For a bank, being insolvent means it cannot repay its depositors, because its liabilities are higher than its assets. The consequence that a bank has if it becomes insolvent is determined by the option of deposit insurance coverage.
An insolvent bank would not be able to repay people deposits in full in a country without deposit insurance. In the case of an insolvency depositors will have to queue up along with other bank creditors to reclaim whatever cash they might from the bank. Therefore for every Ј1.00 the bank owed to customers it could only even pay 90p or less.
Nonetheless, this isn’t the end regarding the story. The failure of 1 bank could lead visitors to bother about the budget of other banking institutions. Additionally the insolvent bank would have truly owed cash with other banking institutions, since would its clients. This might result in a domino impact – a bankruptcy at one bank can cause a ‘cascade’ of defaults, bank runs and insolvencies as individuals panic.
A good way a bank can quickly raise funds in the case of a bank run would be to offer assets. Nevertheless, if ‘distressed attempting to sell’ occurs on a sizable scale that is enough can lead to a financial obligation deflation. The US economist Irving Fisher saw financial obligation deflation among the key factors behind the great despair. In Fishers formula, the procedure proceeds the following: