Why Banks Fail and What Happens to Your Money if They Do

If you're thinking about withdrawing your money from the bank, read this first.

The collapse of Silicon Valley Bank (SVB) was the second-biggest bank failure in U.S. history. Authorities moved quickly to reassure consumers that their money is safe. All the same, SVB's failure, followed swiftly by that of Signature Bank, sparked concerns about how safe banks are. Here's everything you need to know.

How banks work -- and why they sometimes fail

At heart, a bank is a financial institution that stores people's money and makes loans. The two sides of banking operations are important, particularly when understanding why banks sometimes fail. Put simply, a bank is not a giant safe deposit box as banks put the money you deposit with them to work.

I'm simplifying a little, but your deposits enable the bank to lend money to individuals or businesses or buy securities such as bonds. Banks use the interest earned to cover the costs of running the bank, including paying staff and operating, say, a free checking account. It also means the bank can pay you interest on a savings account and generate profits.

You can look at a statement or check online to see how much money you have in the bank. But whether you use a brick and mortar or online bank, that money isn't just sitting there waiting for you to access it. Although there are rules around what percentage of deposits a bank is allowed to loan out, if everybody tried to withdraw their cash at the same time, it would be problematic.

This is known as a "bank run," and there's often a snowball effect at play. Banks can only stay afloat if customers believe their money is safe. If people stop believing, they start to withdraw their money. This triggers panic and leads more people to withdraw their funds. In a worst-case scenario, this can then cause the bank to fail.

In the case of SVB, a lot of its customers were tech companies who've been feeling the pinch recently. As SVB clients started to make higher withdrawals, it had to sell bonds to meet the demand. Bonds have lost value in recent months because of what's happening in the wider economy. Investors and customers got spooked, and regulators had to close the bank.

What happens to your money if your bank fails

Like any business, banks can fail. The trouble is that when a bank fails, it can have a big impact on the economy. If another business such as a supermarket chain fails, it affects its shareholders, employees, and, to a lesser extent, customers. But if a bank fails, not only can it put people's savings and homes at risk, it can also dent trust in other banks, potentially triggering further failures.

The good news is that bank failures don't happen that often, and there's protection in place when they do. According to the Federal Deposit Insurance Corporation (FDIC), there have been ​​563 bank failures since 2001, over half of which happened during the financial crisis of 2008 and 2009.

Nearly all banks have FDIC insurance, which covers customers for up to $250,000 per client, per ownership category. This is a fund that was set up for exactly this situation -- it's designed to protect Americans against bank failure. As of 2019, the average American had $5,300 in median combined checking and savings balances, so the $250,000 limit will protect most people.

One issue highlighted by Silicon Valley Bank's collapse is that some businesses have more than $250,000 in bank deposits. This is why the government stepped in to guarantee all deposits, even those over the FDIC threshold.

Call your bank, look on its website, or check your bank statement to find out if your bank is FDIC insured. This is the best way to ensure your money will be safe in the event of bank failure. The FDIC also has a BankFind tool. Check out our list of the safest banks in the U.S. for more information on choosing a safe place for your money.

If you use a credit union, there's protection against failure for up to $250,000 through the National Credit Union Share Insurance Fund (NCUSIF). If your brokerage runs into trouble, Securities Investor Protection Corporation (SIPC) kicks in, though this works slightly differently from the FDIC.

How much money should I keep in the bank?

Not only have the recent troubles in the banking world reminded us that these institutions can fail, they also raise questions about how much money we should keep in bank accounts.

Don't keep your savings under the mattress

The temptation to withdraw your money from the bank is understandable. The trouble is that -- while they are not perfect -- banks remain one of the safest places you can put your money.

You could keep your savings at home, but it is much riskier than using a bank account. If there's a fire or flood, not only will your home be damaged but your savings could go up in flames or be destroyed by water. There's also a much higher risk of theft. Banks have sophisticated security systems that are almost impossible to replicate in your home. Banks also offer a certain amount of fraud protection.

Even so, it doesn't always make sense to leave large sums of money in a bank account. Sure, FDIC insurance covers as much as $250,000. But if you're keeping that much money in the bank, ask yourself why. Savings and investments are both key financial tools, and it's important to understand the difference between them.

Savings vs. investments

Put simply, there's a limit to the amount of savings you need. The bank is the place to keep money you might need in the short term. If you have additional cash, perhaps you can invest it and build assets that could work for you long term.

Savings

Use your savings account for anything you might need in the near future, for example, your emergency fund or money you're saving toward a vacation. The interest rates are much lower than you might get with investments, but there's also much less risk involved. Plus, banks have clear rates of return, so you'll know how much you'll earn.

Typical accounts:

• Savings accounts
• Certificates of deposits (CDs)
• Money market accounts (MMAs)

Investments

Investing is a way to build wealth for the future by buying assets such as stocks, bonds, or real estate, that will work for you over time. Once you have a solid emergency fund that will cover three to six months or more of living expenses, it's worth considering ways to make any additional cash work for you.

There are no guarantees when it comes to investing, and it takes more work than leaving your money in the bank. If you're trying to build wealth or save for your old age, historically, the stock market has beaten inflation and generated higher returns.

There's one big caveat: Don't invest money you might need in the coming five to 10 years. The average stock market return for the S&P 500 was 14.8% annually from 2012 to 2021, which is much higher than you'd get with a savings account. However, that's an average -- some years the value of your investments could fall. If that happens and you need money quickly, you don't want to have to sell your assets at a loss.

Typical accounts:

• Brokerage accounts
• Individual retirement accounts (IRAs)
• 401(k)s

Sadly, banks do fail

Bank failures do happen. The good news is that in most cases, your money will be protected if yours does. Now is a good time to check that your account is FDIC insured and consider the money you're keeping on hand. If you have significant amounts of money that you don't need in the coming years, consider ways to make it work for you.