What Happens When a Bank Fails?

Did you know that the Federal Deposit Insurance Corporation (FDIC) has a Failed Bank List that includes banks that have gone under since late 2000? Two more banks, Silicon Valley Bank and Signature Bank, were just added to this list as of March 2023. 

With the world abuzz about keeping their money safe with banks that could go under at seemingly any second, it can be scary to think about what happens when a bank fails. After all, if you can’t access your money, how are you going to live? 

The good news is that banks failing is not a common thing. With the fallout from the pandemic still trickling through the economy, it’s not difficult to realize many companies suffered then and continue suffering now. 

Our article takes a closer look at what happens when a bank fails to help you understand the implications of such an event. We’ll also discuss how you can avoid the drama should your bank go under. 

Are you ready to learn more about what happens when a bank fails? Let’s get started!

Why Do Banks Fail

Pinpointing why a particular bank fails can look similar to understanding why someone died. There might be an obvious answer, but sometimes the cause lies beneath a whole lot of other symptoms. 

The most common cause of bank failure is a drop in the value of the bank’s assets compared to the liabilities it’s committed to. In other words, if the bank’s investments lose enough value, it could face closing its doors forever. 

The situation becomes worse when account holders, also known as depositors, make a run to collect their money. Each time a depositor cashes out, the bank has to liquidate part of its funds to provide that amount. 

If the assets the bank has to sell as part of meeting customer demand are sold at a loss, the bank could be in for more than it can get itself out of trouble with. 

An insolvent bank’s failure to repay its debts can cause the federal government and banking commissioners to close it before things get too out of hand. If a bank can see the writing on the wall, it might also seek to find a loan from other solvent banks to keep afloat. 

It can be difficult to predict if or even when a bank might fail. However, the Texas Ratio is an alleged formula you can use to calculate the likelihood of a bank failing. 

The formula requires you to divide non-performing assets by equity capital and loan-loss reserves to achieve a percentage. The greater that percentage is above 100%, the more likely the bank is to fail. 

Related: Do you know how old you have to be to open a bank account? Find out what the best national banks are and some of the best banking apps you can use to manage your money.

The Gamble of Fractional Reserves

Fractional reserve banking requires banks to have only a fraction of the deposits made readily available. For example, if three people deposit $10,000 each at a bank, that bank only has to have a fraction of that $30,000 available to disperse should the depositors request their funds. 

This strategy of investing, loaning, or otherwise making money from the account holder deposits in full makes plenty of banks a lot of money. Banks that play fast and loose with the funds available to them, however, can easily find themselves facing failure if every account holder withdraws their funds in quick succession. 

This is why bank runs are so devastating. If the bank doesn’t have time to make good on the investment to profit and return the deposited funds, it can’t fulfill all its promises. 

What Happens When a Bank Fails

When a bank fails, the question of how to pay off debt remains. Good or bad, there is life after debt, at least for the bank’s employees and account holders. 

Seizure by FDIC

The FDIC has the power to take control of a failed bank. Upon assuming control, the FDIC decides whether or not it will sell the bank to a healthier competitor or liquidate the bank’s assets and dismantle the bank altogether. 

In addition to the power to assume control of a failed bank, the FDIC also commits to finding the least-costly solution to its failure. Costs, in large part, will determine how a failed bank will be dealt with. 

One of the first steps in either scenario is to set up a bridge bank. This temporary bank is chartered to help provide a solution to account holders until a more permanent decision has been made. 

Most bridge banks share a name with the failed bank. Once the failed bank has been taken care of, the bridge bank dissolves. 

Notification of Customers and Identification of a Solution

By the time the world has figured out a bank is failing, the FDIC has often already identified a solution. All that’s left is to notify the account holders and carry out the necessary steps. 

Ideal scenarios happen when a healthier bank can purchase the assets of the failed bank and transition customers over without a hitch. This is known as a Purchase and Assumption Transaction that’s completed in the best interest of the account holders. 

A Deposit Payoff is the alternative and takes the form of the FDIC writing checks to account holders for their remaining balance. The FDIC does not cover life insurance policies, mutual funds, annuities, or stocks. 

What You Should Do if Your Bank Fails

It can often be stressful if your bank fails and you don’t know what to do. While customer service can help you with specific questions, you should aim to be proactive about any upcoming commitments you may have that need covered. 

For example, if you have automatic bill payments, you may want to notify the corresponding companies of the impact your bank’s closure may have on your payments. It can often be best to set up another bank account to use or even just pay manually a few times to ease the transition. 

If you fail to notify your financial commitments of your situation, you may be subject to late fees and even loss of service. 

In the case of a seamless transition between your bank and a new bank taking over, it can be a good idea to learn about what your new account(s) can offer (especially what coverage they offer for accounts). How can your new bank help you meet your financial goals? 

Related: Learn about the best bill negotiation services if you’re struggling to make ends meet each month. 

Historical Bank Failures

The FDIC was created in 1933 to avoid the devastating effects of the Great Depression and people not being able to get their funds back. However, that’s not to say it completely prevents banks from failing, especially as the economic world changes. 

Recent bank failures attest to this possibility. The Federal Reserve has been tasked with aiding both Silicon Valley Bank and Signature Bank account holders in retrieving their insured funds. 

However, over 90% of Silicon Valley’s customer accounts were uninsured. This complicates matters because instead of drawing from the Deposit Insurance Fund that every bank pays into, the FDIC must sell both banks and their assets to make up the difference. 

In light of the pandemic, it was decided that another result of the damaging effects of the Great Depression was to be suspended. Namely, it was the requirement that banks set aside around 10% of their cash reserves to reduce the risk of failure. 

Many consumers are having flashbacks of the 2008 economic crisis when Washington Mutual went out of business. Though J.P. Morgan eventually bought the bank out, it was a run on deposits and the struggling housing market that ultimately caused the downfall of one of the largest banks in history. 

The Bank Term Funding Program 

With this worst-case scenario in mind, the Federal Reserve has announced an emergency lending program for banks to utilize should their customers make a run on funds. When bank after bank closes and economic uncertainties loom, it’s only a matter of time before everyone runs to their nearest branch to demand their money. 

This Funding Program would give banks access to the funds they need to avoid having to sell off assets at a loss. As long as the banks have the collateral to back up the requested loan amount, there is no cap on how much a bank can borrow with the Bank Term Funding Program. 

The key to this whole program, however, is that the Federal Reserve lends money based on whether or not a bank has treasuries or government-backed bonds. Those bonds are also borrowed against at face value, rather than market value. 

Whether or not these stop-gap efforts become a permanent solution remains to be seen. The uncertainty of what happens if several banks fall is something most people don’t want to think about.

How to Avoid Losing Money in a Bank Failure

There are actions you can take to protect yourself from losing everything if your bank fails. One of the best ways to protect your funds is to find a credit union or bank that offers $250,000 or more in insurance from either the National Credit Union Association (NCUA) or the FDIC. 

You can find banks that offer FDIC insurance through the BankFind Suite and credit unions that offer NCUA coverage through this Credit Union Locator. Here are a few other ways you can protect yourself against losing everything you have if your bank fails: 

• Read the fine print: Not all accounts at an FDIC-insured bank are eligible for coverage. Ensure that the account you’re opening makes the list before you deposit a single penny. 
• Note the difference in how accounts are categorized: Many banks will offer FDIC insurance for one or more accounts as a set. For example, a checking and savings account may qualify as one account under the $250,000 coverage. 
• Limit your funds: Though the best bank accounts offer perks for higher balances, you should think twice before putting all your funds in a single account, especially if they’re not insured. 
• Keep several separate accounts: If you’re seriously concerned about a bank failure and don’t want all your financial nest eggs in one basket, consider opening a separate bank account to deposit your additional funds.  
• Monitor financial news: You’re more likely to find out about a bank failure from the internet than a snail mail letter. 

Related: Investing can help you allocate funds away from failing banks. Learn how to start investing for beginners or how to invest $100K with our in-depth guides. 

FAQs

Avoid the Panic if Your Bank Fails

Getting a letter in the mail or finding out via national news that your bank closed can be incredibly stressful. If you’re struggling with a closed bank that holds your money, you’re probably not alone. 

We hope this article has helped you to find the answers you’re looking for concerning what happens when a bank fails. While banks failing isn’t a new event, it can still be jarring to find out and have to deal with. 

The good news is that there are many other banks to choose from so you can continue your daily routine without interruption. Plus, many of them may offer better perks than you had before. 

What’s your plan of action if your bank fails?