If a business fails to pay a creditor when what it owes becomes due then the creditor can apply to the courts to have the business wound up - to be made bankrupt.[170] If that happens then it ceases to trade and as much value as possible is secured for the creditors. The owners receive what is left after all creditors have been paid in full, usually nothing, and often the creditors aren't paid in full. A business fails to pay a creditor because it cannot access sufficient cash to do so, which is not necessarily the same thing as it being insolvent (liabilities exceed assets). An insolvent business can continue to trade as long as it can pay its bills, and a solvent business can fail to pay its bills because of a cash flow problem. Nevertheless, the more a business moves into insolvency the harder it becomes to access the necessary cash to maintain trade, because new creditors become wary of lending money or sending goods in advance of payment, and existing creditors become ever more forceful in pressing for the return of their money or for the goods that they are owed.
Almost any business that fails to pay its bills can be forced by its creditors into bankruptcy, but banks are not just any business. They are tightly integrated with all other banks, businesses and people in the economy, lending to many, borrowing from many others, and administering the country's payments system for all but cash transactions. The payments system is the system that handles all transactions involving bank money. Every time a person or company makes a payment or buys a good or service using a credit card, debit card, cheque, direct debit or standing order the money is transferred from the person's account to the account of the merchant, and banks handle all the mechanics of the transfer using the payments system which operates in conjunction with the settlement system (settlement of accounts between banks), which is administered by various organisations - BACS, CHAPS, FPS etc. - and overseen by the BoE.
People who carry out transactions using bank money (practically everyone) keep sufficient money in a current account for that purpose, and they assume that that money exists and will be available when needed. Indeed banks promise to make it available on demand. But to recap what was discussed earlier almost all bank money comes into existence in response to someone taking on a debt, it did not exist before the debt was incurred, and it just consists of numbers in bank accounts. It first appears in the account of the person who takes on the debt, but rapidly moves to other people's accounts as that person buys whatever he or she wanted the money for. The other people's accounts will be spread between all banks, so in most transactions the bank will have to transfer reserves to other banks (in fact it is just the net amount of reserves at the end of each settlement period that are transferred, because many transactions between banks cancel each other out within a settlement period). Banks can't create reserves, only the BoE can do that, and if a bank runs short of reserves then it must borrow them, preferably from other banks (because the interest rate is lower) or failing that from the BoE. However when other banks doubt whether the bank in question is solvent (they believe that its borrowers are likely to default on their debts, making the failing bank's assets worth considerably less than their original value), they are unwilling to lend reserves for fear of losing them, and the BoE will only lend to a solvent bank, so a bank in this situation can't transfer reserves, and therefore it can't take part in the payments system on behalf of its customers and its role as borrower, lender and custodian of people's money seizes up. A failing bank is like a person with a very infectious disease, it can rapidly spread to other banks, businesses and personal customers because (a) the assets that the failing bank holds that are no longer trusted are more than likely held by all banks, as in the 2008 crash; (b) banks borrow reserves from each other to cover their day-to-day funding requirements, so a bank that can't pay back the reserves it owes to another bank puts the other bank at risk of not being able to pay its creditors and so on throughout the banking system; and (c) businesses and personal customers that rely on new borrowing or overdraft facilities from the bank can't have any more credit because the bank knows that it won't have the reserves to be able to pay the banks of the customers that those borrowers pay in bank money.
The government then has to decide how to handle the situation. Does it allow the individual bank to fail in the hope that it is the only bad apple in the barrel, compensating the bank's customers so that they can continue making transactions? Does it try to persuade another bank to take over the failing bank, perhaps offering a guarantee to cover its bad debts? Or does it embark on a massive confidence building exercise by making blanket guarantees for a wide range of banks' bad debts to persuade the banks to lend to each other again and thereby to rescue the lending and borrowing functions of banks and the payments system? In fact they are likely to try all possible solutions, increasing the stakes as the infection spreads, as they did in 2008. They are much more likely to rescue failing banks than to pick up the bill for deposit insurance because in practically all cases that would be much more costly (Jackson and Dyson 2012 pp91-94). Whatever they do it is the taxpayer that picks up the final bill. For an excellent account of government thinking and activities in this very situation read Gordon Brown's book 'Beyond the Crash' (Brown 2011). In it he gives a blow by blow account of the unfolding crisis and the deliberations and heart searching that went on in government at that very difficult time.
You may be forgiven for wondering why such a vital public service is allowed to be put at risk by banks, which are private, commercial companies with no obligation to manage their operations for anyone's benefit other than themselves and their shareholders. Indeed banks know full well that they will very likely be rescued if they fail, so they have every incentive to take excessive risks in pursuit of profits. This is known as 'moral hazard' - see chapter 50.
Since the crash a great debate has opened up as to what to do about banks that are too big to fail. Breaking them up into smaller entities and tighter regulation are the main contenders, but breaking them up doesn't guarantee to solve the contagion problem which relates to the degree of integration that banks have with each other and with other businesses and people; and private companies are able to devote many more resources into finding ways round regulations than public bodies are into devising those regulations, so the regulators are always one or more likely two or three steps behind. More radical and considerably more effective solutions are examined in chapter 55.