Bank Failure: What Does It Mean for Small Businesses?

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A bank failure occurs when a bank does not have enough money in its deposit accounts to cover withdrawals. To make money, banks lend deposits at higher interest rates than they pay. They count on the fact that all their customers won’t want to make a withdrawal at the same time, so the bank usually has enough cash reserves to cover withdrawals. So what happens when a bank does fail?

What Does Bank Failure Mean for Small Businesses?

Bank failures can affect individuals and small business owners. If a small business owner can’t withdraw money, they might not be able to pay their lease or cover payroll. FDIC insurance will cover deposits up to $250,000, but it might take some time for the business to receive those funds. In the meantime, the business must still find a way to cover expenses.

What Is an Example of Bank Failure?

The U.S. experienced three bank failures in 2023.

  • In March 2023, Silicon Valley Bank failed following a “bank run.” This was caused by depositors withdrawing their funds at the same time since they were afraid of the bank’s future. The FDIC stepped in and created a “bridge bank,” to cover deposits while they tried to sell the bank and its assets. Ultimately, First-Citizens Bank & Trust Company purchased the remaining assets of Silicon Valley Bridge Bank.
  • Days later, Signature Bank suffered the same fate and was shut down by the New York State Department of Financial Services. The bank’s assets were taken over by the FDIC and eventually purchased by Flagstar Bank.
  • In May 2023, First Republic Bank failed, but JPMorgan Chase Bank stepped in to acquire all the deposits and assets.
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What Are the 5 Reasons for Bank Failure?

Banks can fail for many reasons, all largely related to not having the assets to cover withdrawals. But what leads a bank to that situation? The FDIC and other expert sources highlight five reasons a bank can fail.

1. Undercapitalization — Funding Problems

If a bank doesn’t have enough assets to cover its costs — just like any business — that bank will fail. Often, banks hold their assets in a combination of short-term credit, bonds and equity, as well as cash deposits. If a bank has debt that has come due and can’t pay it, this can lead to failure.

Similarly, if the bank can’t secure credit because investors have lost faith in the bank management for whatever reason, the bank might fail.

Undercapitalization may also occur during a bank run, when, for whatever reason, depositors all decide to pull their money at the same time. If the bank cannot liquidate assets quickly enough to cover those deposits, the bank will fail.

2. Poor Risk Management

Just as retail investors must determine their level of risk tolerance before creating a diversified portfolio, banks must do the same. If a bank takes on too much risk and investments drop, creating too much of a loss that the bank can’t cover deposits or pay its bills, the bank will fail.

3. Asset Liability Mismatch

As mentioned earlier, banks lend out money at a higher interest rate than they are paying. However, if the bank’s investments lose money or its assets are not matched to the liabilities supporting them, the bank will continue to lose money. Eventually, it will not be able to support withdrawals.

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This is similar to what occurred at SVB. As a bank focused on tech startups, it grew quickly between 2020 and 2022. SVB purchased mortgage-backed securities and Treasuries at low-interest rates to back its deposits. But the assets did not match the liabilities. So when business owners holding deposits at the bank all began withdrawing their money at the same time, SVB could not cover all the withdrawals.

4. Bad Loans

During the mortgage crisis of 2008, most of the 25 bank failures that occurred were due to bad loans. Banks did not have assets to cover all the liabilities, since much of their money had been loaned out in the form of mortgages that, ultimately, went into foreclosure. As real estate prices dropped, the homes didn’t have enough value to cover the mortgage.

Bad loans can still cause a bank failure today. If a bank has too many loans in default, it won’t have the assets to cover its bills or deposits.

5. Fraud

Fraud, which can deplete a bank’s financial resources and create fear among its customers, can also cause a bank to fail. Fraud can be internal, or it can be the result of bad actors outside the organization. 

Final Take

So what happens to customers and small businesses when a bank fails? If your bank is insured by the FDIC, your deposits will be covered up to $250,000 per account type. This is why Dave Ramsey recommends paying attention to those limits and keeping your money divided across accounts to increase coverage.

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However, many small business owners have to keep much more than that in cash reserves in a bank just to cover payroll. It’s best to choose a bank with a solid history and to divide your money between accounts to maximize your insurance coverage.

FAQ

Here are the answers to some of the most frequently asked questions regarding bank failure.
  • What happens to my money if a bank goes out of business?
    • When SVB and Signature Bank collapsed, the FDIC set up bridge banks to ensure that customers would have access to their money in a timely manner. The U.S. Treasury Department, the Federal Reserve and the FDIC worked together to ensure that all deposits in SVB and Signature Bank would be covered.
    • The Fed also created an emergency program where banks could borrow freely from the Fed to cover deposits without having to sell securities.
  • What is bank failure?
    • A bank failure is when the bank cannot meet its obligation to depositors. It cannot provide funds for cash withdrawals or pay its bills. The federal or state banking regulatory agency will then close the bank. Deposits will be insured, up to the federal limits of $250,000 per depositor, per account type, according to the FDIC insurance.

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