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How does a banking crisis come about?

Mann der sich verzweifelt gegen das Fenster lehnt
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What happens when a borrower or debtor goes bankrupt? The banking crisis.

 

 

 

 

The banking business involves a number of unavoidable risks. When debtors are unable to pay back their loans, for example, the bank has to absorb losses. This is called credit risk. But it is not the only risk which a bank has to take into account. Events on the financial markets, such as fluctuations in interest rate levels, may also adversely affect a bank’s business, and the bank may sustain substantial losses as a result.

Credit risk

It is in the nature of a bank’s business – part of its business model – to grant many loans. Therefore, the risk of non-repayment of these loans is an important factor. If debtors do not repay on time, they are said to default on their due payments, and the loans become non-performing loans, or NPLs for short. When a bank has too many NPLs on its books, it may in turn become unable to meet its payment obligations to savings account holders and others who lend the bank money.

Bank run

News or even rumours that a bank is in trouble or insolvent may cause a “bank run” as account holders scramble to withdraw their money. This reinforces the bank’s problems: as many of its account holders (savers and others) take out their deposits, the bank may quickly run out of cash because most of its funds are invested in long-term credits. In the event of a sustained bank run, the bank may be driven into bankruptcy. However, bank runs do not happen out of the blue. In most cases, they start with a bank’s getting into serious financial problems which are then exacerbated by the bank run.

Effects of a bankruptcy

Because banks play such a pivotal role in our economic system, the failure of even just one bank triggers far-reaching effects. Savers and other account holders lose money, and businesses can no longer get credit. Moreover, other banks may get into serious trouble as well. Because banks lend money to each other, one bank’s bankruptcy always has a knock-on effect on others.

The economy contracts

When a financial crisis hits, many banks reduce the number and size of the loans they grant. As a consequence of this so-called “credit crunch”, companies have less money for investments; production of goods and services shrinks, jobs are lost, and consumers spend less. Overall, economic growth slows down, and a so-called recession sets in.

Deposit guarantee schemes

To protect the large number of small savings accounts in case of a bankruptcy, most countries have instituted so-called deposit guarantees. In Austria, deposits of up to 100,000 euros are covered by a deposit guarantee. Should the bank be unable to pay out the amount due, the government has to step in and assume the liability.

FAQ

This creates what is known as a credit risk for the bank. If many loans default, this can cause financial difficulties for the bank.
A bank run occurs when many people want to withdraw their money at the same time – usually out of fear that the bank will go bust. This can exacerbate the situation.
Companies can no longer obtain loans, investments decline, jobs are cut – a recession may ensue.
In Austria, deposits of up to €100,000 per person and bank are protected by law. If this is not enough, the state steps in.
Because banks lend each other money. If one bank fails, this can trigger a chain reaction and drag other institutions down with it.

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