- Key Insight: Though a liquidity crisis is usually the final catalyst, the true cause of almost all bank failures is insolvency, according to a new study.
- Supporting Data: There were more than 4,000 bank runs from 1863 to 1934, but those that happened at solvent lenders almost never caused a failure.
- Expert Quote: "The illiquidity is kind of a symptom, usually, of a deeper problem, which is that banks have losses on loans they've made, or on securities they hold," said Emil Verner, one of the study's co-authors.
When people think of a bank failure, they typically picture a crowd of anxious depositors demanding their money back. The bank doesn't have enough cash to pay everyone at once, so it collapses.
That scenario, a group of scholars says, is far from the whole story — in fact, it's not even the most important part. While a "run" is often the last thing that happens before a bank fails, it is almost never the root cause, according to
"The fundamental problem is not the illiquidity. The illiquidity is kind of a symptom, usually, of a deeper problem, which is that banks have losses on loans they've made, or on securities they hold," Emil Verner, a professor at the M.I.T. Sloan School of Management and one of the study's co-authors, told American Banker.
Verner co-wrote the paper with Sergio Correia, a senior economist at the Federal Reserve Bank of Richmond, and Stephan Luck, a research advisor at the Federal Reserve Bank of New York. The three scholars surveyed a wide range of studies, including some of their own, to examine bank failures and near-failures dating back to the Civil War.
One of those studies used large language models to pinpoint every bank run from 1863 to 1934. Of the more than 4,000 runs that occurred in that period, some were at strong, solvent banks. But those lenders almost never failed.
"What you see is that if the bank has strong fundamentals, it can usually weather the run," Verner said.
Kevin Stein, managing director of the consulting firm Klaros Group, said he largely agrees with the study's conclusion. "Strong banks don't generally fail when they have a liquidity crisis," he said.
But Stein emphasized that a run is still usually necessary to push a failing bank over the edge, saying that "in the most recent round of failures, it took both insolvency and the run."
One advantage of solvent banks, the study found, is that they can turn to others for help.
Historically, when certain banks experienced runs, other banks often knew the imperiled lender was on solid footing, so they were willing to lend to it. Wealthy customers sometimes offered support. And the bank's owners, rather than liquidating their business in a panic, would go to great lengths to demonstrate its strength.
"They'll put in more cash, and they'll try to do it in a kind of conspicuous way — putting cash in the windowsill," Verner said.
The study also cites more modern examples. In March 2023, Silicon Valley Bank collapsed amid a deposit run turbocharged by social media. The panic quickly spread to other regional banks, two of which also failed.
In the authors' view, it wasn't the runs that caused these failures, but the underlying insolvency that the runs exposed. Silicon Valley Bank, for example, was heavily invested in long-term Treasury bonds that were rapidly losing value as interest rates soared. By the end of 2022, the bank had
"Consistent with the historical evidence, the banks that failed in March 2023 had also suffered large asset losses, in this case on long-term securities holdings, pushing them toward insolvency," Verner and his co-authors wrote.
More solvent banks, on the other hand, were able to perform the modern-day equivalent of piling up cash in their windows.
When the panic spread to Phoenix-based
But Western Alliance executives knew the bank's capital position was strong, so they responded with transparency. On March 10, they issued a press release with up-to-date financial data, and bank managers called hundreds of corporate customers to drive the message home. Three days later, the bank wrote up its fastest 8-K ever, preparing it in just a few hours. Meanwhile, it successfully applied for an emergency cash infusion from the Federal Reserve — something a bank can do when its fundamentals are strong.
By the end of March 13, Western Alliance's stock was rising again, and customers appeared to calm down. In the end, the bank lost $6 billion of deposits in the first quarter of 2023, but gained them all back and then some. By the end of 2023, the bank had more deposits than it did at the start of the year.
Essentially, Western Alliance had faced a run — or at least the beginnings of one — but survived it by demonstrating its sound financials.
"They lost a tremendous amount of liquidity, but they were solvent," Stein said. "The assets exceeded the liabilities by enough that they were able to manage the liquidity."
What should banks and policymakers take away from these examples? In Verner's view, the biggest lesson is that in order to avoid future failures, banks and their regulators need to address the root issue. And that means the solution is not more liquidity, but more capital.
"If banks were required to finance themselves with more equity capital than they do now … that would be probably a good thing," Verner said. "If they start from a higher base, then there's just more cushion to absorb that."
As for the banks themselves, Stein said, vigorous risk management and careful lending decisions are key.
"Don't be a weak bank," Stein said.
