Bank Failures: The Roles of Solvency and Liquidity

2026-02-07

AI Summary

This study investigates the relative roles of liquidity crises and insolvency in bank failures to advance understanding of financial crisis origins and inform financial stability policy. Integrating historical case studies, regulatory post-mortem assessments, asset recovery data, and analysis of institutional responses—such as suspension of convertibility and interbank cooperation—the research systematically examines whether bank runs alone can precipitate the collapse of fundamentally sound institutions. The findings reveal that the vast majority of banks that failed amid runs were already insolvent; runs primarily accelerated rather than initiated their demise. This challenges the conventional view that fundamentally healthy banks can be driven into failure solely by panic-driven withdrawals, underscoring instead that deterioration in underlying fundamentals is the central driver of bank failure.

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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.

Problem

• bank failures
• solvency
• liquidity
• financial crises
• financial stability

Innovation

• bank failures
• solvency
• liquidity
• financial stability
• deposit insurance