What Happens When a Bank Fails?

Bank failures occur when a bank becomes insolvent, which means it cannot meet its financial obligations to its depositors and creditors. In the U.S., the Federal Deposit Insurance Corporation (FDIC) insures up to $250,000 of deposited money per person, per account ownership type. The National Credit Union Administration (NCUA) insures the same amount for deposits at credit unions.

Recent bank failures in the U.S. are relatively rare. According to the FDIC, 14 bank failures have occurred since 2018. In the event of a bank failure, the FDIC assumes control and can arrange for the sale of the failed bank to another bank or take over the failed bank’s operations.

A bank fails when it cannot meet its financial obligations to its depositors and creditors. Usually, in this scenario, the bank’s liabilities are greater than its assets, or it lacks liquidity to cover customer withdrawals. According to the FDIC, no depositor has lost any insured deposits since it was created in 1933.

When a bank fails, the FDIC or a state regulatory agency steps in to facilitate either a closure, sale or dissolution. In a bank closure, the bank is closed, and its assets are liquidated. The FDIC will then use the proceeds from the liquidation to pay depositors up to the insured amount. In a sale or dissolution, the failed bank is sold to another financial institution or its assets and liabilities are transferred to another entity. In this case, depositors typically continue to access their funds through the new institution.

In both scenarios, the goal of the FDIC is to protect the depositors and maintain confidence in the banking system.

Once a bank fails, the FDIC or relevant state regulator steps in to manage the orderly process of its closure.

Typically, the FDIC arranges for a financially stable bank to acquire the failed bank’s deposits and assets. This arrangement helps ensure that depositors can access their insured deposits, typically within a few days following the bank’s failure. In most cases, customers with deposits in the failed bank won’t notice much change in their banking experience and continue to have access to their funds. However, the FDIC only insures your deposits up to a certain limit.

Here are some situations where your funds held at a failed bank are not FDIC-insured:

If a large number of borrowers fail to repay their bank loans, the bank doesn’t receive the money it is owed. This leads to a decrease in the bank’s assets, and if these fall below the value of its liabilities, the bank can become insolvent. This happens when a bank makes poor lending decisions or takes on high-risk borrowers.

Another situation that leads to bank failure is when a bank takes too many risks on its own. If a bank makes high-risk investments and these investments lose money, the bank can suffer significant losses, leading to insolvency.

Market conditions can also lead to a bank’s failure. For instance, during an economic downturn, a bank may suffer large losses in its assets, making it difficult to cover its liabilities.

In terms of recent bank failures, there were five in 2023. Although these captured headlines, this number is relatively low compared to the 140 bank failures in 2009 during the financial crisis. So, what happened in 2023 that caused banks to fail?

Silicon Valley Bank (SVB), Signature Bank and First Republic Bank held many long-term bonds purchased when interest rates were low. As the Federal Reserve increased interest rates in 2022 and 2023, the value of these bonds decreased due to investors seeking higher returns on new bonds. As interest rates rose, depositors moved their money to higher-yielding investments outside banks.

This led to significant deposit outflows from SVB, Signature and First Republic as customers sought better returns. These outflows resulted in a liquidity crunch, leaving the banks with less cash to fulfill their obligations, leading to a bank run and insolvency.

Investment accounts, such as retirement accounts (IRAs and 401(k) plans) and brokerage accounts, are typically insured by the Securities Investor Protection Corporation (SIPC). The SIPC protects investors against losses up to $500,000 per account, including $250,000 for cash in the event of a brokerage firm’s failure.

Note that investment accounts are subject to market risk and market fluctuations, while traditional banking accounts are generally not subject to these risks. This means that you could lose money if the value of your investments declines, which SPIC insurance doesn’t protect.

Understanding what happens when your bank fails can help you stay informed and prepared. Here are some answers to common questions about the impacts of bank failures.