Bank Failures and What They Mean to Investors and Traders

Bank failures can rattle markets in a matter of hours, shaking confidence among depositors, traders, and long-term investors alike. In 2023, the collapses of Silicon Valley Bank (SVB) in the United States and Credit Suisse in Switzerland put those fears on full display.

But these events did not stop with a few headlines. Concerns spread to institutions like First Republic Bank, while many people questioned the safety of their deposits and the stability of the wider financial system. In this article, we examine what causes bank failures, why they matter, and how they can affect markets, ordinary people, stock traders, and investors.

Was the 2023 Situation Different from the 2008 Global Financial Crisis?

Yes, it was very different. The 2023 situation, despite the speed at which stock prices fell, was quite different from what led to the global financial crisis in 2008. While there were negative economic and market consequences resulting from a shortage of available funds in 2023, it didn't cause a complete freeze in the financial system like in 2008.

Back in 2008, the crisis was triggered by banks not knowing the extent of losses on each other's balance sheets. As a result, managers overseeing credit-counterparty risk on trading desks stopped trading with other banks for fear of "jump-to-default risk," meaning the other bank could default in the near future. This caused commercial paper markets to freeze, interbank lending to stop, and trading activities to grind to a halt.

What was different in 2023 was that banks didn't have the same significant holes in their balance sheets as they did back then. Prior to the 2008 credit crisis, banks took on bad quality mortgages with impunity. When the housing bubble burst, these assets were worth almost nothing.

What Should Investors Do in a Crisis?

Investors should avoid emotional decisions in a crisis and base their actions on a disciplined plan. During economic turmoil, people often behave irrationally rather than according to traditional financial theory. That is why behavioral finance matters, because it helps explain how emotions can shape investment decisions under stress.

Behavioral finance says that people are not simply risk-averse, but they are actually more averse to losses. This means that the emotional pain caused by a loss is felt much more intensely than the pleasure gained from a profit. A related bias, the disposition effect, describes the tendency for people to sell their winning investments too early and hold onto their losing investments for too long.

When people are making money, they tend to become cautious and avoid taking risks. However, when they're losing money, they often become more willing to take on additional risks in the hope of recovering their losses.

What does this mean for traders? Let's take the example of a blackjack player at a casino. When the player is on a winning streak, they might start playing it safe, betting smaller amounts in order to protect their winnings. However, if that same player is losing money, they may start taking greater risks by doubling down or betting more on riskier hands, hoping to break even. Investors exhibit similar behavior. Unfortunately, taking on excessive risk when experiencing losses tends to only make those losses even worse in the end. This applies equally during a banking crisis.

That's why, whatever your financial asset, you must develop a trading plan and stick to it, ignoring the urge to deviate.

How Do Bank Collapses Affect Investors?

The collapse of SVB served as an important reminder of the need for thorough research when investing in financial institutions. It was and always is a rough lesson for investors, highlighting the inherent risks involved in investing and the potential impact of one institution's failure on the entire industry. To mitigate such risks, it's crucial for investors to diversify their portfolios and carefully assess the financial strength and stability of any institution before making investment decisions.

So, what led to SVB's collapse? The bank had invested a large share of its deposits in longer-term securities to boost yield, and these lost value as interest rates rose. After SVB announced a $1.8 billion loss on a sale of securities in March 2023, worried depositors withdrew more than $40 billion on 9 March, and the bank failed the next day (Federal Reserve, Vice Chair for Supervision Barr's testimony, March 2023). This underscores the importance of prudent management of interest-rate and liquidity risk.

Remember, retail trading brokers can fail too. Regulated brokers are generally required to keep client money separate from their own funds, and some countries have investor compensation schemes, but the level of protection depends on the regulator, so check it before you open an account.

Hypothetical illustrative example by Arincen

What Do Collapses Mean for Traders?

What impact does a bank collapse have on traders? You can expect increased volatility and a wider range of price movements. At this point, you may be asking, how can the failure of a regional bank in the US affect your stock investments on an Asian market such as Japan's, tracked by the Nikkei 225 index? The truth is the financial world is deeply interconnected. Institutional traders have their eye on world financial events and their portfolio managers will move investments around at the first sign of risk. This is why jitters in a faraway market can be felt in your local stock market.

Some traders see this kind of event as an opportunity, but volatility cuts both ways. One of the great aspects of being a trader is that you don't have to accurately predict how things will unfold. Your main focus is simply reacting to the price movements.

Many traders use price action analysis, which studies a security’s price movements to identify potential entry and exit points. This approach does not heavily rely on indicators or fundamental factors. Instead, it primarily looks at the historical price patterns of the security being traded, often with a few simple tools such as support and resistance levels or moving averages, to help decide when to enter or exit trades. In fast-moving risk-off sessions, we often see correlations rise across indices and sectors, which means traders need to be especially careful about position sizing even when a setup looks strong on an individual chart.

Should Traders Sell Their Stocks and Convert to Cash?

Cash plays a crucial role in a portfolio by providing funds for short-term goals and immediate expenses. While it's natural to feel a sense of unease during market downturns, it's generally not advisable to sell off all your assets and shift entirely to cash.

Historically, stocks have shown a strong tendency to outperform cash over the long term. This is primarily because the value of cash tends to erode due to inflation, especially during periods of high annual price increases. On the other hand, the stock market, such as the S&P 500 index, has typically surpassed inflation over extended periods.

When it comes to making investment decisions, each individual investor should carefully consider their own risk tolerance and investment objectives. Ultimately, finding the right approach for your portfolio requires thoughtful consideration and professional advice to ensure alignment with your financial goals.

Where Is the Safest Place to Put Your Money During a Financial Crisis?

The safest place to put your money during a financial crisis depends on which investment options best protect your capital and fit your needs. If a volatile stock market makes you uneasy, it makes sense to look for ways to preserve and protect your money. Many investors do exactly that when uncertainty rises.

There are several avenues for investment that offer relatively low risk while still providing a modest return. These include high-yield savings accounts, bonds, and even safe havens like gold.

Each of these investment options comes with its own set of advantages and potential risks. It is crucial for you to conduct thorough research on each option’s liquidity, yield, and downside risks before deciding where to allocate your wealth.

By performing due diligence and assessing your risk profile, you can make informed choices about the best places to store your money and achieve your investment goals. Remember to take into account the potential rewards and risks associated with each option to make a well-informed decision.

What Are the Economic Implications of a Bank Crisis?

A bank crisis can slow economic growth if small and regional banks cut back on lending. That pressure can hit small and medium-sized businesses especially hard, as borrowing may become more expensive or less available. It may also become more difficult for these businesses to find new lenders to finance their operations.

In addition, there is an increased risk of bankruptcy, as a weaker economy means that businesses may have less available cash to cover their interest costs. Furthermore, borrowers with higher credit risks may struggle to refinance their debts when they come due. The severity of an economic downturn could also be influenced by reduced consumer spending if the markets experience significant sell-offs.

The factors would naturally affect retail traders as they may have less disposable cash for investments. More generally, when an economy is weakening, there is a natural tendency for traders and investors to be more watchful and to take less investment risks.

Bank failures don’t just affect the institutions involved—they ripple across multiple asset classes, shaping market sentiment and investor behaviour. The chart below shows how different parts of the market typically respond, highlighting where the impact is most severe and where capital tends to flow during periods of financial stress.

Hypothetical illustrative example by Arincen

What Is the Best Advice for Traders During a Banking Crisis?

Let's start by assessing your comfort level with potential losses. Ask yourself if you would be able to sleep well at night if the stock market were to drop to serious lows on the back of a banking crisis. If the answer is yes, then your current investment allocations may not need any major changes. However, if the thought of such a decline keeps you up at night, it might be a good idea to reassess your investment needs, strategy, and time horizon.

Next, keep an eye out for market imbalances that could present opportunities for tactical adjustments within your overall investment portfolio. For example, after a sell-off, compare valuations across investment styles (value, growth and blend) and company sizes: some segments may fall further below their estimated fair value than others. Smaller companies can offer higher potential returns, but they also carry higher risk.

For those who invest in individual stocks, a banking sell-off can be a time to search for undervalued stocks that have been hit by the turmoil in the financial sector. In 2023, for example, some nonbank financial companies were dragged down along with regional banks, even though they operate under different business models and don't rely heavily on deposit funding. Examples of such companies include investment banks and brokers, asset managers, credit card providers, and fintech firms.

Remember, it's important to carefully analyze and consider your options based on your own investment preferences and goals.

How Can Investors Look for Undervalued Stocks After a Sell-Off?

Investors can look for companies and sectors trading at a significant discount to their estimated fair value. Which sectors look cheap changes over time, so check current valuations rather than relying on a fixed list of sectors.

When selecting companies in which to invest, prioritize those with a track record of high quality. These companies can weather economic challenges and have long-term competitive advantages that sustain them during financial crises or market disruptions. Investing in such companies can potentially yield favorable results even during uncertain times.

How Can Investors Take Advantage of a Crisis?

Investors can take advantage of a crisis by buying assets at discounted prices when fear pushes valuations below their worth. Those who remain calm may benefit as prices normalize and rebound over time. Doing this well requires discipline, patience, and enough liquid assets to make strategic purchases.

During times of calamity, markets tend to anticipate the worst and stocks suffer the consequences. Historically, markets have often fallen sharply after major shocks and later recovered as the dust settled, but recoveries have taken anywhere from weeks to years, and past patterns do not guarantee future results. Investors who sell in a panic risk buying back later at higher prices.

Similar patterns can be observed after other geopolitical events. Investors who understand that markets can overreact may look for chances to buy stocks and other assets at more attractive prices, while accepting that prices can keep falling after they buy.

It's important to note that investing during a crisis is not limited to stock markets. The great recession, for example, led to a collapse in home prices as the housing market bubble burst. Many homeowners faced foreclosure due to unaffordable mortgages, and numerous properties had negative equity, with mortgage amounts exceeding the property's value. Homebuyers and real-estate investors capitalized on this situation by acquiring valuable assets at below-normal prices. As the housing market stabilized and recovered, they enjoyed substantial returns. Additionally, astute investors, known as "vulture investors," took advantage of recessions to acquire financially sound companies at reduced valuations.

After the Great Recession, US stocks entered a bull market that lasted about 11 years, from March 2009 to February 2020. Investors who stayed invested saw their portfolios recover and grow, while those who sold near the bottom and waited until the bull market was well underway to reinvest missed much of the rebound.

Remember, investing during a crisis extends beyond stocks and offers opportunities in various asset classes. By understanding the tendency for markets to overreact, investors can make strategic decisions and potentially benefit from favorable returns.

How Can Investors Bet on a Crisis Happening?

Investors can bet on a crisis happening by Short-selling a financial asset or using short equity index futures to profit from a market downturn. In a short sale, traders sell borrowed instruments and try to buy them back later at a lower price. It is a difficult strategy because predicting the next banking crisis is highly uncertain.

Options strategies, such as buying puts that increase in value when the market falls, can also be used to trade a declining market; selling call options is another approach, but it carries large losses if the market rises instead. Similar strategies can be applied to bond and commodity markets.

However, some investors may have limitations on short selling or lack access to derivative markets. Even if they do have access, emotional biases, a normal part of human trading psychology, might discourage them from short selling. Additionally, short sellers may be forced to close their positions at a loss if markets rise instead of falling, leading to margin calls.

For individuals who want to protect themselves from a crisis without speculating on it, a well-diversified portfolio across low-correlated asset classes can help soften the impact. Those who have access to derivative markets can also use hedging strategies, such as a protective put or covered call, to reduce the severity of potential losses.

The Bottom Line

Bank failures remind investors and traders that financial markets can shift quickly when fear spreads through the system. Understanding what causes these collapses, how they affect depositors, banks, and broader markets, and why panic often drives short-term reactions can help you make better decisions when volatility rises.

Whether you choose to stay defensive, look for discounted assets, or consider short strategies, the key is to act with discipline, timing, and perspective. Stay informed, avoid emotional decisions, and use periods of financial stress to reassess risk and opportunity carefully.