Inside the Vault: How Banks Operate and why they can Fail

As we’ve (painfully) seen in the Financial Crisis, and again this week (March 2023): banks can fail.

Most of us probably still remember the Financial Crisis and hearing that banks are failing might bring back some bad memories. Is our money safe? What are the economic consequences?

Still, the situation is different now than it was back then, as I described in the last newsletter.

In this article, we’ll talk about how banks work and how they can fail in the first place.

How do banks work, anyway?

Before we can understand how a bank can fail, we first need to know how they work in the first place.

Banks are financial institutions where people and businesses can deposit their money. The bank then safeguards this money and offers some interest as a reward to the person trusting their money with the bank.

Banks also give loans to people and businesses that need money. On these loans, they charge interest to those taking the loan. The interest they charge on loans is much higher than the interest they offer depositors. This difference in interest rates has to do with the risks involved, as well as having to make up for the costs the bank has. This difference is called the “spread”, one of the main ways a bank makes money.

Furthermore, banks make money on fees they charge for certain services, such as overdraft protection, (international) transfers and ATM withdrawals.

From all the money the banks hold, they don’t only give loans. Banks also invest the money that they hold in reserves or excess deposits in various financial assets, such as government bonds or corporate stocks. These investments then generate additional income for the bank.

Banks also have costs: for example, their employees, rent, utilities and IT expenses. Banks also have to set aside money for loan losses, as some people and companies they loan cash to probably won’t be able to pay them back.

In addition, banks are subject to government regulations and must maintain a certain level of capital to ensure they can absorb losses and remain financially stable. The rules are a bit stricter now than they were back in 2007/2008 😉

How banks can fail

Banks, though heavily regulated, are still companies. And regardless of whether they are owned privately, by the state or by investors, they still need to make more money than they spend.

Here are some ways banks can fail:

1. Mismanagement: One of the main reasons why banks can fail is due to poor management. Banks that make risky loans, invest (too much) in speculative assets, or have inadequate internal controls can put themselves in a challenging financial situation.
2. Economic Factors: Economic factors such as recession, inflation, or unemployment can impact the financial health of banks. In times of economic uncertainty, banks may suffer from a decrease in demand for loans, a decline in the values of their investments, or an increase in the number of people that can’t pay back their loans.
3. Fraud: Just like you and me, banks can be scammed too. Usually for hefty sums. If they don’t identify fraudulent activities, they can be in trouble.
4. External shocks: natural disasters, pandemics, or geopolitical events can also impact the financial health of banks. These shocks can cause widespread economic disruption, resulting in loan defaults, a decrease in asset values, or a liquidity crisis.

This last point is interesting, as human behaviour can create a ‘bank run’. A bank run is when we all try to withdraw our money simultaneously. A mass-exodus of clients can still doom a perfectly healthy bank. No bank has infinitely deep pockets, or more precisely, cash reserves.

Luckily for us, in many countries, there is a form of government guarantee that protects the deposits of individuals (and businesses) against failing banks. Read more about it here.