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Rotman Insights Hub | University of Toronto - Rotman School of Management

How a bank fails

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Susan Christoffersen

The banking crisis that toppled multiple financial institutions in recent weeks remains ongoing, and while the Canadian financial sector is well protected against the contagion, it is not entirely immune.

When Silvergate Capital, a lender that focused heavily on the crypto industry, announced it was shutting down operations on March 8th, it was broadly received as a standalone incident, and the result of being overly dependent on the now bankrupt crypto exchange FTX.

The sudden collapse of California-based Silicon Valley Bank (SVB) a couple of days later, however, marked the largest banking failure since the global financial crisis of 2008. A few days after that, Signature Bank suffered the same fate, becoming the third-largest bank failure in American history. Then came Credit Suisse, which was on the cusp of collapse when it was bought out by Swiss banking rival UBS on March 19th.

While the underlying circumstances can be varied and complex, at its simplest, a bank failure occurs when a financial institution is unable to fulfill its obligations to creditors and depositors, either due to insolvency or a liquidity crunch. And worryingly, a bank failure can spread particularly quickly in a digital era stoked by social media.

“We’re still in the middle of this,” says Susan Christoffersen, dean of the Rotman School of Management. “There’s a contagion problem that can happen when you have a banking crisis, and that’s the reason why you absolutely need regulators to do what they’re doing now.”

Christoffersen explains that when a bank faces unexpected liquidity pressures from depositors, it typically is forced to sell off its assets at heavily discounted prices. Realizing losses on financial products and selling at below market values, however, devalues similar assets held by rival banks. This in turn, can adversely affect the capital buffers and the confidence of depositors at otherwise healthy banks, placing them at risk of getting pulled down themselves. 

“This is why it’s so important for regulators to step in and not let banks like SVB sell off its assets at massive losses,” she says.

In the wake of the SVB failure, American regulators quickly rolled out emergency measures that put the bank under the control of the Federal Deposit Insurance Corporation (FDIC). The FDIC guaranteed depositors they would have access to all their funds, even though the organization only insures individual deposits up to USD $250,000. North of the border the Canada Deposit Insurance Corporation (CDIC) similarly insures deposits held at Canadian banks up to CAD $100,000.

“It seems that the interventions are certainly helping, but it creates nervousness,” Christoffersen says. “If I had an uninsured deposit, I might be anxious about whether or not this crisis might affect my bank since it is difficult to know in real time the quality of assets being held and the potential impacts of economic shocks. The speed at which money can move also adds a whole other level of uncertainty.”

Though regulators have taken steps to reduce their frequency and impact, bank failures are a reality, especially in periods of high inflation and rising interest rates.

Christoffersen explains that we need our banks to use the money we deposit into them in ways that boost the economy, such as handing out loans to new businesses or homebuyers. Doing so, however, leaves banks vulnerable to a sudden panic because the money is invested long term making it difficult to meet short-term liquidity demands should all customers want to pull their money out at the same time.  

In this case, SVB succumbed to pressure from both the liability side and the asset side. On the liability side, the bank was heavily dependent on depositors from a single industry, namely tech. Recessionary pressures and scarcity of alternative funding sources was leading its customers to be more reliant on the funds they had sitting in the bank.

“It also had an abnormally high rate of depositors who were not covered by the FDIC guarantee,” added Christoffersen. “[Clients] were much more wary of their bank’s financial difficulties, and were much faster to pull their cash out, since it wasn’t insured.”

On the asset side, the bank also invested a lot of its assets in low-interest, longer-term bonds. As interest rates went up the value of those bonds plummeted and eroded capital buffers.

Though the circumstances surrounding SVB’s collapse were unique, the banking sector relies on consumer confidence. And the high-profile banking failures dominating the news in recent weeks now put every bank at risk. That being said, Christoffersen argues that Canadian institutions are much less exposed. “Our banks fared very well during the [2008] financial crisis, and I think part of it is the different regulatory environment that we’re in,” she says.

For example, while the United States has a patchwork of state and federal regulators overseeing its financial sector, the Office of the Superintendent of Financial Institutions (OSFI) oversees all banks in Canada regardless of size or ownership structure. Furthermore, while there are more than 4,200 banks south of the border, there are just 81 banks operating on Canadian soil — only 34 of which are owned and operated domestically.

“Our banks are fewer, larger, and tend to have more diversified types of deposits. In addition, our regulations are more standardized; we have pretty robust capital requirements,” says Christoffersen. “That means the asset values can fluctuate pretty significantly without resulting in insolvency and affecting depositors.”

Canada’s largest banking failure occurred at the Home Bank of Canada in 1923. Since then, only two small regional banks — the Canadian Commercial Bank and Northland Bank — have gone under, both in September of 1985. (Both institutions were founded during the oil and gas boom of the mid-‘70s and invested heavily in energy-related real estate, only to have their loan portfolios deteriorate in the early ‘80s due to rising interest rates and downward pressure on the Canadian dollar.)  

“Canada has a pretty robust and healthy system — that’s the benefit of having larger and more diversified banks that can better manage risks,” says Christoffersen. “That doesn’t mean bank runs can’t happen here, but I’m not pulling my money out just yet.”

Susan Christoffersen is the dean at the Rotman School of Management, and the William A. Downe BMO chair, professor of finance.