This Is How Banks Die
Banks Can Fail
Banks are an essential part of our modern economy. It’s hard to imagine life without banks.
They provide financial services to individuals, businesses, and governments. They are safe place to store your money, and a place to get credit when you need more than you have right now.
Some banks are the biggest and most stable businesses in the entire world. Some have a bigger income than the countries that they operate in, they seem so stable.
But, banks can and do collapse.
Even though they seem so essential and stable, like any business, banks are not immune to failure, and the collapse of a bank can have serious consequences for the broader economy.
‘Recently, many banks have found themselves in real trouble’
Recently, many banks have found themselves in real trouble, some have collapsed under the pressure. Banks are in trouble!
Let’s talk about why this is happening and look at some examples, like Lehman Brothers in 2008 and both Silicon Valley Bank, and Credit Suisse in 2023 to see how banks could die.
A Difficult Time For Banks
Banks are a safe place to keep your money.
When you have money that you want to save, it is not a great idea to hide it under the mattress. Much better to take those funds to a bank, and pay to keep that money safe (and to have it insured).
The banks, in turn, use that money to run their other business of investing and trading. They also use some of that money to give other people loans or credit. They charge interest and thereby make money.
Because banks no longer have to have gold on hand to match what they lend out, governments and regulators demand that they at least have some money on hand (and insurance). The amount they are allowed to lend out is closely linked to how much they have saved with them.
These days we all know, that it is hard to save. Very few people are able to save anything at all.
Banks also have a lot of competition these days, more and more digital banks are entering the market. This means the banks are fighting over a small group of clients.
Even giving people credit, which is very profitable for banks, is becoming harder. These days, the banks have to check that you can actually afford to repay the money you borrow. They also have to double check the information you give them when you apply for credit.
More than that, because so many people do not have jobs, they cannot really afford credit. Young people in particular are not getting work, thereby not qualifying for credit.
This results in banks having less money saved with them, fewer clients, and are making less profit due to fewer people qualifying for credit.
Banks are experiencing challenges that they have rarely seen before.
How Banks Make Money
You may wonder: How do banks make their money?
It’s complicated. At its core, they make money by charging for services like protecting your money, and charging people who want to borrow money (things like initiation fees and interest).
Banks also have shareholders who buy into their bank, and thereby have a small say in how the bank is run, and get a bit of the profit when the bank is doing well.
Investors may take on shares, or may invest in various types of bonds that the bank offers. This provides the bank with more money to use.
Let’s dive a little into the mysterious way banks work, and look at what they do and see how that can leave them exposed.
To start with let’s figure out what stocks and bonds are, and how securitisation works. Then let’s see how banks make money and how they can lose it.
Shareholders vs Bondholders: What’s the difference?
When you own a share (or shares) in a bank, you are a shareholder.
This means that you own a small piece of the bank, and you have a say in how the bank is run. You might get to vote on important decisions e.g. who sits on the bank’s board of directors.
Shareholders also have the potential to make money if the bank’s stock price goes up, because they can sell their shares for a higher price than they paid.
On the other hand, when you own a bond issued by a bank, you are a bond holder.
This means that you have lent money to the bank and the bank has promised to pay you back with interest.
Bonds are a type of loan that investors make to companies, governments or other organizations. The bondholder receives regular interest payments from the bank over a set period of time, and at the end of that period, the bank repays the initial amount of money that was borrowed.
The main difference between a shareholder and a bond holder is the type of ownership they have in the bank.
What Are Bonds?
No, not James Bond, the other bond.
Think of bonds like loans that people or companies take out. When you buy a bond, you’re essentially lending money to the person or company (or bank) that issued the bond. In return, they promises to pay you the amount you loaned them, plus interest over a certain period of time.
So, you lend them money now and you make a profit over time as they pay you back the loan amount with interest. It’s kind of how all credit works these days.
‘some bonds are considered riskier than others’
Now, some bonds are considered riskier than others. For example, if you’re lending money to a company that’s struggling financially, there’s a higher chance that they might not be able to pay you back. So, if you invest in that risky company’s bonds, you might demand a higher interest rate to compensate for that risk.
Similarly, bonds with longer maturities (the length of time until the bond matures and the issuer pays back the loan) also tend to be riskier, since there’s more time for something to go wrong. So, investors might demand a higher interest rate on those bonds too.
The price of a bond can vary depending on a few factors. For example, if interest rates in general are low, then investors might be willing to pay more for a bond that offers a higher interest rate. They want something that makes them more profit than just a boring savings account.
Conversely, if interest rates go up, the price of existing bonds with lower interest rates might go down. This means those investments can lose money.
So, to sum up: different bonds have different prices and risks because they represent loans to different borrowers with varying levels of financial health and different maturities. The returns on those bonds (the interest rates) reflect those risks, and can vary depending on market conditions.
Securitisation - what is it?
When you put your money in a bank, the bank uses that money to make loans and investments.
Sometimes, the bank might take some of the loans and investments they’ve made and package them together into something called a “security.”
A security is basically a bundle of loans or investments that are sold to other people or organizations in order to raise money.
For example, let’s say that a bank has made various home loans to clients. The bank might take a bunch of those loans and bundle them together into a security called a “mortgage-backed security.” Then they will sell shares of that security to investors.
When someone buys a share of a bank security, they become part-owner of that bundle of loans or investments. They’ll get paid a share of the money that’s made from those loans or investments, either in the form of interest payments or dividends.
‘a bundle of loans or investments that are sold to other people or organizations in order to raise money’
Bank securities are just bundles of loans or investments that banks sell to investors as a way to raise money that they then use for other investments or costs.
There have been many court cases about this topic and how securitisation impacts on who really owns consumer’s mortgages and who can collect on them when people miss payments. It can be somewhat mysterious and obscure.
Borrowing & Leveraging
You “need money to make money”, that’s how the saying goes.
One of the main reasons why banks collapse is because of their heavy reliance, these days, on borrowing money themselves, and then leveraging those funds to make money before they have to pay it back.
Banks do not have bank vaults full of gold, like in the old days. In modern times money is mostly 1’s and 0’s on a computer. In fact, you might even find that banks give people loans that are based almost totally on the promise of money that the client will eventually pay back. Still, banks are required to have at least some of the money they lend out or use.
‘Banks do not have bank vaults full of gold, like in the old days’
Banks borrow money from depositors (their savings clients) and other creditors and then in turn, they use that money to grant loans and investments. This process is known as leveraging, and it can amplify profits when things are going well.
However, it can also magnify losses when things turn sour. Since banks have borrowed money, they also have to pay it back. To do that they need to be making a profit or to borrow even more money (from the reserve bank or investors) to make payments.
We all know how hard it can be to repay debts to lots of different people.
Famous Banks That Have Collapsed | Lehman Brothers
Lehman Brothers is perhaps one of the most famous example of a bank collapse.
At the time, it was the 4th biggest bank in the USA. By 2008, the investment bank had made a lot of money by investing in different things like stocks, bonds, and mortgages, but they had taken on a lot of debt to do so.
‘At that time, a lot of people, too many perhaps, had been given loans to buy houses’
Unfortunately, some of the investments that Lehman Brothers had made were in the over-inflated US housing market. At that time, a lot of people, too many perhaps, had been given loans to buy houses, there was a false sense of euphoria in the market and many people were “flipping” house after house for a profit.
Lehman Brothers took over many of these mortgages, then those people realised they had too much debt and couldn’t afford to repay them. As sales began to slow, the problem got worse. As a result, a lot of houses went into foreclosure (then the property is repossessed). This caused the bank to end up with so many repossessed properties, and no one to buy them (because it had been over priced in the first place and because no one had any money to buy anything).
‘the value of those houses dropped suddenly, which meant that the investments Lehman Brothers had made in the housing market also lost value’
When that happened, the value of those houses dropped suddenly, which meant that the investments Lehman Brothers had made in the housing market also lost value. This was a big problem for Lehman Brothers, because now they owed more money than they had, and they couldn’t repay it.
As a result, the people and companies that had lent money to Lehman Brothers started worrying that they might not get their investments back. They started to pull their money out of the firm, which made it even harder for Lehman Brothers to pay off their debts. Eventually, the firm had to file for bankruptcy.
That triggering a global financial crisis among banks and other investment firms that had all done the same, it was chaos!
We are still feeling the effects decades later.
Image credit: David Shankbone
Some Famous Banks That Have Collapsed | Saamfou
Saambou Bank, was a local South African bank founded in 1942.
In 1970 it merged with Nasionale Bouvereniging. They went public in 1987 and traded under the name Saambou Bank.
Saambou Bank was eventually the 6th biggest bank in SA, and focused on personal loans and mortgages to individuals. The bank experienced financial difficulties in the early 2000s, and ultimately filed for bankruptcy in 2002.
‘Saambou Bank was eventually the 6th biggest bank in SA’
One of the reasons Saambou Bank experienced financial difficulties was because they lent money to high risk customers (kind of how African Bank did). This meant that the bank charged higher interest rates to compensate for the risk, which made their loans more expensive than those of their competitors.
Like Lehman Brothers, who would fall not too long after, the bank invested heavily in property and suffered losses when the local property market went down. As a result, the bank didn’t have enough cash to repay their debts.
The bank went into bankruptcy in 2002 after newspaper articles appeared about it being bankrupt and customers withdrew R1 billion in just two days. Trading stopped and eventually First National Bank took over some of its business.
Fortunately, many smaller clients eventually got some of their savings out of the bank but the bank itself was done and was liquidated in 2006.
A dividend of 4.53 cents per share, was paid out to shareholders (the share had traded at R2 per share before the bankruptcy).
Some Famous Banks That Have Collapsed | Silicon Valley Bank
Another example of a bank that suddenly got into trouble is Silicon Valley Bank.
They specialised in investing in and assisting tech companies. In 2023, the bank was hit hard by a series of high-profile tech company failures.
Many of those companies dealt in cryptocurrency. When the value of crypto fell suddenly towards the end of the pandemic, so did the value of those businesses. As their values dropped, people stopped investing in them, and those firms could not pay back what they owed the bank or to save money in the bank like they had in the past.
As a result, SVB suffered significant losses on its loans to these companies.
Once people heard the bank wasn’t making as much profit, they began to quickly withdraw savings and investments in the bank, and this made other investors and clients nervous, the result was a “run on the bank”.
Some Famous Banks That Have Collapsed | Credit Suisse
When you were young, you probably heard of spies or criminals who banked in Switzerland. It was long considered the safest place to bank on the planet.
One of the 30 most stable banks in the work was based in Switzerland for the last 160 years and was called Credit Suisse.
What happened to Credit Suisse is very interesting, the bank had been having issues in the background, and was exposed to some financial losses due to bad deals and investments in the UK and USA. They had also been issued big fines and recently many clients had been withdrawing funds (for a variety of reasons). This meant the bank had to ask one of its newest investors for more money. When they said no, things came to a head.
‘the bank had lots of assets and plenty money in the vaults’
Even though the bank had lots of assets and plenty money in the vaults, the market was very nervous after the demise of two big American banks (one of them being Silicone Valley Bank) and reacted with panic. This sent the bank’s shares into freefall, losing 30% value in one day.
That huge and sudden drop made investors and other clients panic even more! Eventually, the Swiss banking regulators had to get involved and brokered a big deal to get another bigger bank to buy them.
The buy-out deal had some unusual decisions that have made certain types of bond holders worldwide very angry and others very nervous.
That chaos is still going on.
What is A Run on the Bank?
When news gets out that a bank’s share prices are dropping, or that some of their investment plans are not working out as expected, this can make their clients begin to panic, causing what is known as a run on the bank.
A “run on the bank” happens when many people all start to worry that a bank might not have enough money to give back to all of its customers. They try to withdraw all of their money at the same time, which can cause big problems for the bank.
Often the situation will snowball from just a few nervous clients, then a few more, then more and more as the panic spreads.
‘When too many people try to take out their money all at once, it can cause the bank to run out of cash’
When too many people try to take out their money all at once, it can cause the bank to run out of cash.
That’s because banks usually keep only a small amount of their customers’ money on hand, and loan out the rest to other people or invest it in different ways. If too many people try to take their money at once, the bank might not be able to get enough cash in fast enough to return it to everyone.
This can be a big problem because it can cause a bank to go bankrupt. If a bank runs out of money, it really can’t pay back all of its customers, and that can lead to a chain reaction of financial problems for everyone involved. No wonder people panic.
As Safe as a Swiss Bank
Recent years have shown that, like any business, banks can fail.
Bankers are some of the smartest people in dealing with money and investing money but even they are effected by what is happening around the world. The world is an unstable and complicated place.
If someone in China gets flu, it can cause the world to go into lockdown for years. We now have massive and destructive storms and weird fire tornadoes and that’s before you consider the impact of wars and climate migration.
Things like the creation of cryptocurrency and even digital banking have had massive impacts on traditional banking and the profits banks can make.
A shrinking base of new clients, new investors and a drought of people with money to deposit is putting banks under pressure. When government agencies like the US Fed or SA Reserve Bank put up the Repo Rate, this makes it even more expensive for banks to borrow money or make money on existing investments.
Even the failure of other banks like SVB or Credit Suisse or when bond holders don’t get paid out when things go wrong means that it influence other banks to borrow money or insure their money. That in turn puts all banks under strain, and makes it harder for them to make a profit.
Banks Can Die
Banks need our money to make money.
They have investors who give them money, but only if the bank will make them a good return on their investment. Global markets and global conditions are hard to predict, thereby making consistent profit from investments almost impossible. These days, investors are fickle and only want the most profitable investments.
Investing has always been volatile and with the increases in government regulation and the incredible speed of communication, it is harder and harder to hide even the smallest financial difficulties and it has become harder to keep investors calm.
‘The picture of the banks being too big to fail has truly been shattered’
These days fickle, nervous, demanding investors and easily panicked clients can quickly withdraw their support and their cash in just minutes. Runs on the bank are becoming more common.
The picture of the banks being too big to fail has truly been shattered. We now live in the time when banks can easily die.