Banks are the backbone of each economy but are extremely prone to falling under financial stress for a myriad of intrinsic and extrinsic reasons. Banks come under financial stress, which will cause liquidity crises, regulatory fines, and decreased ability to lend, which in turn will have some effect on consumers as well as business firms.
Policymakers, financial experts, and the public at large need to understand why banks are bound to be under financial pressure in an effort to ensure financial system stability. Below are some of the primary reasons banks usually fall under financial pressure, economic implications, real-life instances of bank failure, and measures to avoid such events.
What banks usually fall under financial pressure due to:
Financial distress in banks is a situation in which banks cannot pay their financial debts, stay in the black, or achieve operating stability. It can be caused by various factors like shortages of liquidity, nonperforming loans (NPLs), regulatory body fines, and economic depression.
Indications that a bank is financially distressed are:
- Liquidity problems – Inability to sell assets for cash.
- Excessive nonperforming loans (NPLs) – Too many nonpaying customers.
- Regulatory sanctions – Penalty and fine for failure.
- Declining share prices – Investor loss of confidence.
If these warnings continue, banks will be bankrupt, need to be bailed out by the government, or even collapse, with very adverse economic impacts on the masses in general.
Banks generally fall into financial trouble due to:
Credit Risk Mismanagement
Pressure on banks’ finances is generally the consequence of poor credit risk management. The bank exposes itself to higher levels of defaulting when it gives loans without sufficient risk analysis. When over half the borrowers fail to repay loans, the banking balance is ruined.
Economic Slumps and Recession
Banks are also adversely affected because of economic slumps and recession. When there are economic slumps:
- Companies find it hard to earn, and thus, loans get defaulted more.
- Consumer expenditure reduces, thus slowing demand for fresh loans.
- As a greater rate of job loss is felt, repayment of loans becomes tougher for people.
- Recessions lead to a vicious circle: the more defaults, the more financially strained banks become and the less lending they can do, further tightening the economy.
High Risks of Taking Speculative Investments
All the central banks invest in high-risk activities such as real estate speculation, speculative business in the stock exchanges, or dealing in derivatives. While such investments can bring humongous returns, they can trigger humongous losses when markets meltdown.
Lehman Brothers, for example, collapsed in 2008 due to its excessive investment in subprime mortgage-backed securities, and one of the worst financial crisis in world history was the result.
Poor Liquidity Management
Liquidity refers to the convenience of a bank to accept money at any given time when needed. Banks cannot fulfill short-term financial obligations if such are not efficiently managed with respect to liquidity.
Pressure on liquidity is created due to:
- Sudden large-scale withdrawal by the depositors (bank runs).
- Lack of adequate cash balances to honor obligation.
Asset-liability mismatch
The banks invest long-term but are forced to mobilize funds short-term. Banks without a liquidity buffer risk insolvency.
Regulatory and Compliance Failures
Banks are under stringent regulatory criteria for financial health. Banks are involved in criminality, money laundering, or poor capital, so open to regulators’ action.
Non-compliance may lead to:
- Harsh sanctions and penalties.
- Revocation of bank licenses or suspension.
- Reputation loss, leading to customer confidence loss.
Interest Rate Volatility
Interest rate volatility is a key determinant of the financial health of a bank. Movement of interest rates fluctuation can:
Change the ability to repay loans since lending would not be reimbursed at a greater expense.
Develop assetliability mismatch, loss on banks’ investments in an uncertain rate environment.
Boost Nonperforming Loans (NPLs)
When lenders do not reimburse their loans, the banks are left with nonperforming loans (NPLs), which are harmful to their balance sheet. A higher NPL ratio signifies financial stress, which forces banks to:
- Invest more in low-quality debt.
- Reduce new lending and thus reduce profitability.
- Become vulnerable to bankruptcy on intolerable loan loss.
How Bank Financial Stress Impacts the Economy
Credit-starved banks lengthen loan maturities, and corporations and individuals cannot borrow. This will slow economic growth and increase unemployment.
Bank Runs and Consumer Loss of Confidence
The depositors lose trust in a bank and make large withdrawals of deposits, and it leads to bank runs. It accelerates the bankruptcy of a bank and leads to financial panic.
Systemic Risk
Bank failure has a snowball effect, and that sets off financial crises. The failure of Lehman Brothers in 2008 rattled financial markets across the globe.
Government Bailouts and Taxpayer Spending
Government bailouts as a policy of prevention of banks’ failure do not come without a cost to taxpayers. Bailouts put debt on a country and even invoke debtor’s revenge on citizens.
Examples of Bank Failures Resulting in Financial Crises
The 2008 Financial Crisis
Lehman Brothers’ failure was due to excessive subprime mortgage lending and investment risk. To prevent total financial collapse, the US government had to intervene and bail out some of the banks, including Bank of America and Citigroup.
Recent Collapse
Silicon Valley Bank (2023) – Failed due to inadequate risk controls and inadequate liquidity management.
Credit Suisse (2023) – Was on the verge of serious financial hardship because of investment blunders and scandals, leading to a government-supported takeover by UBS.
Government Responses
Governments, in response to past banking crises, have:
- Conducted stress tests to test banks’ strength.
- Raised capital buffer requirements to prevent future collapse.
- Enhanced regulation to prevent high-risk bank practices.
- Prevention of Financial Stress in Banks
Better Risk Management
Banks must use sound models of risk in assessing loan applicants and investment opportunities.
Capital and Liquidity Reserves
Regulatory making rules oblige banks to maintain sufficient capital and cash reserves to enable them to withstand financial shocks.
Stress Testing and Scenario Planning
Periodic stress tests allow banks to prepare themselves in advance for economic downturns and financial crises.
Regulatory Oversight
Regulators keep a close watch on banks as part of an attempt to eschew risk-taking and supervise financial regulation.
Asset Diversification
Banks must diversify their investment portfolio such that they diversify risk without taking positions in risk markets.
Conclusion
Banks plunge into financial distress by way of poor risk management, economic downturn, liquidity crises, and regulatory exposures. These bring lending instability and bank failures and affect the economy at a world level. But by ensuring risk management through prudent means, adhering to regulations, and undergoing stress tests, banks are capable of building immunity against financial distress. Bank stability is essential to economic progress, and it is an exigency on that account which requires policymakers, regulators, and banking institutions to perform proactive tasks on risk curtailment.
