What Happens When a US Commercial Bank Fails?

Today I want to discuss what happens when a commercial bank fails, and what the FDIC has done historically.

Typically, if a bank fails, we’re going to see the FDIC come in and either arrange the sale of the bank to another healthy bank or the FDIC will take control of it. The FDIC says it will pay off the depositor up to insured limit, which is 250,000. 

Now, we saw a lot of this happening in the great recession and the years after. In 2008, Wachovia was 4th largest bank in the country by assets and by end of the year it had merged with Wells Fargo. Wachovia was the one of the largest owners of adjustable-rate mortgages in the country. 

In 2023, Silicon Valley Bank failed. This was due to company having a massive amount of money in bonds. Like most banks, as deposits came in from investors, SVB invested the money. However, As the Federal reserve raised interest rates at a historical pace, the bonds values decreased. At first these losses weren’t apparent as the losses didn’t have to realized. But once these unrealized losses became realized, the funds the company had invested were dropping dramatically. As this was occurring, investors got wind of what was happening and began pulling their deposits. To make matters worse, the bank served mainly tech companies, and didn’t have diversified customer base. The Fed would step in and arrange the sale of SVB to Regions Bank.

And this brings up the importance of stopping bank runs.

The FDIC will do anything and everything to prevent a bank run. This is due to fractional reserve banking which is the system we use where only a fraction of bank deposits are kept in the bank. The rest of this money is loaned out. Say, I deposit $10,000, the bank may only keep 500 or $1000 in the bank. This is known as the reserve requirement, which is set by the Federal Reserve. Historically, we have seen the reserve requirement around 10%, but once COVID came, the Federal Reserve lowered it to 0%. It should be said though banks have not loaned out all the money as they do have meet capital requirements.

Should we be concerned about our banking system though? I think so, right now, around 77% of Banking Assets are owned by just 10 banks and there’s never been serious talk about breaking theses banks up. In 08’, we saw the banks bailed out because they were considered too big to fail and today, they are bigger than ever. This creates incentives for them to take risky bets creating a moral hazard. Now, I strongly feel these banks are way too complex to manage, and they have significant power to lobby rules and regulations in their favor. Can we really be sure what’ s happening inside them? Also, there is a huge conflict of interest as we’ve seen that the regulators and bankers switch roles often, meaning a top regulator goes to work at the bank he was auditing.

There is an argument that consumers benefit from the economies of scale, lower interest rates, but I would argue that smaller banks would need less regulation and the cost of money would decrease.

But what do you think, do you use a small or big bank?