Banks face several types of risks, including default (or credit) risk, interest rate risk, foreign currency (or country) risk, liquidity risk, fraud risk, and operating risk. I would like to focus on credit risk, since this is the key area where banks tend to get in trouble. Credit risk is inherent in real-world lending. At its core, managing credit risk involves careful evaluation of borrowers and careful monitoring and collection after loans are made. Inevitably, there will be loan losses as banks make loans with diversified risk characteristics. As such, banks maintain reserves against anticipated loan losses. In addition, they maintain sufficient capital to make sure that additional losses are charged off to shareholders rather than depositors.

In a situation where a bank’s loan portfolio goes sour and loan loss reserves and capital are insufficient to cover losses, the bank will become insolvent. This creates the danger that depositors will seek to withdraw their deposits, sometimes called a bank “run.” But such problems need not spread to other banks, if they are healthy. In fact, the deposits would simply transfer to other banks and the overall financial system would remain intact. Thus, banks fail just like any other business.