A bank
failure is when a bank runs short of liquid money. This classifies as a
crisis and it negatively affects all the services offered by the bank. But what
does bank failure mean
for the economy? See below a depiction of India’s GDP with respect to China’s,
USA’s, and the world’s GDP since 1990. When banks fail to do their job, this
crucial area for the whole country inevitably declines. For instance, the Great
Recession of 2008 was a bank-related crisis.
This recession led to a significant dip -strikingly clear on the
graph- in the USA’s GDP, causing it to be the lowest it has even been in this
timeline. This recession was the direct result of giving individuals with poor
credit history home loans that they were unable to pay off, eventually leading
to banks without enough cash. With a bank failure causing a dip in the GDP of an entire nation, we
can expect that it affects multiple other areas of economic growth. Here’s the
complete impact of bank
failure on the economy of a country.
Source: The Economist
No Lending
The present rule of thumb is that the lower your credit score,
the less likely your bank is willing to give you a loan. This rule becomes even
stricter or completely void during a bank crisis. You can say goodbye to any
personal loans or business loans when there is a bank failure. A liquidity issue means that banks
will be less willing to lend any money to both consumers and firms. Some
lenders may not give out any loans at all.
The consequence of not receiving a business loan for a firm is
quite drastic. Without a loan, a firm will employ fewer people so they can
afford to financially support all their employees, thereby leading to more
unemployed individuals. Product development might slow down without the
business loan to purchase machines, appropriate manufacturing hardware, and
storage units. Whatever the product is, it is going to reach the shelf in the
supermarket much slower. This leads to a lag in economic growth.
Lowering Demand
Without banks giving out any personal loans, business loans, and
financial assistance to their borrowers, the amount of money put into
investments diminishes and the financial markets underperform. However, there
is also a cyclical effect. When investment slows down, economic growth slows as
a consequence and customer demand is low as items become difficult to afford.
As more people become unemployed, consumer demand drops even
further. Lowering demand leads to industries requiring fewer investments to
fuel the production of their goods and services. Hence, a reduction in lending
leads to lower investments required in the long run.
Consumer Confidence Dips
With low employment rates, no lending available from banks and
FIs, and slower turnover rates for products in markets, investor sentiments
become more risk-averse. This is the direct result of losing confidence in
economic growth. Consumers will favor putting their money into savings deposits
as opposed to reckless spending.
This creates low demand, as consumers' sentiments will be geared
more to protecting their own wealth as opposed to living a comfortable lifestyle.
Consumers will also probably become wary of the bank, which is undergoing a
crisis. They will avoid using any of its services as a means for depositing
their money and keep their cash in liquid form in physical safes.
Demand-Deficient Unemployment
Bank failure causes two types of
unemployment. The unemployment mentioned earlier was the direct result of firms
not being able to afford to pay more employees without receiving the requisite
business loans or personal loans. Following this is a negative feedback loop
that results in low demand from the newly unemployed consumers which leads to
lower production from companies. The outcome of all this is the second type of
unemployment: demand-deficient unemployment.
As the term suggests, demand-deficient unemployment is when a company has to let go of its current employees or stop employing new individuals as demand for their product is low. In the first case, demand may still exist but the company does not have capital from the bank to afford extra employees. In the second case, there is no demand and, hence, sales are low and money spent on production is wasted. To cut costs that the company is not able to make-up for via sales, it drops its employee count and stops hiring new people. In conclusion, bank failure has a significant ripple effect on a nation’s economy. Luckily, with the right advice and financial products, you can secure your funds while growing your wealth. Financially plan your future with Tata Capital’s bouquet of wealth management products including the consultation of financial experts. Explore the Tata Capital website to learn more about all the offerings you can receive.
20 April 2020
5 mins read
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