      Well said. This website/campaign is deeply misleading. The worst thing is that the people who put together do actually know how it works but they seem to want to deliberately mislead people…probably so they can sell their book.

      • Mira Tekelova

        What exactly do you consider misleading? We make all important information available free online on our website.

        • db1

          Making information ‘freely available’ does not mean it is not misleading.
          Take this section for example. You could summarise it very simply by saying “banks become insolvent when too many people wish to withdraw their money at the same time, because that money has been largely leant to others as loans.” I suspect however that such a straightforward description might lead people to ask “why can’t the banks create more money to pay these depositors”. The answer obviously being that they cannot, because the M4 measure of money is really just cash+credit. Banks extend credit in the same way that everyone alwasy thought they did.

          • GWHodgson

            I’m currently reading “Liquid Money” by Michael Schemmann, an accountant, academic and former banker, who demonstrates how, using the principles of bookkeeping as applied to the current banking system, it is possible to create from scratch a system of banks with no central bank or other money. Start-up company A, with no capital, agrees to buy shares in start-up company B, with no capital. A now has an asset (its right to B’s shares) and matching liability (its obligation to pay for them) and B has an asset (A’s obligation) to match its equity, pledged to A. B enters into a similar arrangement with start-up company C and C undertakes to buy shares in A. All now have assets (shares in or obligations from each of the others) which exceed their liabilities (obligations to one of the others). So all have positive equity. They each agree that the others’ assets are acceptable in settlement, and each can therefore start creating deposit accounts by extending loans to others, by which those account holders can make payments to anyone else prepared to hold an account with any of the three companies.

          • db1

            Sounds interesting, might try to seek it out. The key however is in the last sentence “anyone else prepared to hold an account with any of the three companies.”. This whole exercise might work in some abstract accounting sense (I still don’t really get it, but will give the beneift of the doubt) but could it create money to actually buy something outside of the cartel created? It sounds to me like what they may have created is another currency..not one you can use in the real world.

          • GWHodgson

            All banking systems are cartels by regulation. They can compete only at the edges. What this shows is that the bookkeeping works. It is perfectly possible to set up and operate a payments systems from scratch without gold, silver or state money. Getting people to use it is another matter. The Civil Service department I joined in the mid ’70s still paid its junior clerical and technical staff in cash. A couple of years later it switched to bank transfer only payments and paid each employee affected £100 (bank money) in compensation. Cash has a potent hold on the human psyche, but as a means of payment it is increasingly marginalised.

          • db1

            Nice anecdote, but not really that material in terms of the discussion. Of course it is perfectly possible to set up payment systems that aren’t based on gold, silver or state money. There is nothing intrinisic about the those three either that makes them money! As you say, it is all about acceptance. State money is accepted for various reasons, not least the fact you need it to pay tax. However that whole discussion is a tangen from the original discussion which is that this website seeks to promote a, lets say, misleading impression of what banks do.

          • Damian Penston

            In what way and at what point do the assets exceed the liabilities?

          • RAGE

            The glaring problem with the sort of scheme you are describing is this: You can only make inter-company payments within these three entities. If you would actually do that in real life you would get no customers, because nobody wants to be tied to only three just started banks in a global world. If you can’t pay your bills with your “money” it’s just no good.

          • sally farmer

            The money paid in by depositors is not lent out! The loan is created in the ledger. Period. – out of thin air. The loan enjoys at best fractional prior existence.

    • Rasmus

      Your example starts with the traditionel money multiplier model, which is flawed in many ways. Where does the initial 10.000 comes from? You would probably say that its cash coming from the central bank, but reality is that under the current system, for normal people, even to get hold of cash require that someone take out a loan at a bank and then ask to get the cash paid out afterward.

      • Vincent Cate

        If the biggest flaw in my post is I did not tell you where the initial $10,000 came from, then there are no flaws.

        My example would work find if there was no central bank and people used gold coins. The problems of fractional reserve banking existed in the USA way before the FED was created.

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  • New Rich

    When you say that the depositors funds are used to fund risky loans, that doesn’t make sense. If loans are created from out of thin air using bank credit, how does this affect a depositors funds? Isn’t the basic premise of modern fiat banking that deposits (bank liabilities) do not fund loans?

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  • http://www.moneryreformsindia.org Sumal Raj

    Banks do not act as intermediary between savers and borrowers. They simply create money by an accounting technique by adding the amount on liability and asset side of the balance sheet when they issue loans. This money disappears when the loan is repaid. If the borrower does’t repay the money and if the bank write off his loan, the amount should also disappear from both side of the balance sheet. so how can a bank go insolvent?? really did’t understand ….Pl help..

    • James Kiely

      When the borrowed money is spent after borrowing, the bank takes away the money spent from its cash reserves on its assets side. It also takes away the money spent from its liabilities (emptying the new account). After this, to keep its sheet balanced, the bank will need to replace its cash reserves in its assets by borrowing from someone else (another bank or depositor). This add’s another liability to the sheet and makes it balanced.

      If the original borrower deposits more money into his/her account then the bank will repay the loan by taking away a liability (money in account) and an assets (money still owing on loan) like you said and the bank’s balance sheet will be balanced.

      But if the borrower’s account is empty (because he/she hasn’t redeposited) and they aren’t going to repay the loan, the bank can’t do this. This reduces the value of the asset (the debt owing originally loan), if this happens to enough loans the assets become worth less than the liabilities and the bank is insolvent.

      Hope that explanation was helpful/correct.

      • http://www.moneryreformsindia.org Sumal Raj

        “When the borrowed money is spent after borrowing, the bank takes away the money spent from its cash reserves on its assets side. It also takes away the money spent from its liabilities (emptying the new account).” if this is the case the balance sheet will already be balanced… why to balance again?

  • Marco Saba

    In Italy it is the central bank that provide banknotes to the banks. The artificial shortage of banknotes is only a political decision by the central bank. That’s what happened in Greece, it was the local central bank refusal to give banknotes to the banks that created the crisis to blackmail the local government into submission. Banknotes are not borrowed into existence but are bought from the banknotes suppliers (typographies) with no scarcity in sight. Ultimately, it is the ECB responsibility to coerce NCBs through ANFA agreements.

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