What it means
Banks fail for two related reasons: insolvency and illiquidity. Insolvency means the assets are worth less than what is owed, typically after heavy loan losses or a sharp fall in the value of bonds the bank holds.
Illiquidity means the bank still owns valuable assets but cannot turn them into cash fast enough to pay depositors who want out. The two problems feed each other.
A rumour of losses prompts withdrawals, withdrawals force the bank to sell assets at poor prices, and those forced sales confirm the losses that started the panic. Modern payment systems make this cycle far quicker than it once was, because money can now leave in minutes rather than in queues.
For a business, the exposure is not theoretical. Operating cash, a payroll run about to leave, and undrawn facilities all sit with one named institution.
If that institution is taken into resolution on a Friday evening, access to accounts can be restricted while a buyer or a pay-out is arranged. Resolution usually takes one of three forms: a sale of the whole bank to a healthier buyer, a purchase of the good assets with the remainder left in a receivership, or a straightforward pay-out of insured deposits.
Buyers frequently assume all deposits rather than just the insured ones, which is why many failures end with customers barely noticing. Sensible defence is dull and effective.
Know which banks hold your cash, keep balances near or below the insurance limit where you practically can, and maintain a second operating account at another institution so that payroll can still run.
In practice
Real-world examples.
Example
A software startup that has just raised $4,000,000 keeps the entire amount at one bank because that is where the account was opened. When the bank is placed into resolution, the founders spend a weekend working out whether Monday's payroll will clear.
Example
A family engineering business runs its payroll from an account at a small regional lender. After watching a competitor struggle to pay staff during a bank closure elsewhere, it opens a second account and keeps one month of wages there permanently.
Example
An estate agency holds client money on behalf of buyers and sellers. Its professional rules require the funds to be spread across institutions and reconciled daily, precisely so that one bank failure cannot wipe out other people's deposits.
Formula
Calculation
Uninsured exposure = deposit balance - insured amount, where the insured amount is the lower of the balance and the deposit insurance limit per depositor per bank.
A company holds $780,000 with a single bank in a country where deposit insurance covers $250,000 per depositor per bank. The insured amount is $250,000, so uninsured exposure is $780,000 - $250,000 = $530,000. If the receiver eventually returns 70 cents in the dollar on uninsured balances, the recovery is $530,000 x 70% = $371,000 and the permanent loss is $530,000 - $371,000 = $159,000. Splitting the same $780,000 evenly across four banks would give $195,000 at each, every dollar inside the limit and nothing at risk.Case study
Seen in the real world.
Cordell Analytics is a fictional company invented for this illustration. It held $2,600,000 of investor money in a single account and had no written policy on where cash should sit, because the finance function had grown up around one relationship manager who was easy to deal with.
When press coverage suggested its bank was under pressure, the board asked a simple question that nobody could answer quickly: how much of our money is actually protected? The answer was $250,000 out of $2,600,000. Within a fortnight the company had opened accounts at two further institutions, moved to a treasury arrangement that spread balances automatically, and written a one-page policy setting a maximum balance per bank.
The illustrative moral is that the cost of preparing was a few days of administration, while the cost of not preparing would have been measured in weeks of frozen cash at the worst possible moment.
Watch out
Common mistakes.
- Believing that a large, well-known bank cannot fail. Size reduces the odds and usually improves the resolution outcome, but it does not remove the risk of restricted access while a rescue is arranged.
- Assuming deposit insurance covers each account. The limit generally applies per depositor per institution, so three accounts at the same bank share a single limit.
- Forgetting that a loan does not disappear when the lender fails. Borrowings are assets of the failed bank and are transferred to a buyer or a receiver, who will still expect payment on schedule.
Questions
People also ask.
What happens to my money the day a bank fails?
Insured balances are typically available within days, either at a purchasing bank or through a direct pay-out, while uninsured balances wait on the outcome of the resolution.
Does deposit insurance cover business accounts?
In most systems yes, on the same per-depositor basis as personal accounts, though the treatment of client money and trust accounts varies and is worth checking.
How can a company reduce the risk cheaply?
Split operating balances across at least two institutions, keep one month of payroll at the second bank, and review balances against the insurance limit as part of the monthly close.
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