Introduction and summary
Bank failures are widely viewed in all countries as more damaging to the economy than failures of other types of firms of similar size for a number of reasons. The failures may produce losses to depositors and other creditors, break long-standing bank-customer loan relationships, disrupt the payments system, and spill over in domino fashion to other banks, financial institutions and markets, and even to the macroeconomy (Kaufman, 1996). Thus, bank failures are viewed as more likely to involve contagion or systemic risk than are failures of other firms.
The risk of such actual or perceived damage is often a popular justification for explicit or implicit government-provided or -sponsored safety nets, including explicit deposit insurance and implicit government guarantees, such as "too big to fail" (TBTF), that may protect dejure uninsured depositors and possibly other bank stakeholders against some or all of the loss. (1) But even with such guarantees, bank failures still invoke widespread fear. In part, this reflects a concern that protected and/or unprotected depositors may not receive full and immediate access to their claims on the insolvent banks at the time that the institutions are legally declared insolvent and placed in receivership. (2) That is, they may suffer post-resolution losses in addition to any loss at the time of resolution. Unprotected depositors may be required to wait until the proceeds from the sale of the bank's assets are received. Protected depositors may also not be paid in full immediately if the insurance agency has no authority o r procedures for advancing payment before receipt of the sales proceeds, or if there is insufficient time to collect and process the necessary data on who are the insured depositors and how much is insured for each depositor. If depositors are not paid the full value of their claims immediately, some or all of the deposits are effectively temporarily "frozen." In the absence of an efficient secondary market for frozen deposits, both protected and unprotected depositors will experience losses in liquidity. Protected depositors will also experience present value losses if they are paid the par value of their claim after the date of resolution without interest. At the same time, the ability of the bank to conduct its normal lending business is greatly reduced. It is effectively partially or totally physically, as well as legally, closed. Indeed, a European bank analyst recently observed that
The issue is not so much the fear of a domino effect where the failure of a large bank would create the failure of many smaller ones; strict analysis of counterparty exposures has reduced substantially the risk of a domino effect. The fear is rather that the need to close a bank for several months to value its illiquid assets would freeze a large part of deposits and savings, causing a significant negative effect on national consumption (Dermine, 1996, p. 680).
That is, both the great fear of bank failures and the magnitude of any damage that such failures impose on other sectors of the economy are triggered as much if not more by losses in liquidity by both insured and uninsured deposits as by credit losses in the value of uninsured deposits. (3, 4)
The potential magnitude of losses to depositors and other stakeholders in bank failures is likely to affect both the supply of and demand for government guarantees to protect some or all bank stakeholders and to influence the resolution options available to a deposit insurer. The larger the potential losses in bank resolutions are perceived to be, the greater the demand for government guarantees by depositors and other stakeholders is likely to be and the more willing governments are likely to be to bow to such political pressures and supply the guarantees. Likewise, the larger the potential losses, the greater the probability that the accounts will be partially or totally frozen, the greater the potential harm to the macro-economy, and the more likely the government will supply the guarantees to minimize the potential damage. …