Bank failures are not common, neither limited to specific countries. Bank failure can be disastrous for a country’s financial system as the cost of bank failure can be high and it causes instability. This instability in the financial system can then affect the nation’s growth rate and consequently, the central bank or the government intervenes to save the failing bank. The cost of saving the failing bank is high and difficult to organize, especially if there is a competitive market.
Bank failures are most common in countries that have deregulated or liberalized their financial market, however, they are also common where banks have made bad loans or they have high non-performing loans in the countries with highly regulated financial market
Thus, the question is why do banks fail?
Learnt from the experience of “The Great Depression”, that bank failure generally arose because of the depositors panic and this caused a run on the banks. Before we go further into the discussion of bank failure, it is important that we understand about ‘credit risk’ and ‘credit standard’. Credit risk is the risk that the borrower will fail to make the required payment to the bank i.e. default on a debt and credit standard is a set of the guideline issued by the company to see if the borrower is creditworthy.
Argued in this report is that in a competitive atmosphere under which the banks operate, it is not possible that the banks can secure their entire loan portfolio by credit standards and because of this, there is always an element of fragility within this sector. In past few years, this fragility has increased because of the intense competitive atmosphere and this caused banks to undermine the importance of the credit standard to maintain their market share or to increase it. This has exposed bank’s loan capital to high credit risk and it may have been the contributing factor to many bank failures in the past few decades.