What Happens When a Bank Fails (And How You Can Protect Yourself Now)
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Summary:
When a bank fails and declares itself insolvent, it will usually be acquired by another bank, and its assets, including deposits, will be transferred. However, a bank could be declared insolvent with no options available. In this case, the bank will declare bankruptcy and only deposits up to $250,000 in aggregate will benefit from FDIC insurance.
A bank failing is one of the worst things that can happen to an economy, and multiple banks failing can be absolutely detrimental. If there is anything we have learned from the Great Depression, it’s that multiple bank runs can result in panic and the loss of an entire life’s savings. These days, although rare, bank failures still occur for a number of reasons. Anything from a lapse in management to a rise in yields for banks holding treasuries can cause failure. Most of the time, these banks are acquired and then go through a restructuring with the assets transferred to the new owner. However, for those banks that fail with no life raft, the FDIC will insure the money up to a certain limit. Here is what you need to know about what happens when a bank fails.
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What happens if my bank fails?
When banks fail, they are usually acquired by another bank, and the assets, such as your deposits, are transferred to that bank. If not, then the Federal Deposit Insurance Corporation (FDIC) will insure the money and pay you up to $250,000. If the money exceeds $250,000, then you can make a claim on the money, but there is no guarantee you will be paid.
Here is one scenario: The heads of a bank gather around a table to go over their numbers, mainly their assets and liabilities. A group decision is made that this bank must be declared insolvent and file for bankruptcy. This is the process the group will now go through.
Attempts to rectify the situation
The first order of business is to attempt to rectify the situation before there is any legal declaration of insolvency or bankruptcy. There are two ways to do this.
Restructuring
A bank might be able to restructure its existing balance sheet to continue to operate while paying down debt. This could include refinancing chunks of debt for a better interest rate or more forgiving payment terms.
Merger, acquisitions
A common way to avoid insolvency is to merge with a larger bank or become acquired. In this case, the assets and liabilities transfer to the new bank.
Declaration of insolvency
If a bank is able to rectify the situation, then it must declare itself insolvent. This declaration will be made to the relevant government and authorities, both local and foreign.
Court proceedings: Appointment of receiver (FDIC)
The bank will appoint a receiver to handle the bankruptcy proceedings — in most cases, the FDIC. They will determine asset liquidation and the seniority of the creditors to whom they owe money. Court dates and court appointments then need to be made with an accredited judge to oversee the proceedings.
Asset liquidation
Finally, the receiver will determine how to liquidate all assets available and use that to pay creditors. These creditors could be investors in the bank, or they could be depositors whose accounts exceeded the $250,000 threshold. The courts will determine who gets paid first, how much they will be paid, and how they will be paid.
What happens to accounts when a bank fails?
So the primary question people ask is what will happen to their cherished accounts if their bank fails. Remember that most of the time, big banks aren’t really allowed to fail, as in “too big to fail.” For those in a situation in which their bank does indeed fail, there are two options.
Aggregate account value < $250,000
If your aggregate account value is $250,000 or less, then the FDIC is legally obligated to reimburse you the full amount of money on your accounts. But what does “aggregate accounts” mean? It means your total account value is up to $250,000. For instance, if you had $20,000 in your savings account and $3,000 in a money market account, that is all covered.
Below are some examples of account types and financial instruments that are/are not covered by the FDIC.
| Accounts Protected by FDIC | Accounts Not Protected by FDIC |
|---|---|
| Checking | Stock or bond investments |
| Savings | Mutual funds |
| CDs (certificates of deposit) | Cryptocurrency |
| Money markets | Life insurance policies |
| Negotiable Order of Withdrawal (NOW) accounts | Annuities |
| Cashier’s checks, money orders, or any bank-issued check | Municipal securities |
| U.S. Treasury bills, bonds, or notes | |
| Safe deposit boxes |
Aggregate account value > $250,000
If your aggregate account value is over $250,000, then the FDIC does not insure all of the money exceeding $250,000. That doesn’t mean it’s lost forever. However, there are mechanisms that allow individuals seeking reimbursement to make claims. That being said, the best course of action might be to protect yourself before a bank fails. Some of the ways that can happen are:
Diversify banks
The FDIC rules are applicable per financial institution. If you have $500,000, and half is at Chase while half is at a different bank, then that money is still insured in full. The more banks you bank with, the more $250,000 insurance limits you have. Credit unions also have protections on deposit accounts, such as savings and checking accounts, but the National Credit Union Association (NCUA), not the FDIC, governs them.
Add beneficiaries
You can add beneficiaries to your accounts in order to achieve more than $250,000 coverage. For example, you can add your wife and children to the account (over age 18), and that will give you $1 million in coverage, even for the same financial institutions.
Find an alternative insurer
You can find an alternative insurer, such as the Depositor’s Insurance Fund, to ensure your money is above the $250,000 threshold that the FDIC stipulates. You will, of course, need to pay insurance premiums, just like you would any other type of insurance.
Do banks fail often?
Since the Great Depression, it’s been quite rare for banks to fail. That doesn’t mean it doesn’t happen, though. The Silicon Valley Bank and Signature Bank debacle is the most recent. Below are some of the largest bank failures in U.S. history. You might note that the majority of them came around the time of the 2008 financial crisis.
| Bank Name | Year of Failure | Assets at the Time of Failure |
|---|---|---|
| Bank of United States | 1931 | $200 million |
| Continental Illinois National Bank | 1984 | $40 billion |
| Washington Mutual | 2008 | $307 billion |
| IndyMac Bank | 2008 | $32 billion |
| Wachovia | 2008 | $812.4 billion (acquired by Wells Fargo) |
| Colonial Bank | 2009 | $25 billion |
| Silicon Valley Bank | 2023 | $211.8 billion |
Pro Tip
What did the SVB failure teach us? We spoke to Ron Geffner, an SEC legal expert and partner at Sadis & Goldberg, LLP in New York City. The SVB failure taught us that in today’s fast-paced and co-dependent business ecosystem, risk management is one of the top priorities for any business owner. One key lesson of the SVB failure is the importance of diversifying banking relationships. A depositor whose cash balance exceeds $250,000 should strongly consider depositing excess balances across multiple banks. Taking this one step further, borrowers should negotiate exclusivity clauses with lenders, which require the borrower to maintain assets in excess of $250,000 with the lending bank. Another lesson is to routinely and periodically review the financial health of your important partners and counterparties.
How banks fail
Many think that banks failing is a simple formula of lending more than they take in as deposits and those loans going bad. There are a number of different ways, however, that banks can fail.
Bad loans/credit risk
Bad loans and credit risk are the No. 1 reason that banks fail. This was evident during the 2008 mortgage crisis when banks faced failure due to a mountain of bad debt in the form of mortgages.
Insufficient capital
Banks need to maintain a healthy balance sheet with plenty of capital to both issue debt as well as meet their obligations. Furthermore, there is a federal regulation that imposes certain capital requirements for banks to uphold or face closure.
Liquidity issues
Even if a bank could theoretically meet its obligations, it might have problems with liquidity. Banks need liquid assets to meet withdrawal requirements; if they cannot, it could trigger a bank run. Remember, under fractional reserve banking rules, banks always lend out more money than they take in as deposits. A bank run caused by a liquidity crisis can cause a bank to collapse.
Interest rates
Banks borrow money from the federal reserve window and thus are susceptible to rising interest rates. Furthermore, some banks hold significant amounts of treasuries as assets, which lose value when interest rates rise. A case in point is Silicon Valley Bank, which held an unusual amount of treasuries. When a run of withdrawals caused the bank to have to convert treasuries to cover its obligations, those treasuries dropped in value.
Operational failure/mismanagement
Human failure, in the form of gross mismanagement, can cause a bank to collapse and become insolvent. This could be from stealing funds directly from the bank or just investing bank money in red herring investment schemes, in which the bank loses money.
Find a bank account you can trust
Before you open a new bank account, make sure you do your homework and compare the features of different accounts. You can start with our list of the best no-fee checking accounts.
What happens to loans when a bank fails
Many people are fixated on what happens to their savings and checking accounts when a bank fails, but what about the debt? Most people would probably trade in $50,000 in a checking account that is issued by the FDIC to have a $250,000 mortgage wiped away, right? Julia Mathers, an executive at Pasha Funding and expert on credit and business loans, says loans are always transferred. “If your bank fails, you will still owe the money on your loan, even if the bank is no longer there to collect it. The FDIC will try to find another bank to acquire the failed bank’s assets and liabilities, including your loan. If they are successful, your loan will be transferred to the new bank, and you will continue to make payments to them as usual.”
If your bank fails, you will still owe the money on your loan, even if the bank is no longer there to collect it. The FDIC will try to find another bank to acquire the failed bank's assets and liabilities, including your loan. - Julia MathersClick to Tweet
Alex Shekhtman, a mortgage broker with LBC Mortgage, agrees with this. “The mortgages the bank had are usually moved over to another bank. This switch is carefully managed by special groups that make sure things go smoothly so you don’t get bothered. Your loan terms and how you pay would stay just the same, but you’d be dealing with a different bank.”
Why is this? It’s because your loan to the bank is actually one of the bank’s ASSETS. Thus, even in the case of insolvency, your loan is an asset that will be actioned off to creditors.
FAQ
Can banks seize your money if the economy fails?
No, your money is safe as long as it is in an FDIC-insured bank. A failed economy doesn’t necessarily mean a failed bank. But the two can go hand in hand, so make sure you pay attention to the FDIC limit in order to protect your money.
How can I protect my money from a bank collapse?
If you hold an account at an FDIC-insured institution, then the government will guarantee up to $250,000. If you have FDIC-insured deposits, then no matter where they are held, the government will compensate you.
What happens if banks run out of money?
If a bank runs out of money, most of the time, it can borrow from the Federal Reserve’s discount window.
How much money is guaranteed if a bank fails?
The only insured money is $250,000. Unless you have an alternative financial institution that guarantees more or you pay for additional deposit insurance, you are only guaranteed up to $250,000 in case of a bank failure.
Key takeaways
- When a bank fails and declares itself insolvent, it will most likely be acquired by another bank and transfer its assets, including deposits.
- If a bank fails and there is no opportunity to rectify the situation, then the bank will become insolvent and go through bankruptcy proceedings.
- The FDIC insures up to $250,000 in total aggregate account value per financial institution. If all money is held in the same bank, this can be risky. It’s best to diversify banks or divide money among account holders.
- A bank can fail for many reasons, from bad loans to a rise in treasury yields brought on by the federal government.
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