10.2 Commercial Bank Failure Flashcards
1. What is a liquidity crisis in commercial banking?
A liquidity crisis in commercial banking occurs when a bank does not possess enough short-term liquid assets to fulfill its short-term liabilities. This situation can arise if a bank depletes its liquid cash assets, obtained from savings, to make long-term loans that offer higher profitability. Alternatively, the bank may borrow short-term funds from the money markets and use them to increase less liquid assets, such as long-term loans. If the bank faces an immediate need to meet its short-term obligations, such as when depositors demand their savings, it will be unable to fulfill these obligations, leading to panic and a run on the bank. This scenario is known as a liquidity crisis.
- What is insolvency in commercial banking?
Insolvency in commercial banking refers to a situation where a bank does not possess sufficient capital or other assets to offset its long term asset losses. If a bank takes on excessive risk on things like mortgages or loans or retains assets with declining values, without adequate capital to absorb potential losses, it can become insolvent. Insolvency means that the bank owes more than it owns, making it an unsustainable position. In such cases, the bank’s overall stability and ability to meet its financial obligations are severely compromised.
- What is systemic risk in the context of bank failure?
Systemic risk refers to the potential for the failure of one commercial bank to have a cascading effect throughout the banking industry, leading to further bank failures and potentially causing a complete meltdown of the entire industry. When one bank fails, the assets held by other banks may lose value and need to be offset by a reduction in capital. If the capital is insufficient to absorb these losses, the affected bank can become insolvent and fail, triggering problems for other banks in a similar manner. This interconnectedness and interdependence within the banking system create systemic risk, where the failure of one institution poses a significant threat to the stability of the entire financial system.
- How can bank failure contribute to a recession?
Bank failure and the associated systemic risk can contribute to a deep recession or depression within a nation. The financial industry plays a crucial role in economic growth, and when banks fail, it can lead to a reduction in lending and borrowing for investment and consumption. This decrease in borrowing hampers aggregate demand significantly, leading to job losses, reduced incomes, and lower living standards. Additionally, the negative multiplier effects of a financial sector collapse can impact the entire economy, affecting businesses, individuals, and government spending. Governments may also face limitations on borrowing for stimulus measures, further deepening the crisis and exacerbating unemployment.
- What are the negative externalities and moral hazards associated with bank failure?
Bank failure can result in negative externalities and moral hazards. Governments may feel compelled to bail out failing banks to prevent systemic risk from destabilizing the economy. This means taxpayers’ money is used to fund the bailout, leading to increased borrowing and a long-term burden of debt repayment and interest servicing. This impact is borne by current and future generations through higher tax rates. Furthermore, bank bailouts create moral hazard by incentivizing excessive risk-taking. Banks may engage in risky activities, such as holding insufficient liquid assets or offering riskier loans, knowing that if they fail, the government will bail them out to continue operations. This behavior shifts the consequences of risky decisions onto third parties, as banks believe they are “too big to fail.” Despite potential regulatory measures, the expectation of a bailout can encourage further risk-taking, putting taxpayers at risk and increasing the likelihood of future bank failures.
