Table Of Contents
What Is Banking Crisis?
A banking crisis occurs when a significant portion of a nation's financial institutions simultaneously face liquidity or solvency problems. This situation often arises due to an external shock or the failure of a central bank or a group of banks, leading to widespread losses in the banking system.
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During such a crisis, the affected country's economy typically enters a recession or downturn, and current account reversals occur. Financial sectors and companies may need help to fulfill their contractual obligations. Additionally, the crisis can have severe global repercussions, potentially leading to a worldwide depression if policy measures are ineffective.
Key Takeaways
- A banking crisis refers to an adverse situation where most of a nation's banks simultaneously encounter liquidity, solvency, and financial hardships due to an external shock or other failures.
- The first banking crisis in world history occurred during the Panic of 1819.
- Such a crisis negatively impacts both the local and global economy, eroding the trust and confidence of depositors, investors, and consumers.
- It also hinders the growth of small businesses that rely on bank loans.
Banking Crisis Explained
A banking crisis is an unfavorable condition that arises when most of a nation's banking institutions undergo financial difficulty, insolvency, or liquidity crunch within the same period. Such critical situations can occur due to the financial distress of a leading bank, turmoil among a group of banks in a significant economy, or an external shock. A banking crisis significantly impacts economic stability and growth, as the banking sector ensures the mobility of funds within the economy through borrowing and lending functions.
A banking system undergoing a crisis faces the following issues:
- Liquidity concerns: If banks break down, depositors lose confidence and withdraw their funds all at once. Banks would not be able to facilitate all these withdrawals since their assets couldn't be readily converted into cash, raising liquidity issues.
- Solvency issues: If banks have a large number of bad loans that cannot be recovered, their solvency position is compromised, and even financially stable banks could face bank runs in this condition.
However, the establishment of the Federal Deposit Insurance Corporation (FDIC) has significantly reduced the risk of loss to depositors in case of such a crisis by insuring bank deposit accounts up to $250,000. Additionally, central bank and government policies, regulations, and reforms ensure that these financial institutions behave responsibly and avoid taking excessive risks to sustain a stable financial system.
History
The first-ever banking crisis can be traced back to the 19th century when the Panic of 1819 shocked the U.S. economy. During this time, the Second Bank of the United States (SBUS) limited the credit it offered to state-chartered banks, leading to their collapse. Many depositors lost their money, which further led to more bank failures due to bank runs.
The Panic of 1837 saw 343 out of 850 U.S. banks shut down, and 62 banks became partially incompetent. This crisis was driven by significantly falling cotton prices, speculative lending practices in the western territories, and a land price bubble. Many customers lost all their savings during this period. The Panic of 1873 occurred when Jay Cooke & Company (JCC) declared bankruptcy in September 1873, leading to a series of bank failures and the onset of a major economic depression in the U.S. Railroad speculation was a prominent cause of this turmoil.
The Panic of 1907 resulted from a failed speculation attempt by F. Augustus Heinze and Charles W. Morse, who tried to profit from the speculative trading of United Copper. This led to multiple bank runs, including the failure of Knickerbocker Trust.
The Great Depression of 1929 marked the failure of approximately 9,000 banks during the 1930s. The U.S. economy witnessed massive bank runs, especially in the Southeast, which highlighted the need for proper insurance for bank deposits. Consequently, in 1933, the Federal Deposit Insurance Corporation (FDIC) was established.
The Savings and Loan Crisis of the 1980s-1990s was another significant banking failure, with over 1,000 savings and loan institutions failing by 1989.
The world experienced the Great Recession in 2008, during which more than 500 banks failed between 2008 and 2015. During the COVID-19 pandemic in 2020, the banking system faced hardships, and four banks in the U.S. collapsed. The most recent banking failures occurred in March 2023, which are discussed further in this article.
Causes
A local or global banking crisis can arise due to various factors in a dynamic and complex financial environment. Below are some of the major causes of such adversities:
- Unsustainable macroeconomic policies: Banks may become financially vulnerable due to unfeasible public debt or significant current account deficits.
- Balance sheet fragility: Weaknesses in banks' balance sheets, such as high levels of debt or insufficient capital, can lead to instability.
- Policy paralysis: When the government cannot pass critical reforms and policies for regulating the banking sector, it often results in a financial crisis.
- Large capital inflows: Excessive credit booms through dependence on substantial foreign capital can expose local banks to global banking crises.
- Limited diversification: Small banks that fail to diversify their lending portfolios are more exposed to economic fluctuations and default risk.
- Market competition: Intense competition in the banking sector can make small financial institutions less competitive compared to large, diversified banks.
- Inefficient risk management: Banks that lack proper corporate governance to manage various risks, such as credit, liquidity, market, default, and currency risks, may encounter difficulties.
- Regulatory and supervision constraints: Regulations that restrict banks' size and operations can interfere with their risk management capabilities.
- Historical factors: Traditional banking systems with limited finances and single-branch operations were often incapable of handling economic downturns.
- Weak monetary policies: Loopholes in the Federal Reserve's monetary policies can sometimes lead to financial instability.
- Excessive non-performing loans: Banks with a high volume of non-performing loans can face financial crunches and liquidity concerns.
- Low capital adequacy ratio (CAR): A small CAR, which serves as a safety net for the bank's weighted assets against various risks, can be a significant concern.
2023 United States Banking Crisis
In March 2023, the United States experienced a significant banking crisis with the collapse of three central banks: Silicon Valley Bank (SVB), First Republic Bank (FRB), and Signature Bank (SBNY). This incident sent shockwaves through the global financial system, marking the most significant failure of the U.S. banking sector since the 2008 collapse of Washington Mutual Bank. The primary cause of this crisis was a considerable outflow of deposits. Small banks were particularly vulnerable due to their exposure to commercial real estate, excessive uninsured deposits, and unrealized losses.
Silicon Valley Bank was the first to collapse, suffering a total loss of $1.8 billion and facing a $42 billion withdrawal request from its checking account customers. The bank could not meet these demands due to liquidity issues and long-term reserves' interest-rate risks. Signature Bank, which collapsed after SVB, was scrutinized for illicit activities and subsequently taken over by the FDIC. The last to fail was First Republic Bank, which had a high loan-to-deposit ratio. Despite a $30 billion rescue effort by central banks, FRB could not survive. In response, the Federal Reserve intervened to ensure the stability of the financial sector by providing emergency loans and reassurances.
Effect On Economy
A banking crisis can be temporary but may have some irreversible repercussions for economies at both local and global levels. Let's discuss these consequences in detail:
1. Local Level
- Nations experiencing a troubled banking system may face economic issues like recession or depression. The failure of small banking units in various parts or states can disrupt the provision of loans and advances to small businesses and consumers, hindering the growth of budding enterprises and adversely affecting the economy.
- The economy may experience current account reversals, and corporations and banks may face difficulties in repaying contracts.
- A loss of confidence in the economy may lead people to save more and spend less, slowing down overall economic activities.
- Investors may become cautious due to a declining stock market, leading many to withdraw their investments to avoid losses.
2. Global Level
- The banking crisis of 2008 demonstrated that adverse outcomes can spread to other economies worldwide due to financial globalization.
- Banks often have overseas branches and partners, so the failure of a banking system in a developed country or the turmoil of a leading bank engaged in international operations can cause economic instability across the globe.
- In the worst-case scenario, world economies may face a global recession or depression.