What Does a Bank Failure Mean for Small Businesses? 4 Things to Know

March 31, 2023

The recent banking crisis has had a significant impact on small business owners and startup founders. This article will explain what you need to know about the recent banking failures, as well as provide tips for protecting your company from similar events that could happen in the future.

What is a bank run?

Before getting into the specifics of the most recent turmoil in the banking sector, let's take a step back. It's important to understand the basics of the situation. This will provide a foundation for looking at the current circumstances, creating a context to review your own place in the unfolding drama.

A bank takes in cash from depositors. However, the institution doesn't just sit on that money. It uses the funds on various investments. This includes offering loans, as well as buying other assets that deliver a return, such as Treasury bonds.

This creates a situation known as fractional reserve banking. In short, the bank only holds a fraction of depositors’ cash on hand. It has what is judged a sufficient amount in reserve to pay out withdrawals as they happen. But, fundamentally, the bank makes a bet that not every customer will want to withdraw all their funds at the same time. (This is standard practice in the banking industry, by the way &#151 it shouldn't be considered particularly risky.)

However, this process creates a vulnerability. What happens if depositors attempt to withdraw significant funds at one time, draining the fractional reserves the bank has on hand? That's the definition of a bank run.

What happens if depositors attempt to withdraw significant funds at one time, draining the fractional reserves the bank has on hand? That's the definition of a bank run.

In these cases, the bank can remain technically solvent. It has assets at least matching the value of its deposits. It could make its depositors whole, given enough time. However, some event has triggered its customers to want to withdraw funds in a hurry, putting too much near-term pressure on the bank's available cash.

This creates the classic It's a Wonderful Life moment. There aren't enough funds in the vault because too many people are demanding too much cash all at once, while the bank has a large chunk of its assets tied up in illiquid investments, like loans.

What caused the recent bank failures?

Several institutions were swept up in the recent string of bank failures. The factors contributing to the turbulence were similar in each case. To understand these disruptive economic influences, let's look at the highest profile case during the tumult: Silicon Valley Bank.

In early March, federal regulators stepped in to take over Silicon Valley Bank, a California-based institution that, as the name implies, largely serviced the tech and startup community centered around the dynamic Bay area. This marked the second biggest bank failure of all time and the largest threat to the overall financial system since the crisis of 2008.

What caused the run on the bank? The details are a bit complicated, but summarizing as concisely as possible, the company had purchased a large amount of medium- and longer-term Treasury bonds prior to the recent interest rate increases by the Federal Reserve. The sharp rise in rates made those assets less valuable on the open market, leading to billions of dollars in potential losses if the company was forced to sell them.

If SVB had been able to hold those bonds to maturity, those losses might not have materialized. But the presence of potential losses prompted concern among the bank's depositors, some of which had millions in uninsured deposits at the bank. These large customers, including high-profile companies and venture capitalist firms, began pulling out funds, leading to the run on the bank.

It's important here to underline a difference between the recent bank failures with, say, the collapse of FTX. In that situation, the cryptocurrency exchange effectively gambled away depositor funds on risky crypto assets that subsequently plunged in value. It couldn't pay back the money even if it wanted to. It's the difference between a liquidity crisis and insolvency.

For a bank run to occur, the institution doesn't necessarily need to be insolvent. Instead, a bank run can create a liquidity crisis so severe that regulators are forced to step in to protect depositors. That's exactly what happened in the recent bank crisis.

What happens to small businesses when a bank collapses?

Here, it's important to highlight the role of the Federal Deposit Insurance Corporation, or FDIC. This regulatory body insures bank deposits of up to $250,000. That's a large amount for an individual. However, deposit amounts for a business, even a relatively small one, can easily top that amount.

For instance, streaming TV company Roku disclosed that it had nearly $500 million deposited in SVB, a significant portion of its overall cash. Most of this was uninsured under normal FDIC rules.

Obviously, Roku is a relatively large business, with a market capitalization of more than $8 billion. However, scale the numbers down by 100. Imagine an $80 million company with $5 million deposited in a bank. Or even an $8 million company with $500,000 deposited. Under the normal rules, a large chunk of this could be vulnerable if a bank fails.

In the case of SVB, regulators stepped in to guarantee the full amount of deposits. That's good for Roku and all the other depositors with amounts above $250,000. However, this won't necessarily happen for every bank run. You need to protect yourself.

The precise impact of a bank collapse on any small business depends on a wide variety of factors. At core, the company's relationship with the bank will decide how intimately its business operations will be affected. Here are some key questions to think about when you hear about a bank failure:

Was the failure contained to a single bank or does it have the potential for impacting the banking sector in general?

"Contagion" becomes a key word with any bank run. Regulators, depositors, and other interested parties will consider how self-contained the implosion will be. Does it just impact this single bank? Or does its failure make other institutions vulnerable?

Does your business have funds deposited in the bank? If so, how much?

Say a bank failure is limited to a single institution. No contagion. In that case, it will only impact your business if you have a connection to that bank.

Let's start with deposits. Any amount less than $250,000 will be protected by FDIC insurance. That said, a bank failure could create a dislocation. Your funds might be difficult to access while the regulators work out the details.

Do you have other dealings with the bank (such as a loan through the institution)?

Beyond deposits, banks have other business relationships. These include loans. If you have borrowed money from a failed institution, plan on paying the amount owed on your regular schedule. That said, stay alert for changes of status. For instance, a sizable portion of SVB's loans were sold to First Citizens BancShares. If you were part of this group, you might need to update the procedures surrounding repayment.

How to prepare your small business for a potential bank crisis

Typically, we don't think about our banks. They just exist in the background, protecting our money and facilitating transactions. However, with the recent turmoil, doubts have started to seep in, leading many business leaders to prepare contingency plans.

What can you do to protect your small business from a future crisis? Here are a few steps to take:

  • Don't Rely on One Bank: Spread around your deposits. Just as you diversify your investments, you shouldn’t become overly reliant on a single institution.

  • Limit Your Deposit Sizes: Wherever possible, keep your deposit amounts below the FDIC limit. This isn't always possible. But by limiting your deposit size, you reduce your exposure in a catastrophic situation.

  • Generally Practice Good Risk Management: Periodically review your overall risk profile. This will help you avoid complacency in all your financial dealings.

  • Remain Informed: Stay up to date on the state of the overall economy and the health of the banking system. During times of calm, you can relax your guard a bit. But the overall challenges of the last few years, including the quick rise in interest rates, could have provided a crucial red flag that some banks would be more vulnerable than normal.

Protecting your assets during a bank run

Crises like the one going on in the banking industry happen from time to time. You need to build a startup that can thrive, despite the uncertainty. Luckily, there are steps you can take to reduce the vulnerability of your small business.

Spread around your deposits. Just as you diversify your investments, you shouldn’t become overly reliant on a single institution.

Use the information provided here to get started. By staying informed and taking a strategic approach to your finances, you can make sure your business is ready to navigate any banking challenge that may come its way.