Bank failure/financial market failure Flashcards
reasons for bank failure
bank run - not enough liquid short term assets to meet short term liabilities
insolvency - where theres not enough capital to offset losses in asset values, liabilities>assets
- A bank run most often arises from public fear pushing a bank into insufficient liquidity rather than actual insolvency
chain of analysis for how bank run leads to bank failure
- Depositors fear the bank is unstable and rush to withdraw their money (self-fulfilling prophecy of failure).
- Banks hold only a fraction of deposits as cash (fractional reserve banking), so they struggle to meet withdrawal demands.
- To raise cash, the bank sells assets (e.g., loans, bonds) quickly, often at discounted prices (fire sales).
- Selling assets at a loss reduces the bank’s capital, making it harder to cover liabilities.
- As losses mount, the bank may become insolvent, leading to bankruptcy or government intervention (e.g., bailout, central bank support, deposit insurance activation).
- The failure of one bank can lead to a loss of confidence in other banks, potentially triggering more bank runs and causing systemic risk throughout the financial system.
how does insolvency lead to bank failure, chain of analysis
- Insolvency occurs when a bank’s liabilities exceed its assets, meaning it cannot meet its financial obligations, including paying back depositors and creditors.
- A bank’s assets (e.g., loans, investments) lose value due to bad loans, falling asset prices, or economic downturns.
- If liabilities (customer deposits, debt) exceed assets, the bank becomes insolvent and unable to meet obligations.
- Investors and depositors notice the bank’s financial weakness, leading to a withdrawal of funds and refusal of lenders to provide liquidity.
- With funding sources drying up, the bank cannot cover short-term liabilities, making it vulnerable to a full-scale bank run
- Authorities may step in to shut down the bank, force a merger, or provide emergency liquidity—if no intervention occurs, the bank fails and ceases operations.
tools to reduce the risk of bank failure
- cash ratio - forcing commercial banks to hold enough cash assets to meet their short term liabilities - If a bank holds a high level of cash relative to its liabilities, it can better withstand a sudden surge in withdrawals during a bank run
- liquidity ratio - forcing commercial banks to hold enough short term liquid asssets to meet their short term liabilities
- The leverage ratio measures a bank’s core capital relative to its total assets or its total exposure,A higher leverage ratio indicates that the bank has a larger cushion of equity capital relative to its assets. This capital buffer can absorb losses during economic downturns or financial shocks, preventing the bank from becoming insolvent.
- capital ratio measures the proportion of a bank’s capital to its risk-weighted assets (RWAs). It is an indicator of a bank’s financial strength and its ability to absorb lossess,
how do reserve requirements reduce the risk of bank failure
Banks Must Hold a Minimum Reserve → Central banks set reserve requirements, forcing banks to keep a percentage of deposits as cash or with the central bank.
Limits Over-Lending → Since banks cannot lend out all deposits, they maintain a liquidity buffer, reducing exposure to bad loans or excessive credit expansion.
Enhances Liquidity for Withdrawals → With higher reserves, banks have immediate funds available to meet customer withdrawals, lowering the risk of a bank run.
Boosts Confidence in the Banking System → Depositors and investors feel more secure, reducing the likelihood of panic withdrawals and loss of trust.
Prevents Insolvency & Systemic Risk → By ensuring banks have enough liquid assets, reserve requirements help prevent liquidity crises from turning into full-scale bank failures.
how do banks maximise profit
- borrowing short term with low interest and lending long term with higher interest
- taking more risk using less secure loans(charge more interest)
bank failure consequences - systemic risk
Systemic risk - the risk that the failure or distress of one financial institution, or a group of institutions, could trigger a widespread collapse across the entire financial system
bank failure consequences - recession
A bank failure often leads to a credit crunch, where banks become more conservative in lending, or credit dries up entirely. Businesses that rely on loans for operations, expansion, or working capital find it difficult to secure financing. This reduction in available credit slows down investment, consumption, and economic growth.
bank failure consequences - lost jobs
- Without access to necessary financing, many businesses, particularly small and medium-sized enterprises, may be forced to downsize or close entirely. This leads to significant job losses as companies reduce their workforce to cut costs.
- As businesses lay off workers, unemployment rates rise. The increase in joblessness can lead to further reductions in consumer spending, as unemployed workers have less income to spend, deepening the economic downturn.
bank failure consequences - lower output and incomes
- Decline in Production: With businesses scaling back operations or shutting down, overall production in the economy decreases. This reduction in output can lead to shortages of goods and services, further slowing economic growth.
- Lower Incomes: As companies reduce wages, cut jobs, or close down, household incomes fall. Lower incomes reduce purchasing power, leading to decreased consumer demand, which further impacts businesses and the broader economy.
- Multiplier Effect: The reduction in income and output has a multiplier effect, where the initial economic impact spreads and amplifies throughout the economy. For instance, when one industry suffers, related industries also face downturns, leading to widespread economic difficulties.
broad impacts of bank failure
- Financial Market Turmoil: The failure of a significant bank can lead to loss of confidence in the financial system, causing stock markets to plunge and further eroding wealth and consumer confidence.
- Government Intervention: In severe cases, government intervention may be required, such as bailouts, increased unemployment benefits, or fiscal stimulus. While these measures can mitigate some damage, they also place additional strain on public finances and can lead to long-term economic challenges.
consequences of bank failure - bank bailouts
- A bailout can prevent the failure of one bank from spreading to others, thus stabilizing the financial system. By injecting capital into the failing bank or providing guarantees, the government reassures depositors and investors, reducing the risk of a bank run.
- Bailouts are often funded by taxpayer money, which can lead to significant public expenditure. This use of public funds can lead to increased government debt and may require future tax increases or cuts in public services to balance the budget.
- Bailouts can create a moral hazard, where banks and other financial institutions might take on excessive risks, knowing that they could be bailed out if things go wrong. This can encourage reckless behavior in the financial sector, leading to future crises.
- In some cases, the increased debt burden from bailouts can lead to austerity measures, where governments cut public spending or increase taxes to manage their debt. These measures can further slow economic growth and exacerbate social inequalities.
- Bailouts can distort financial markets by propping up failing institutions, potentially leading to misallocation of resources. This can stifle competition and innovation, as weaker institutions are kept alive at the expense of healthier, more competitive ones.
how can banks prevent bank failure
- holding sufficient liquid assets, such as cash, government securities, or reserves with the central bank. These assets can be quickly converted into cash to meet withdrawal demands or other short-term obligations
- Risk Management: Implementing robust risk management practices, including credit risk assessment, market risk monitoring, and operational risk controls, helps banks identify and mitigate potential threats before they lead to significant losses.
- Cybersecurity: With the increasing reliance on digital banking, robust cybersecurity measures are essential to prevent fraud, data breaches, and other cyber threats
- come at the price of profit
role of the central bank
- to implement monetary policy, eg meet inflation target
- acts as a banker to the government, eg open market operations(buying+sell govt bonds)
- acting as a banker to other banks(“lender of last resorts”) - preventing bank run
- regulate financial system
why is financial stability important
- to prevent panic and bank runs
- to reduce financial instability and systemic risk
- to advise govt of bank bailouts
what is moral hazard and how does is lead to financial market failure
when a decision is made and if that decision goes wrong, the cost affects a 3rd party
Financial Institutions Take Excessive Risks → If banks and investors believe they will be bailed out (e.g., by the government or central bank), they may engage in risky lending or speculative investments without properly considering potential losses.
Short-Term Profit Motive Overrides Prudence → Banks may offer high-risk loans (e.g., subprime mortgages) or create complex derivatives, prioritizing immediate profits and bonuses over long-term stability.
Increased Exposure to Systemic Risks → If multiple financial institutions take similar reckless risks, the system becomes highly interconnected and fragile, making it vulnerable to shocks or economic downturns.
Market Confidence Collapses → When bad investments start failing (e.g., mortgage-backed securities in 2008), investors and depositors lose trust in financial institutions, leading to panic selling, liquidity shortages, and potential bank runs.
Financial Market Failure Occurs → A full-scale crisis emerges as banks fail to meet obligations, credit markets freeze, and the wider economy suffers from falling investment, lower consumer confidence, and recession.
consequences of banks being the “lender of last resort”
moral hazard: The availability of emergency support from the central bank might encourage financial institutions to take on excessive risks, believing that they will be rescued in times of trouble. This can lead to reckless behaviour.
- Knowing that they can rely on the central bank as a lender of last resort, banks might be less motivated to maintain higher levels of liquidity. Instead, they may choose to allocate more resources towards higher-yield but less liquid investments, reducing their cash reserves and liquidity buffers
Regulatory capture- Banks that anticipate central bank bailouts may exert influence over regulatory bodies to shape regulations in their favor. They might push for favorable policies or less stringent oversight, knowing that they can rely on emergency support if needed.
- ## Financial institutions, such as banks and large corporations, often receive direct bailouts or emergency liquidity, while smaller businesses and other industries might not have access to the same level of support. This selective assistance can exacerbate inequality and create an uneven playing field.
what is financial market failure
when free functioning financial markets fail to allocate financial products at the socially optimum level of output
reasons for financial market failure - excessive risk
1️⃣ Excessive Risk-Taking by Financial Institutions → Systemic Risk Externality
Banks and financial firms engage in high-risk lending and speculative activities (e.g., subprime mortgages, derivatives) to maximize profits.
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They do not internalize the full risks of their actions, assuming they will be bailed out if things go wrong (moral hazard).
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If multiple institutions engage in risky behavior, the financial system becomes fragile, increasing the likelihood of widespread defaults and crises.
2️⃣ Contagion Effect → Negative Externality on Other Banks & Markets
When one major financial institution collapses or faces liquidity issues, creditors and counterparties lose confidence, leading to panic.
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Other institutions suffer losses due to their interconnected investments, triggering a domino effect of declining asset values.
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This amplifies the initial shock, creating systemic risk that spreads instability across the entire financial system (e.g., 2008 financial crisis).
3️⃣ Misallocation of Capital → Boom-Bust Cycles
If financial markets overinvest in speculative assets (e.g., housing bubbles, stock market booms), asset prices inflate beyond sustainable levels.
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When the bubble bursts, asset prices plummet, leading to bankruptcies, mass layoffs, and a sharp decline in credit availability.
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This results in economic recessions, negatively affecting households, businesses, and governments that had no role in the risky investments.
what are asset bubbles
where the prices of assets (such as real estate or stocks) inflate rapidly due to speculative investments.
what is credit crunch
A credit crunch is a situation where there is a significant reduction in the availability of loans or credit from financial institutions, making it difficult for businesses and consumers to borrow money.
consequences of excessive risk
- systemic risk
- confidence in banks reduce
- lost jobs, incomes, output throughout entire economy
- recession
- bank bailouts
how does monopoly pricing(collusive interest rates) lead to financial market failure
- Banks or financial institutions may engage in collusion, agreeing to set interest rates at artificially high levels rather than competing
- restricts competition and keeps interest rates higher than they would be in a competitive market.
- Higher interest rates increase the cost of borrowing for businesses and consumers. As a result, fewer people can afford to take out loans, leading to reduced access to credit.
- This limits investment in businesses, housing, and consumer spending, slowing down economic growth.
- As defaults rise and economic activity slows, the financial system becomes increasingly unstable. The reduced access to credit, coupled with inefficiencies and higher default rates, can lead to a broader financial market failure, characterized by reduced liquidity, loss of confidence in financial institutions, and potential economic recession.
Why did the deregulation (Big bang) of 1986 increase systemic risk in the UK - removal of reserve requirements
- was used to encourage people to move away from mining and move into financial sector
- Elimination of Reserve Requirements:
- With fewer reserves required, banks could lend more aggressively, often to riskier borrowers or for speculative activities, increasing their exposure to default risks.
- As banks operated with minimal reserves, a sudden economic downturn or increase in loan defaults could rapidly deplete their available funds, leading to widespread banking failures.
examples of excessive behaviour
- speculation
- market bubbles
what is speculation and how do they lead to financial market failure
- speculation occurs when assets are bought at a low price and sold at a high price
- Investors buy assets, like stocks or real estate, hoping prices will keep rising, even if the assets aren’t really worth that much.
- As more people buy, prices skyrocket, creating a bubble where asset prices are much higher than their true value.
- To maximize profits, investors and companies often use leveraged deals, borrowing money to invest even more into the bubble. This leverage amplifies both potential gains and potential losses, increasing the overall risk in the financial system.
- When people realize the assets are overpriced, prices crash. Those who borrowed heavily to invest face huge losses. demand and price of assets fall
- The crash causes widespread financial trouble, leading to defaults, panic selling, and a loss of confidence, which can destabilize the entire financial market. ppl sitting on worthless assets
explain a leveraged deal
- In a leveraged deal, an investor or company buys another company mostly using borrowed money, with only a small portion of their own funds.
- The debt used to buy the company is expected to be paid off using the profits or assets of the acquired company.
- Because so much of the purchase is funded by debt, there’s a high risk. If the bought company doesn’t make enough money, it can be hard to pay back the loans.
- If the deal works out, the buyer can make big profits with little investment. But if it doesn’t, the buyer could face huge losses, and the bought company might even go bankrupt.
leveraged deal meaning
- borrowing to amplify the end outcome of a deal
how does asymmetric info lead to moral hazard and ultimately financial market failure
- Asymmetric information occurs when one party has more or better information than the other party in a transaction.
- In financial markets, a bank might have more information about the risks associated with a loan than the lender does.
Adverse Selection → High-Risk Borrowers Dominate Lending Market
If lenders cannot accurately distinguish between low-risk and high-risk borrowers, they may charge higher interest rates to compensate for potential losses.
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This discourages creditworthy (low-risk) borrowers from taking loans, leaving banks with a disproportionately high-risk customer base.
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As a result, default rates increase, leading to loan losses and a credit crunch, where banks restrict lending, slowing economic activity.
- Moral Hazard → Borrowers Take Excessive Risks
Once loans are approved, borrowers may take on riskier projects than originally stated, knowing that lenders bear the losses if they fail.
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This is especially common in financial markets, where firms engage in reckless speculation (e.g., subprime lending or leveraged derivatives).
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If enough risky investments fail, financial institutions face liquidity crises, eroding market stability and leading to potential bank failures. - Hidden Information in Complex Financial Products → Market Instability
Banks and financial institutions may package risky assets (e.g., subprime mortgages) into complex securities (e.g., mortgage-backed securities) without fully disclosing their risks.
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Investors buy these securities based on misleading credit ratings, unaware of their actual exposure to risk.
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When defaults rise, investors panic, leading to fire sales, collapsing asset values, and financial contagion (as seen in the 2008 financial crisis).
What is adverse selection
when the most likely buyers of a financial product are not the buyers that the seller would prefer to sell to
how does asymmetric info lead to adverse selection and ultimately financial market failure
- Lenders or insurers, lacking complete information, may have difficulty accurately assessing the true risk of borrowers or applicants.
- those with higher risks (who know they have more risk) are more likely to seek loans or insurance because they benefit from not disclosing their full risk level.
- eg someone with a high risk lifestyle may purchase life or disability insurance as they know they will be more likely to collect on it - The presence of more high-risk individuals leads to higher default rates or claims, forcing lenders or insurers to increase prices or face losses. This inefficiency reduces the availability and affordability of financial products
how does commercial banks ignoring negative externalities lead to financial market failure
- eg - cost to taxpayers for bailouts, lost jobs,income,growth,savings
- : By focusing on short-term profits and ignoring potential negative outcomes, banks may engage in excessive-risk activities
- When risky practices lead to financial instability or crises, governments often intervene with bailouts or financial support to prevent widespread economic collapse.
- Taxpayers bear the cost of bailouts through higher taxes or reduced public services. Additionally, the broader economy suffers from reduced growth, lost jobs, and decreased income due to the financial crisis.
- The financial crisis triggered by risky banking practices leads to widespread job losses, reduced economic growth, and lower household savings as businesses and consumers cut back on spending.
what is market rigging
where banks/intermediaries/traders collude and manipulate markets(like forex) and make huge profits
how does market rigging lead to financial market failure
1️⃣ Collusion Between Market Participants → Artificial Price Manipulation
When firms or individuals collude (e.g., forming cartels, fixing prices, or insider trading), they manipulate the market to create artificially high or low prices for financial assets or goods.
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This distorts the supply and demand balance, as prices no longer reflect true market values or competitive forces.
2️⃣ Reduced Market Transparency → Misinformation and Inefficiency
Market rigging leads to reduced transparency in the market, as participants are intentionally misled about the true state of the market.
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Investors and consumers make decisions based on false or incomplete information, causing misallocation of resources and inefficient investment choices.
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This undermines market efficiency, as prices no longer signal true economic value or risk.
3️⃣ Loss of Investor Confidence → Market Instability and Reduced Investment
When investors become aware of market rigging or suspect manipulation, it destroys confidence in the fairness and integrity of the market.
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This leads to a mass exit of investors, as they seek safer markets, and investment flows shrink.
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The reduction in investment slows economic growth and reduces capital availability for businesses and innovation.
how did the big bang deregulations increase the risk of systemic risk - use of commercial bank funds for investment bank activities
1️⃣ Deregulation of the Banking Sector → Increased Risk-Taking by Banks
The Big Bang Deregulation of the 1980s in the UK removed many restrictions and allowed banks to engage in riskier activities.
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This deregulation gave commercial banks greater freedom to engage in investment banking activities, such as securities trading, mergers, and acquisitions, which were previously kept separate.
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Banks started using deposits (customer funds) for high-risk investments, rather than sticking to traditional lending, which created a conflict of interest and increased their exposure to market fluctuations.
2️⃣ Commercial Banks Diversifying into Riskier Markets → Increased Exposure to Volatility
As commercial banks began to diversify into investment banking, they took on more volatile assets such as derivatives, stock trading, and complex financial products.
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These investments had higher potential returns, but also much greater risk, especially during economic downturns or market crises.
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When market conditions turned unfavourable (such as the market crash of 1987 or during the financial crises), these risky ventures began to erode the financial stability of banks.
3️⃣ Loss of Depositor Confidence → Bank Runs and Liquidity Shortages
As banks exposed themselves to high-risk investments, their financial stability became more uncertain.
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When losses occurred, depositors feared the safety of their funds, and confidence in the banking system began to collapse.
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This led to bank runs, where a large number of depositors rushed to withdraw their funds simultaneously, putting further strain on the banks’ liquidity and increasing the risk of bank failure.
4️⃣ Mismanagement of Funds → Insolvency Risks
With banks using customer deposits to engage in speculative investment banking activities, they became overleveraged.
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If those investments did not yield expected returns or the market turned, banks were left with insufficient capital to cover their obligations.
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This increased insolvency risks, as banks could not meet the claims of their depositors or other creditors, leading to potential bank failure.
5️⃣ Systemic Risk and Contagion Effect → Collapse of the Banking System
As multiple commercial banks were involved in investment banking activities, the failure of one major institution had the potential to trigger a domino effect across the banking system.
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The interconnectedness between banks meant that the failure of one financial institution could lead to a broader loss of confidence in the entire financial system.
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This systemic risk could lead to widespread bank failures, especially if regulatory authorities could not step in quickly enough to contain the crisis, exacerbating the risk of a full-scale financial collapse.
why might a bank become insolvent
- bad loans or falling asset prices.
- ## Banks require a capital buffer to absorb unexpected losses, but excessive lending or risky investments can deplete these reserves.
Flashcard: Bank Run vs. Insolvency
Bank Run 🏃💰
What it is: A sudden, widespread withdrawal of deposits from a bank due to fears that the bank will fail.
Key Cause: Loss of confidence among depositors, even if the bank is fundamentally solvent.
Effect: If too many withdrawals happen at once, the bank may run out of liquid cash, leading to collapse.
Insolvency 📉⚠️
What it is: When a bank’s liabilities (debts) exceed its assets, meaning it is financially unable to meet its obligations.
Key Cause: Poor investments, excessive bad loans, or a decline in the value of assets.
Effect: Even if no bank run happens, an insolvent bank is at risk of long-term failure unless rescued or restructured.
💡 Key Difference: A bank run is caused by panic and liquidity issues, whereas insolvency is a deeper financial problem where the bank’s assets are worth less than its liabilities.
how does speculation lead to financial market failure
1️⃣ Excessive Speculation → Asset Price Inflation (Market Bubbles)
Investors and financial institutions speculate on rising asset prices (e.g., housing, stocks, commodities) rather than underlying economic fundamentals.
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This drives up demand artificially, causing asset prices to rise rapidly, beyond their intrinsic value (market bubble formation).
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As more investors follow the trend (herd behavior), speculation accelerates price inflation, creating a self-reinforcing cycle of overvaluation.
2️⃣ Misinformation & Herd Behavior → Misallocation of Capital
Speculators rely on short-term gains rather than productive investment in businesses or infrastructure.
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Financial institutions channel excessive credit into speculative activities rather than long-term economic growth sectors.
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This distorts capital allocation, leading to an economy that is overly dependent on unsustainable asset price growth.
3️⃣ Market Crash → Widespread Financial Losses & Panic Selling
When confidence fades or a small shock occurs, investors rush to sell their assets to avoid losses (bursting of the bubble).
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Prices plummet sharply, leaving many investors and institutions with huge losses and illiquid assets they cannot sell.
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Financial markets collapse as investors panic and withdraw from trading, leading to extreme market volatility.
4️⃣ Banking & Liquidity Crisis → Systemic Risk
If speculative bubbles were fueled by excessive borrowing, banks and financial institutions face huge bad debts when asset values collapse.
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Banks tighten credit, reducing lending to businesses and consumers, causing a liquidity crunch in the economy.
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This amplifies economic contractions, leading to business failures, rising unemployment, and falling consumer confidence.
what are market bubbles
when asset prices rise significantly above their fundamental values due to speculation and irrational exuberance
