The answer to the question whether creditors can expect a full refund of their outstanding account balance in bank failure and liquidation requires a thorough understanding of the financial industry. Banks may fail for different reasons. The common reason for such failure concerns insolvency issues. As most financial institutions improved their capital cushions over time, their failure is no threat to financial stability anymore. As such, banks and other financial institutions that fail can be resolved in an identical way as any other business via traditional insolvency procedures.

Financial institutions have an important and peculiar position in society. As credit and liquidity providers they allow the market economy to operate and thus serve the public interest. To fulfil this duty, three theories must be considered. The theory of financial intermediation assumes that banks collect deposits from savers and provide them to borrowers. Fractional reserve lending then furthers the possibility of money creation by systemic interaction. The third and final way of liquidity enhancement is explained by the credit creation theory where individual banks extend credit. The result is a potentially toxic cocktail of highly leveraged money creation techniques. This, however, is only a problem when things go wrong. As the global financial crisis revealed, a systemic collapse can disrupt economies having severe spill-over effects.

The public interest doctrine

The global economy and financial system must be protected against systemic failure. Bank customers and other stakeholders have a more complex relationship than the traditional contractual arrangement. To maintain confidence in the financial system and mitigate risk for bank customers, it is mandatory for banks and credit institutions to participate in a domestic deposit guarantee scheme. Even though bank creditors receive some level of protection, the public interest doctrine merely seeks to ensure a stable financial ecosystem and safeguard the position of external and uninvolved tax payers.

Expensive rescue missions funded with tax payer money were common in the aftermath of the global financial crisis. Even though nationalization of financial institutions eventually generates a return on investment when the shares are brought back onto the market again, unfair competition and a disruption of the free market is lurking. As such, the public interest doctrine requires governments to scrutinize possible acquisitions and minimize the use of nationalization of financial institutions. Resolution authorities, responsible for solving the financial problems of the institution in the broadest sense of the word, may therefore choose for bail in or bail out strategies.

Bail in versus bailout of financial institutions

Bank recovery and resolution

Civil action against wrongdoers

Creditor repayment in bank liquidation