Bank Failures: The Roles of Solvency and Liquidity

TL;DR

This paper reviews evidence on bank failures, emphasizing that most failures are due to poor fundamentals like insolvency and asset quality, with runs often being a symptom rather than a cause, informing financial stability policies.

Contribution

It provides a comprehensive review distinguishing the roles of solvency and liquidity in bank failures, highlighting the primacy of fundamental issues over runs in causing failures.

Findings

Most failed banks had poor asset quality.

Runs mainly triggered failures of insolvent banks.

Strong banks rarely failed due to runs after policy changes.

Abstract

Bank failures can stem from runs on otherwise solvent banks or from losses that render banks insolvent, regardless of withdrawals. Disentangling the relative importance of liquidity and solvency in explaining bank failures is central to understanding financial crises and designing effective financial stability policies. This paper reviews evidence on the causes of bank failures. Bank failures -- both with and without runs -- are almost always related to poor fundamentals. Low recovery rates in failure suggest that most failed banks that experienced runs were likely fundamentally insolvent. Examiners' postmortem assessments also emphasize the primacy of poor asset quality and solvency problems. Before deposit insurance, runs commonly triggered the failure of insolvent banks. However, runs rarely caused the failure of strong banks, as such runs were typically resolved through other mechanisms, including interbank cooperation, equity injections, public signals of strength, or suspension of convertibility. We discuss the policy implications of these findings and outline directions for future research.