Explaining Banking Crises How and Why They Occur and How Depositors are Insured
Explaining Banking Crises How and Why They Occur and How Depositors are Insured.
Bank run is a vivid term that brings about a strong mental picture: long queues of nervous depositors, closed doors, wasted life savings. Since the Great Depression through the global financial crisis of 2008 and the Silicon Valley Bank collapse of 2023, banking crises have caused the shaking of the economies and the breaking of lives many times over. However, what are the causes of these crises? And in the event of their happening, what safeguards common depositors? These questions are important to understand and this is almost everybody who places his savings in a bank.
Why Banking Crises Happen
Banks, in their essence, only do a single risky task: they accept short term deposits and provide long term loans. The mortgage that will not be repaid in 30 years is being financed with your money that you can reclaim any time. This growth depends on this maturity transformation, which without, businesses will not be able to invest and families will not be able to purchase houses. And yet it makes one susceptible.
The Confidence Game
Banking runs on confidence. As long as the depositors are convinced that their money is safe, they keep it at the bank. A healthy bank can fail just in case a good many people owning deposits lose trust and attempt to pull out simultaneously. None of the deposits are held in cash by any bank, most of them are loaned out. A sudden rush of withdrawal request will drain the liquid cash in the bank, whereby the bank will have to sell their assets at very low prices. That may render the bank bankrupt.
This self-fulfilling prophecy is the result of this dynamic. The fear of a bank run is a cause of a run in itself. When individuals observe others waiting, it would only be rational to get to the line, even in cases where they think that a bank is stable.
The Root Causes
Although any bank may face a panic attack, there are underlying roots of most crises:
- Asset bubbles and crashes. Financial bubbles tend to be spurred on by banks lending freely on an escalating price. Loose money collateralizes at the moment the bubble explodes- in the housing, stocks or commodities- and loans become bad. The crisis of 2008 was more or less a housing bubble narrative: banks had borrowed heavily against houses that were to turn out to be worth much less than they had lent.
- Economic shocks. Extreme recession may bring about massive defaults of loans in most sectors. Companies go bankrupt, people lose their jobs and mortgages default. This happens to the banks as well, as banks lose their loan portfolios and this weakens the entire system.
- Poor risk management. Others become excessively risky, either by making concentrated lending, or by thin capital ratios, or by complex derivatives which they do not really understand. When risks become a reality, then those banks are exposed.
- Contagion. With a related financial system failure of one institution can contain others. The banks borrow among themselves, carry the debt of one another and depend on common payment systems. In the year 2008, when Lehman Brothers collapsed, it caused a world wide panic as nobody was aware of the other institutions that owned the debt held by the company.
Protection to Depositors.
Due to these weaknesses, all contemporary economies have mechanisms to guard depositors to retain confidence. Such protections differ between countries but have much in common.
Deposit Insurance
The nearest safeguard to this is deposit insurance: a government guarantee that in case a bank collapses depositors will receive their money until a predetermined limit. This prevents the vicious circle of self-induced bank-runs: when you are certain that your money is safe, then there is no need to panic.
United States: The Federal Deposit Insurance Corporation (FDIC) was established in 1933 in the wake of thousands of bank failures in the Great Depression. Currently it guarantees a deposit of up to $250,000/depositor, per bank. No depositor in an FDIC-insured bank failure has been insured and lost money in a bank since its inception.
European Union: The Specific Directive on the Deposit Guarantees Schemes harmonises coverage across the member nations with a minimum of coverage amounting to 100,000 per depositor. There is no standard procedure, yet the minimum assurance is the same.
Nigeria: The Nigeria Deposit Insurance Corporation (NDIC) guarantees deposits to N500 000 per depositor in any bank. This includes the majority of retail depositors but exempts larger balances - as a policy of discipline.
Kenya: In Kenya, the Kenya Deposit Insurance Corporation (KDIC) insures up to KES500, 000 per depositor per institution which covers approximately 90 percent of the depositors.
South Africa: The deposits are insured by the Corporation for Deposit Insurance (CODI) which was set up in 2021, and which covers deposits to a level of ZAR100 000 per depositor per bank, insuring approximately 85% of the depositors.
The deposit insurance is not financed by taxpayers, rather by banks through premiums which are paid, however, in a systemic crisis the governments can bailout the system.
Prudential Regulation
Prevention beats cure. Regulators place regulations that prevent the banks to take unnecessary risks:
-Capital requirements compel banks to finance themselves, not only through debt, but also through extensive equity. The greater the capital of the bank, the more losses it is able to absorb before the depositors are at risk. Basel III standards have minimum capital requirements of 4.5 per cent of risk-weighted assets and buffers.
- Liquidity requirements are required in order to make sure that the banks have sufficient liquidity assets so that they can pay off the short term commitments. Liquidity Coverage Ratio will ensure that banks have sufficient quality liquid assets, which can sustain them during a 30-day stress period.
- Stress tests are exercises that are conducted to recreate crisis situations to determine the quality of capital needed by banks. In the US, EU, and UK, regulators release the results on regular basis providing transparency on the resilience of systems.
Supervision and Oversight
The regulators keep a watch over the banks and their loan portfolio, risk management and internal controls. Once issues emerge, they may step in early, such as a requirement of management changes, without division or capital limit, thus a bank is not put into crisis.
Resolution Authority
In the case of a bank failure, the current regime of resolving failures tries to ensure that management is done without affecting the wider financial structure or injuring taxpayers. The FDIC has the best resolution process. In case of the bank failure, the FDIC usually makes a healthy bank purchase deposits and branches of the failed bank. Customers end up the customers of the acquiring bank, and usually the customer does not miss even a single day of using his or her accounts. Depositors who are not insured can lose part of the money, whereas those who are insured can be guaranteed immediately.
Have you ever given a thought to the security of your bank deposits? What are your inquiries of deposit protection in your country? Write your comments in the comments section. To continue reading and analyze economic policy and financial systems, read on WAPDAY25.
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