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Why banks fail – Il Post

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Why banks fail – Il Post

Usually when several crises occur together, and for extremely different reasons

Within a few days, two banks in the United States (Silicon Valley Bank and Signature Bank) went bankrupt and one European bank went into crisis (Credit Suisse). Banks can fail for many reasons: both related to bad management – wrong investments, illicit behavior – and related to contextual factors – widespread financial instability, saver panic, interest rates that go up or down.

Precisely because of the importance that contextual factors sometimes have in triggering banking crises, rules, laws and supervisory systems exist to ensure that banks comply with certain standards of solidity, useful in the event that they are faced with difficulties. Furthermore, due to the nature of their business, banks are exposed to many uncertainties and risk management and mitigation are part of their operations.

A bank’s business is based on a delicate and widely known balance, which has a lot to do with the trust that investors and account holders have in the system. Banks collect money from account holders and investors and use it largely to invest themselves, grant mortgages and loans: therefore they never have all their customers’ money at their disposal. They run a risk, the so-called liquidity risk, but trust that it is unlikely that everyone will withdraw all funds at the same time. It is a remote possibility, but the so-called bank run can seriously put a bank in a position to fail regardless of its strength.

– Read also: How bank runs work, told with the Nobel prize winner Ben Bernanke

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A bank is exposed to various other risks: the credit risk, i.e. not getting back the money it lends; interest rate risk, linked to unexpected changes in interest rates; sovereign risk, linked to non-payment of foreign debts due to political or government interference, but also to the performance of government bonds that a bank may have in its portfolio, for example in the event of a state default.

In most cases, banking crises occur because various events linked to these risks occur together: for example, the bankruptcy of Lehman Brothers in 2008 occurred not only because the bank had made too risky investments and in very risky financial instruments, but also because in the US financial system many customers had stopped paying the installments of their mortgages, the so-called mortgages subprime.

In modern financial systems, banks are also very interconnected, even at an international level, and this makes the whole system vulnerable to the crisis of a single institution: even the mere fear that one bank will go into crisis affects all the others in a chain, and the Panic among investors can lead to projecting the weaknesses of a single institution onto the whole sector, even if the sector is solid. Simplifying, it means that, seeing a bank in difficulty, investors could start selling the shares of other banks which may be perfectly healthy, but which at that moment are perceived as fragile because the whole system is perceived as shaky. The risk, at that point, is that the whole system will really suffer because investors panic.

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For this reason, central banks, governments and supervisory authorities are sometimes willing, in order to safeguard the general banking system, to grant large emergency loans to a single institution.

– Read also: How do you decide whether to let a bank fail?

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