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Bank Failures: The Roles of Solvency and Liquidity

Sergio Correia, Stephan Luck, Emil Verner

TL;DR

The paper argues that bank failures are predominantly driven by fundamental insolvency rather than illiquidity, with runs acting mainly as triggers for banks already weakened by poor asset quality and capital. A simple two-date theory links solvency thresholds $\theta^{Solvency}$ and liquidity thresholds $\theta^{Liquidity}$ to the likelihood of runs and failures, while interbank funding and depositor heterogeneity modulate these effects. Empirically, 160 years of US data show failures are predictably tied to deteriorating fundamentals, recoveries around $0.75$ of debt, and relatively few failures caused by runs on solvent banks, though runs played a role in pre‑FDIC episodes. The policy implications emphasize solvency maintenance and timely recapitalization alongside liquidity support, with deposit insurance and lender-of-last-resort tools shaping crisis dynamics but not fully substituting for prudent capitalization and governance.

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.

Bank Failures: The Roles of Solvency and Liquidity

TL;DR

The paper argues that bank failures are predominantly driven by fundamental insolvency rather than illiquidity, with runs acting mainly as triggers for banks already weakened by poor asset quality and capital. A simple two-date theory links solvency thresholds and liquidity thresholds to the likelihood of runs and failures, while interbank funding and depositor heterogeneity modulate these effects. Empirically, 160 years of US data show failures are predictably tied to deteriorating fundamentals, recoveries around of debt, and relatively few failures caused by runs on solvent banks, though runs played a role in pre‑FDIC episodes. The policy implications emphasize solvency maintenance and timely recapitalization alongside liquidity support, with deposit insurance and lender-of-last-resort tools shaping crisis dynamics but not fully substituting for prudent capitalization and governance.

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.
Paper Structure (17 sections, 1 equation, 2 figures, 1 table)

This paper contains 17 sections, 1 equation, 2 figures, 1 table.

Table of Contents

  1. Introduction
  2. Liquidity versus Solvency: Theory
  3. Fundamentals and Bank Failures
  4. Aggregate and Narrative Evidence
  5. Bank-level Evidence from Specific Episodes
  6. Broader Bank-Level Evidence on Fundamentals and Bank Failures
  7. Fundamentals in Failures With and Without Runs
  8. Weak Fundamentals and Bank Asset Booms
  9. Recovery Rates in Failure
  10. Expert Assessments of the Causes of Bank Failures
  11. Why Are Runs on Solvent Banks a Rare Cause of Failure?
  12. Runs and Bank Fundamentals
  13. Mechanisms for Resolving Runs and Depositor Heterogeneity
  14. Government Interventions
  15. Deposit Insurance and the Role of Runs versus Supervisory Closures
  16. ...and 2 more sections

Figures (2)

  • Figure 1: Bank Failures, With and Without Runs, 1863--2024
  • Figure 2: Failing Banks Exhibit Deteriorating Fundamentals Irrespective of a Run