Understanding Bank Failures: Definition, Causes, and Impacts

What Is a Bank Failure?

A bank failure occurs when regulators shut down a bank because it can no longer meet its obligations due to insolvency, often triggered by sharp declines in asset values or liquidity issues. Federal and state authorities can close troubled banks, and insured deposits are protected up to $250,000 per depositor at banks through the FDIC and credit unions via the NCUA.

High-profile failures like Washington Mutual and Silicon Valley Bank illustrate the risks, but modern safeguards and regulatory oversight are designed to limit failures' impact and protect consumers.

Insights into Bank Failures

A bank fails when it can’t meet its financial obligations to creditors and depositors. This could occur because the bank has become insolvent or no longer has enough liquid assets to fulfill its payment obligations.

Bank failures often happen when a bank’s assets are worth less than its liabilities due to significant investment losses. It’s not always possible to predict when a bank will fail.

Consequences and Processes of a Bank Failure

When a bank fails, it might borrow from solvent banks to pay depositors. If it can't, this may lead to a bank panic, causing a bank run, where depositors withdraw their money. This can make the situation worse for the failing bank by shrinking its liquid assets. When a bank's assets decrease, it has less money to lend to borrowers.

Since the FDIC's creation, the U.S. government insures deposits up to $250,000 per bank per person. If a bank fails, the FDIC either sells it to a solvent bank or takes over its operations..

In many cases, depositors who have money in the failed bank will experience no change in their experience of using the bank. They’ll still have access to their money and should be able to use their debit cards and checks like normal.

Notable Cases of Bank Failures

During the 2008 financial crisis, the biggest bank failure in U.S. history occurred with the closure of Washington Mutual (WaMu), which had $307 billion in assets. Washington Mutual struggled for several reasons, including a poor housing market and a run on deposits. JP Morgan Chase eventually bought WaMu for $1.9 billion. JP Morgan Chase took on another failed bank in May 2023 when the FDIC sold it First Republic Bank.

The second-largest bank failure in the U.S. was the closure of Silicon Valley Bank in 2023 after a bank run in which customers had withdrawn $42 billion within 48 hours (the bank had $209 billion in assets in December 2022).

Bank failures were common leading up to and during the Great Depression when thousands of banks failed. By the time the FDIC was created in 1933, American depositors had lost a substantial amount of money due to bank failures. Without federal deposit insurance protecting these deposits, they had no way of getting their money back.

How Bank Failures Are Prevented and Managed

The Federal Reserve now usually requires banks to keep a certain amount of cash reserves on hand to try to reduce the risk of failure. The reserve amount is a portion of the deposits it holds. Typically a bank must hold over 10% of its liabilities in cash reserves, but this requirement was suspended in 2020 amid the COVID-19 pandemic and was not reinstated for 2024.

To better protect yourself against losing money if a bank fails, consider keeping only up to the FDIC- or NCUA-insured limit, or $250,000, in one bank or credit union. If you need to deposit more funds, you can open another account at a different bank for the same FDIC protection.

Financial institutions called bad banks can also help protect failing banks. Bad banks will buy the illiquid assets and bad loans from the failing entity.

The Bottom Line

Although bank failures are far less frequent than in the pre-Depression era, they still happen when institutions become insolvent or face sudden runs on deposits, despite reserve requirements and federal insurance protections.

The FDIC and NCUA insure deposits up to $250,000, offering significant but not unlimited protection. Because regulations can't eliminate risk entirely, it's wise to monitor your bank's stability, spread deposits across institutions if needed to remain fully insured, and consult a financial advisor for tailored strategies to safeguard your funds.