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Understanding Bank Insolvency: Costs, Capital Injection, and the Realities of Financial Rescue

By Asif Khan, CFA

Chairman

EDGE AMC Limited

Posted on: 30 Jan, 2024

When a bank becomes insolvent (i.e. liabilities exceed assets) there are only a few ways to get out of the problem.

Method 1: Someone pays the price

Basically here someone has to lose. Maybe the depositors will lose as they either don't get their full deposit amount back or they get shares instead of cash (which is still a loss for the depositor).

Or you can pass the buck on the country's taxpayers by getting the state to bail out the depositors. Here the price is paid by citizens.

Another method is to force an acquiring bank to take over the problem bank. In this case the shareholders of the acquiring bank pays the price. Even if the shares are given for free, the acquiring shareholders are taking on net liability.

A final version is a combination of any of the above.

Method 2: Equity capital injection

Capital injection can also come in a few ways. One way could be to force the existing shareholders to inject capital. The challenge with this method is that not all existing shareholder may have capital and even if they have they may be reluctant to do so. This is a problem as some shareholders were complicit in causing bad loans while others were not.

You can also have new shareholders come in and inject capital. For totally insolvent banks, I feel existing shareholders should completely get wiped up in this instance. This method also has own challenges like regulations on minimum share prices (face value etc) and whether new shareholders have the confidence that they can turn around the bank.

Conclusion:

The narratives that there are utopian solutions where nobody pays a price are actually 'fairy tales'. Someone absolutely has to pay a price or take a risk (if new capital injection). We don't just make a big bad loan problem and then not get hurt in some way or form.