Why banks fail

When miscalculations occur in conjunction with a significant market movement, huge losses are possible. Inappropriate loans to bank insiders. In the s, many savings and loan banks made risky loans to directors and insiders for real estate and many other projects that were ill-conceived. These transactions resulted in huge losses and many bank failures. Rogue employees. Rogue traders who are unable to cover losses and bypass internal controls have brought down a number of financial institutions or set them back significantly.

The JPMorgan hedging debacle may turn out to have some of these same characteristics. Runs on banks. Depositors do not subject banks in the U. But, in other places like Europe , the risk still exists.

If depositors all demand their money, a bank will likely fail. Banks are temperamental and sensitive businesses because they operate with significant leverage. As a result, we could be on the precipice of another crash, one different from less in kind than in degree. This one could be worse. John Lawrence: Inside the financial crash. The financial crisis of was about home mortgages. Hundreds of billions of dollars in loans to home buyers were repackaged into securities called collateralized debt obligations, known as CDOs.

In theory, CDOs were intended to shift risk away from banks, which lend money to home buyers. In practice, the same banks that issued home loans also bet heavily on CDOs, often using complex techniques hidden from investors and regulators.

When the housing market took a hit, these banks were doubly affected. In late , banks began disclosing tens of billions of dollars of subprime-CDO losses. The next year, Lehman Brothers went under, taking the economy with it.

The federal government stepped in to rescue the other big banks and forestall a panic. The intervention worked—though its success did not seem assured at the time—and the system righted itself.

Of course, many Americans suffered as a result of the crash, losing homes, jobs, and wealth. Yet by March , the economy was on the upswing, and the longest bull market in history had begun. To prevent the next crisis, Congress in passed the Dodd-Frank Act. Under the new rules, banks were supposed to borrow less, make fewer long-shot bets, and be more transparent about their holdings. Congress also tried to reform the credit-rating agencies, which were widely blamed for enabling the meltdown by giving high marks to dubious CDOs, many of which were larded with subprime loans given to unqualified borrowers.

Over the course of the crisis, more than 13, CDO investments that were rated AAA—the highest possible rating—defaulted. After the housing crisis, subprime CDOs naturally fell out of favor. Demand shifted to a similar—and similarly risky—instrument, one that even has a similar name: the CLO, or collateralized loan obligation. A CLO walks and talks like a CDO, but in place of loans made to home buyers are loans made to businesses—specifically, troubled businesses. CLOs bundle together so-called leveraged loans, the subprime mortgages of the corporate world.

These are loans made to companies that have maxed out their borrowing and can no longer sell bonds directly to investors or qualify for a traditional bank loan. The majority are held in CLOs. The two securities are remarkably alike. The bottom layer is the riskiest, the top the safest. If just a few of the loans in a CLO default, the bottom layer will suffer a loss and the other layers will remain safe.

If the defaults increase, the bottom layer will lose even more, and the pain will start to work its way up the layers. The top layer, however, remains protected: It loses money only after the lower layers have been wiped out. Annie Lowrey: The small-business die-off is here. Just as easy mortgages fueled economic growth in the s, cheap corporate debt has done so in the past decade, and many companies have binged on it.

Check out the full table of contents and find your next story to read. Despite their obvious resemblance to the villain of the last crash, CLOs have been praised by Federal Reserve Chair Jerome Powell and Treasury Secretary Steven Mnuchin for moving the risk of leveraged loans outside the banking system. Like former Fed Chair Alan Greenspan, who downplayed the risks posed by subprime mortgages, Powell and Mnuchin have downplayed any trouble CLOs could pose for banks, arguing that the risk is contained within the CLOs themselves.

These sanguine views are hard to square with reality. A more complete picture is hard to come by, in part because banks have been inconsistent about reporting their CLO holdings.

From the September issue: Frank Partnoy on how index funds might be bad for the economy. I have a checking account and a home mortgage with Wells Fargo; I decided to see how heavily invested my bank is in CLOs. Issue Vol. ISSN: X. Make a Submission Make a Submission.

Apply market research to generate audience insights. Measure content performance. Develop and improve products. List of Partners vendors. A bank failure is the closing of an insolvent bank by a federal or state regulator. The comptroller of the currency has the power to close national banks; banking commissioners in the respective states close state-chartered banks.

Banks close when they are unable to meet their obligations to depositors and others. When a bank fails, the Federal Deposit Insurance Corporation FDIC covers the insured portion of a depositor's balance, including money market accounts. This could occur because the bank in question has become insolvent, or because it no longer has enough liquid assets to fulfill its payment obligations. This might happen because the bank loses too much on its investments.

When a bank fails, it may try to borrow money from other solvent banks in order to pay its depositors. If the failing bank cannot pay its depositors, a bank panic might ensue in which depositors run on the bank in an attempt to get their money back.

This can make the situation worse for the failing bank, by shrinking its liquid assets as depositors withdraw cash from the bank. When a bank fails, the FDIC takes the reins, and will either sell the failed bank to a more solvent bank, or take over the operation of the bank itself.