bank failure logic chains

what are the causes of bank failure

• liquidity problems

• equity problems

explain how liquidity problems can lead to bank failure

• if banks do not have enough cash or liquid assets to cover liabilities this can lead to bank failure

• this can be caused by a bank run - sudden demand for liabilities for a bank

give the liquidity problem logic chain (4 bank failure)

• demand on a banks liabilities

• banks have already exchanged liquidity for profitability

• they do not have liquidity equal to liabilities

• not able to satisfy liabilities

• bank failure

what is a real world example of bank failure due to liquidity problems

northern rock

• during Great Recession due to fears about insolvency consumers wanted to withdraw deposits

explain how equity problems can lead to bank failure

• if banks do not have sufficient equity (assets - liabilities) they will fail

• this can happen due to Incorrectly valued assets or current assets loosing their value

give the equity problem logic chain

• economic downturn or recession

• assets are likely to loose value

• customers are unlikely to repay loans

• assets loose value

• assets are less than liabilities = insolvency

give a real world example of equity problems

• global financial crisis - assets based on mortgages to subprime borrowers lost value

• mini-budget/liz truss - giv bonds lost value and affected the equity of pension funds

what is the effect of bank failure for macroeconomic performance

• banks provide credit to consumers and firms - less C + l - less AD

• less consumer and business confidence

• banks are a large sector in the UK - bank failure = less output - more unemployment

• financial services are a source of comparative advantage - reduce X - affect balance of payments

how can bank failure be prevented

• imposing ratios

• stress tests

• gov bailouts in capital crises

what ratios can regulators impose

• liquidity ratio

• capital ratio

what is the liquidity ratio and how does it work

a minimum amount of liquid assets compared to liabilities

• means that banks have more access to liquidity to satisfy their liabilities, so liquidity problems are less likely to happen

why dont banks like the liquidity ratio

liquid assets are less profitable

what is the capital ratio and how does it work

a minimum amount of equity compared to loans issued

• banks can lose more value of their assets without being insolvent

why dont banks like the capital ratio

makes it harder for banks to expand through credit creation

define a bailout

where Govs bu shares in banks to provide them with equity.