What is default?

People, companies, and other organizations can default

For individuals, a default can result in a warning from the bank, additional accrued interest to be paid, and a decrease in your credit score. If resolved rapidly, the damage can be limited. For companies, especially public ones, the implications are usually much greater in the event of default. It can have lasting consequences on borrowing costs and credit access, as markets tend to lose confidence in borrowers that don’t respect their contractual payment schedules.

What’s the difference between default and bankruptcy?

While both individual and corporate default can lead to bankruptcy, companies will usually do everything in their power to avoid default. This means that when companies do default, they’re often also on the brink of bankruptcy. That’s why default and bankruptcy are frequently conflated, even though they have different meanings.

What can cause default and bankruptcy?

Default often occurs when a borrower’s liquidity isn’t sufficient to cover an upcoming payment. The inability to generate enough cash flow is a common cause of defaults, and if the situation isn’t handled, defaults can turn into a bankruptcy.

But bankruptcy can also happen without an entity ever defaulting—there are factors or events that can hit so hard and fast that bankruptcy rapidly becomes the only option.

Bank runs

A bank run is when a relatively high concentration of customers suddenly and simultaneously withdraw deposits from a bank, out of fear that the bank is on its way to insolvency. Since banks keep only a fraction of the deposits liquid and invest (or lend out) the rest, a bank facing a run likely won’t have the cash on hand to meet large, abrupt withdrawals, and bank runs can dry up a bank’s liquidity relatively quickly.

That’s what happened to Silicon Valley Bank, for example: in a single day, investors and depositors tried to pull $42 billion. At the close of that day, the bank had a negative cash balance of $958 billion and was incapable of paying its obligations, resulting in the second largest bank failure in U.S. history.

Bank runs are often seen as self-fulfilling prophecies. As some depositors start withdrawing money because of a special event, others may start losing confidence in their bank and also start withdrawing money, fearing that their bank will become insolvent. As panic mounts, the run on the bank accelerates. 

Frauds

Despite stringent bank and securities regulations, nefarious financial actors have found ways throughout history to inflate profit numbers and fool regulators, investors, and creditors.

One of the most infamous cases of fraud culminated with the collapse of Enron in 2001. The energy and commodity services company, one of the largest in the world, artificially inflated its profits for years before its fraudulent accounting practices were exposed when the economy weakened, leading to the largest corporate bankruptcy ever at the time.

Widespread crises

The very nature of a crisis is that it’s unpredictable. Its cause and reach usually remain unknown until it’s too late. Take the COVID-19 pandemic, for example—the global economy went from expanding to contracting almost overnight, one of the sharpest and most sudden economic downturns since the Great Depression.

Airline companies, for example, were particularly hard hit by COVID-19 measures, and losses started to mount. Many airlines were injected with cash from their national governments to prevent bankruptcy. Others didn’t have that chance—a total of 64 airlines have ceased operations since 2020.

This introduces the concept of “too big to fail.” In some cases, the contagion and the economic impact would be too high for governments to let companies default on their debt, so they bail them out. This was the case with multiple banks and insurance companies during the Global Financial Crisis.

Too big to fail can also apply to countries. Greece, for example, received €110 billion in loans from the International Monetary Fund and the European Union to avoid default in 2010.

Minimizing default risk

While there’s always a chance that a borrower won’t meet a payment obligation, it’s crucial for investors and creditors to minimize default risk and reduce the likelihood of large losses within their portfolios. This can be achieved through diversification and a thorough due diligence process across geographic regions, sectors, and assets.

Ultimately, default risk can’t be eliminated, but investors and creditors should always assess the risk of default in their portfolios, and if they’re being rewarded for bearing it.