Understanding Bank Failures
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What Happens during a Bank Failure?

In July, 2008, IndyMac Bank, a California-based institution, failed. News images showing customers lined up outside the bank's branches to make withdrawals evoked scenes from the Great Depression, the last time in American history when bank failures played a significant role in the country's economic landscape.

Unfortunately, the worry IndyMac's failure caused may have left many people unclear about what it means for a bank to fail - and whether or not they should be worried about their own financial institutions.

Bank Failures as Self-Fulfilling Prophesies

To understand why banks fail, it's important to understand how they work. Here are a few key features of the modern banking system in the United States:

  • Fractional-reserve banking: When customers put money in their accounts, banks don't keep the entire amount on their premises. They keep only a fraction of the total amount on reserve (in the banks themselves), and use the remainder for securities and loans. This works fine on a normal day - banks have enough cash to handle ordinary withdrawals.
  • Deposit insurance: Thanks to the New Deal-era Federal Deposit Insurance Corporation (FDIC), the government can insure the money you put in banks. FDIC-insured banks offer protection for up to $100,000 per depositor per bank (more for retirement and joint accounts). This means that, even if a federally insured bank fails, depositors are still guaranteed their money (up to the limit).

So here's how a bank run could lead to a bank's failure: A rumor spreads that the bank doesn't have enough liquidity (cash) to pass federal guidelines. Depositors worry that they'll lose their money if the bank fails, so they withdraw their money.

As more and more people make large withdrawals, the bank loses even more cash and becomes less likely to survive the crisis. In extreme cases, even a false rumor that a bank is struggling could lead to a bank run and ultimately a bank failure.

IndyMac's Bankruptcy

The failure of a bank is nothing more than a bank becoming insolvent, or bankrupt. But instead of the bank announcing its own bankruptcy, the FDIC swoops in and takes over.

The failure of IndyMac Bank provides an interesting example of the role rumors can play in a bank run. Apparently, Senator Charles Schumer suggested in a letter that IndyMac Bank was on the brink of collapse. When that letter went public, people began withdrawing their money.

Though the bank was troubled before Senator Schumer's intervention, the letter could have been a factor in the bank's ultimate collapse - even depositors who thought the bank would be okay may have worried that other depositors would withdraw money, and so did so themselves to beat the rush, as it were.

The Government's Role in Bank Regulation

Though you may be surprised by bank failures, the FDIC keeps a careful watch on the institutions it insures. It evaluates banks based on how much capital (actual money) they have access to, among other things. The scale runs like this:

  • Well-capitalized: 10% or more of deposits backed up by cash;
  • Adequately capitalized: 8% or more of deposits backed up by cash;
  • Undercapitalized: less than 8% of deposits backed up by cash;
  • Significantly undercapitalized: less than 6% of deposits backed up by cash; and
  • Critically undercapitalized: less than 2% of deposits backed up by cash.

The FDIC monitors banks and issues a warning when one falls below the 8% mark. If an organization hits 6%, the FDIC can force a bank to take corrective steps. When a bank becomes critically undercapitalized (with less than 2% liquidity), the FDIC can declare it bankrupt and swoop in to take control. When that happens, the bank has failed.

Protecting Your Money

The chairwoman of the FDIC has reportedly assured Americans that the vast majority of U.S. banks are secure and the organization has increased its number of staff members capable of dealing with bank run situations.

However, you may still want to make sure your funds are secure, particularly if you're a small business owner. Businesses tend to have greater amounts of money in accounts than individuals and may be more likely to be affected by federal insurance limits.

You can call the FDIC's consumer hotline (1-877-275-3342) to verify the protection of your funds. Experts from the FDIC evidently do not expect any major banks to fail.

Protect Your Money - Talk to A Bankruptcy Attorney

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Further Reading

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