Bank failures and rescues

Many of the numerous bank failures that have occurred over the years have not proved harmful to their national economies. Governments have found it necessary, however, to guard against the danger of "systemic failure" resulting from a general loss of confidence in the banking system and have, from time to time, rescued a failing bank in order to avert that danger. There have nevertheless been several instances of banking crises that have done serious damage to national economies.

For definitions of the terms shown in italics in this article, see the glossary.

For a detailed list of failures and rescues in their historical sequence, see the timelines subpage.

Background

The vulnerability of banks

The fact that banks often lend as much as twenty times the value of their share capital makes their continued solvency sensitive to defaults on those loans. "Retail banks", that obtain funds from depositors, are also vulnerable to the risk that fears of insolvency can result in "bank runs". They are also vulnerable to the "contagion" that can occur when depositor "herding" converts the news of a run on one of their number into runs on the others. "Wholesale" or "investment" banks, that obtain their funds by borrowing on the "money markets" and the "interbank markets", can also suffer from contagion resulting from herding by market operators. Before the adoption by central banks of the roles of "lenders of last resort", herding and contagion were believed to have led to the failure of many otherwise solvent banks. The pre-war creation of the Federal Reserve Bank as lender of last resort did not eliminate contagion in US banking in the inter-war years, but there is evidence to suggest that it was no longer common . However, the development in the latter years of the twentieth century of complex systems of "securitisation", added progressively to their vulnerability to contagion by making the banks a component of a complex, tightly-coupled interactive, financial system; and by adding to the difficulty of assessing risks. That development led to the word-wide incidence of 0 banking crises that have been termed "systemic" on a World Bank database because they were so extensive that they threatened the integrity of their national financial systems , a growing number of which had been contagious in the sense of spreading into neighbouring countries. The culmination of that trend was the world-wide crash of 2008.

The case for rescues

There are cogent arguments for not rescuing failing banks. In the first place a rescue could hamper the normal competitive process by which failures are replaced by more efficient competitors and secondly, its precedent creates a moral hazard by motivating banks to increase their profitability by taking otherwise unwarrantable risks. The contrary argument came to light in 1866 when contagion from the collapse of the English Gurney-Overend bank led to the collapse of over 200 companies . The influential commentator Walter Bagehot urged that in a future panic the Bank of England should "advance freely and vigorously to the public out of its reserves", and in 1890 the Bank rescued the failing Barings bank by guaranteeing loans to it by other banks. A similar conclusion by the United States authorities led to the creation of the Federal Reserve System with powers to act as lender of last resort. Those measures were designed to prevent failures caused by contagion, and they were not intended to prevent failures that were the direct result of insolvency. In time, however, it came to be recognised that some financial organisations had become "too big to fail" because their failure would endanger too large a proportion of the financial system. In the late twentieth century, after there had been several cases of international contagion there were even proposals to turn the International Monetary Fund into an international lender of last resort .

The treatment of banking crises

The proliferation of banking crises during the last two decades of the twentieth century led to the development of a variety of preventative and corrective measures . The preventative measures included schemes to insure depositors against loss and the designation of selected organisations as TBTF (too big to fail). Corrective measures taken at the early stages of an incipient systemic failure have included government promotion of the takeover of failing banks by stronger survivors , but action in response to a fully-developed systemic crisis has usually taken the form of injections of capital or the acquisition of equity by government agencies.

The inter-war years

The United States

In the immediate post-war years there was a rapid growth in the number of United States banks, and there were relatively few failures. In 1921, however, there was a surge in the number of bank failures, especially in farming areas, and the number of banks started to decline. In 1930, a massive further increase in failures occurred in response to the Great Recession, and failures continued at a high level until the "banking holiday" of 1933. The introduction in that year of the Federal Deposit Insurance scheme restored investors' confidence, and there were few failures during the remainder of the inter-war period.