Closing Troubled Banks: How the Process Works

B usiness failure typically occurs when a financially weak firm can no longer pay its creditors. Failure generally involves a series of steps. First, the firm suffers losses. Second, when the firm’s creditors learn of the losses, they increase their estimate of the firm’s probability of default. To compensate themselves for this increased risk, creditors demand higher interest rates or require debt repayment. Third, the firm finds itself unable to raise or generate additional funds to meet those demands and defaults. Creditors then either force the firm into bankruptcy, in which case a bankruptcy court decides how to best allocate the firm’s assets to meet its debts, or the firm privately arranges with creditors for a payout of firm assets. In either case, the assets can be redeployed in more valuable uses. While business failure is often exceptionally disruptive for the firm’s managers and employees, it is beneficial for society since it ensures that business resources are not devoted to ineffectual enterprises. But what about banks? How does their failure ensue? A high proportion of bank liabilities are government-insured deposits. Deposit insurance primarily exists to prevent inappropriate bank runs that may occur when many of a bank’s depositors seek to withdraw funds even though the bank is healthy. While it solves one problem—inappropriate runs—deposit insurance can create another. Insured depositors have no incentive to demand higher interest rates or debt repayment when their bank is troubled. While uninsured bank creditors will likely demand repayment, the bank can often raise funds to meet these demands by gathering new insured deposits at little extra cost. As a result, the market-driven process of failure and subsequent reallocation of assets is short-circuited for banks, and its societal benefits are muted. Because market forces are unlikely to bring about the timely closure of troubled banks, the government agencies that charter and supervise banks