It is a question that can be interpreted in a thousand different ways and answered in a thousand more. Banks, even in the digital era, hold an incomprehensible amount of power – because they hold an incredible amount of money. And so when a bank fails, there really are an untold number of events that can ensue.

Imagine waking up one day to the news that your hard-earned savings, money that you’ve been carefully setting aside for years thinking it all in safe hands, all end up at risk of disappearing, hell, it might not even be yours anymore. Or so you’d think at that moment anyway. Though it hasn’t always been the case, a large amount of funds held in individual accounts are nowadays backed by substantial guarantees. That is to say, even if your bank faces a crisis, you won’t be left with nothing. But that doesn’t mean there won’t be any problems. If a bank faces so many liquidation issues that it has to default, someone has to pay. Which leads us to the far more manageable, and arguably more relevant question – Who pays when banks fail?

Lets rewind.

In their day-to-day operation, banks don’t simply keep your money locked away in a vault. Instead, they lend it to others or use it to make their own investments. This is how they make their money. But they can go wrong, and when things go wrong, the bank will lose money, like you would if your investments went south. If things go very wrong on many fronts and a lot of money is being leveraged, a bank can become insolvent. 

This process will likely only become exacerbated when people and investor companies start pulling out their own money the second they hear bad news. This is where the term ‘bank run’ originated. Of course, a situation like this is unlikely and relatively rare nowadays, though it still happens (and a bit more frequently than we’d like). The US FDIC alone counts 565 bank failures in the past 23 years. Europe may expect to see less of these dramatic fallouts due to its robust Emergency Liquidity Assistance facility in place, but again, happens still.

And when it does happen, the options (simplified), are two, either the Investors bear the brunt, or the Public Taxpayer bears the brunt.

Traditionally, Public Funds would step in with an infamous ‘bailout’ mechanism. This intervention involves financial support meant to stabilise the bank, either by buying the ‘troubled’ assets, injecting fresh capital directly, or by providing a loan. But while this method may well serve its purpose, it does come with several drawbacks. Bailouts lead to a false sense of security among financial institutions – it encourages them to take on more risk, knowing that the public will be there to cover them if things go south. Indeed it can be seen and has been seen to aid and abet in the nascence of the ‘Too big to fail’ sentiment. This only increases the likelihood of future insolvencies, not to mention the clear drawback of having the burden falling on the taxpayer – shouldering the losses of private mismanagement. In some cases, the market distortions created by such a bailout can even end up giving the subject bank an unfair advantage over others operating under normal circumstances.

But the 2008 financial crisis marked a turning point. It highlighted the need for a new strategy to handle bank failures, especially in the European Union. The proposed departure from the bailout era then, was the creatively named ‘bail-in’ mechanism. This purports a strategy where the bank’s own assets are mobilised to stabilise the situation, which means that the event primarily impacts shareholders and unsecured creditors, NOT the public (again, your savings are generally secured to a certain amount, often reaching 100,000). The Bank Recovery and Resolution Directive laid the groundwork for this approach. The Single Resolution Mechanism Regulation then helped establish a unified approach to ensure effective bail-in procedures even for larger, widely cross-border banks. 

Of course, bail-ins, while addressing some of the gaping issues with the first method we discussed, do come with their own drawbacks. Implementing and subsequently supervising a bail-in is an incredibly complex operation that needs to manage liquidity, make swathes of critical calculations, prevent investor and public panic, and maintain market stability, all in one operation that spans hours or even days, but not much more. Nevertheless, the rationale remains one;

“The financial crisis has shown that there is a significant lack of adequate tools at Union Level to deal effectively with unsound or failing credit institutions and investment firms…Such tools are needed, in particular, to prevent insolvency, or, when insolvency occurs, to minimise negative repercussions by preserving the systematically important functions of the institution concerned. During the crisis, those challenges were a major factor that forced Member States to save institutions using Taxpayers’ money. The objective of a credible recovery and resolution framework is to obviate the need for such action to the greatest extent possible”

from “Directive 2014/59/EU of the European Parliament and of the Council”

And so, it is pretty clear that the answer to the question, ‘What happens when banks fail’ is currently undergoing a major shift, and one originating in Europe. Of course, it is yet to be seen whether this change will be contagious, but it nevertheless represents a conscious effort to start distributing risks more equitably, to come to a final form of the answer that guarantees both immediate stability and long-term sustainability.

The views expressed in this article are those of the author/s and do not necessarily represent a position or perspective of this or any organisation