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Bank Insolvency and the Role of Deposit Insurance
Banks can become insolvent in two primary ways: normal insolvency and cash flow insolvency. Normal insolvency occurs when a bank's liabilities exceed its assets, often due to customers defaulting on loans. For example, if a bank's borrowers fail to repay their loans, the bank may have to write down these loans, reducing its assets. If the value of these bad loans surpasses the bank's shareholder equity, the bank becomes insolvent. Cash flow insolvency, on the other hand, happens when a bank cannot meet its debt obligations as they come due, despite having assets that exceed liabilities. This often results from a bank run, where a large number of customers withdraw their deposits simultaneously, depleting the bank's liquid assets.