However, suppose that more and more of the banks’ borrowers either tell the bank that they are no longer able to repay their loans, or simply fail to pay on time for a number of months. Initially this is not a problem – the bank can absorb loan defaults up to the value of its shareholder equity without depositors suffering any losses (although the shareholders will lose the value of their equity). Step 2: Some of the customers the bank has granted loans to default on their loans. In the situation shown above, the shareholder equity is positive, and the bank is solvent (its assets are greater than its liabilities). In other words:Īssets – Liabilities = Shareholder Equity. It can be calculated by asking, “If we sold all the assets of the bank, and used the proceeds to pay off all the liabilities, what would be left over for the shareholders?”.

Shareholder equity is simply the gap between total assets and total liabilities that are owed to non-shareholders. In this balance sheet, the assets are larger than its liabilities, which means that there is a larger buffer of ‘shareholder equity’ (shown on the right). Step 1: Initially the bank is in a financially healthy position as shown by the simplified balance sheet below. The following example shows how a bank can become insolvent due customers defaulting on their loans. This is known as cash flow insolvency, or a ‘lack of liquidity’. Secondly, a bank may become insolvent if it cannot pay its debts as they fall due, even though its assets may be worth more than its liabilities. Firstly, for some reason the bank may end up owing more than it owns or is owed. In accounting terminology, this means its assets are worth less than its liabilities. This usually happens for one of two reasons. Insolvency can be defined as the inability to pay ones debts.

If banks can create money, then how do they become insolvent? After all surely they can just create more money to cover their losses? In what follows it will help to have an understanding of how banks make loans and the differences between the type of money created by the central bank, and money created by commercial (or ‘high-street’) banks. How do banks become insolvent and the importance of deposit insurance

Bank bust