Study: More bank failures due to balance sheet issues, not spontaneous runs

Banks are more likely to fail due to underlying balance sheet issues than deposit runs, according to a recent report from the Federal Reserve Bank of New York..Released April 16, the study included a review of more than 5,000 U.S. bank failures across 160 years. Poor local economic conditions, asset losses and fraud were listed as the most common causes of bank failures. According to the study, runs and liquidity issues were listed as the cause in less than 20 of more than 2,000 failures. “A common precursor to failure is rapid asset growth, usually from aggressive lending,” wrote the authors of the study, Federal Reserve Bank of Richmond Senior Economist Sergio Correia and New York Fed Financial Research Advisor Stephan Luck. “These patterns hold for bank failures with and without runs. They also hold across institutional regimes with and without deposit insurance or a public lender of last resort.” Failing banks consistently showed declining income and capitalization, increasing asset losses and growing reliance on pricier funding sources in the years leading up to their failures, according to the report. When bank runs happened, those with stronger fundamentals were less likely to fail as they could use several ways to remain solvent. “The importance of bank runs is somewhat overstated,” added Luck and Correia. “Runs matter, but in most cases they trigger or accelerate failure at already weak banks, rather than cause otherwise sound banks to fail.” Regulatory focus should shift toward equity capital standards, supervision and risk management and away from deposit insurance and lender-of-last resort policy, according to the report. Effective supervision ensures banks recognize losses and identifies where they need recapitalization, wrote Correia and Luck. The report was released three years after Silicon Valley failed. Its 2023 failure was attributed to a bank run sparked by a liquidity crisis, with depositors withdrawing $42 billion in one day. Lawmakers have since unsuccessfully called for increasing the deposit insurance limit. Before federal deposit insurance was introduced in 1934, creditors recovered, on average, only 75 cents on the dollar, compared to 66 cents on the dollar for unsecured depositors, according to the report. “This means failed bank assets fell substantially short of covering debt claims, indicating most failed banks were fundamentally insolvent,” wrote Correia and Luck. The advent of deposit insurance has increased supervisory intervention as a cause for bank failures. “This framework reduces the occurrence of potentially costly runs, but it also reduces the ex post discipline runs impose on insolvent banks,” according to the report. “Without this discipline, there is more onus on supervisors to identify potential insolvent banks and then to mitigate the associated losses over time.” BankTech Ventures Managing Director Carey Ransom supports raising deposit insurance limits—with different limits for commercial and consumer accounts—if a proper cost-benefit analysis takes place. “That is the kind of data that as an industry we should be getting a better handle on,” Ransom added. The FDIC has protected depositors beyond legal limits when banks fail, Ransom noted. Deposits have left smaller banks to financial institutions deemed “too big to fail” in crises since the Great Recession, including the failure of Silicon Valley Bank, due to their implicit insurance guarantee he added.