When banks fail, credit contracts, which is deflationary. From Alasdair Macleod at goldmoney.com:
The theme of this article is debt deflation. How likely is it that the downturn in broad money supply will continue, and if so, why? And what are the consequences?
The major central banks have increasingly resorted to interest rate management as their principal means of demand management. Yet history shows little correlation between managed interest rates and the growth of credit, which is represented by broad money statistics.
It can only be concluded that central banks have finally lost control over interest rates, and that they are now being driven by the contraction of commercial bank credit. The great unwind of the credit bubble, which was four decades in the making, is being driven by a growing fear of lending risk among bankers, exacerbated by the recent failures of a few significant banks. For bankers, it is no longer a time for greed, but for fear and a reduction of their debt obligations.
This article draws on the experience of the 1970s for empirical evidence and expands on the reasons behind it. It notes that the dynamics behind the crisis for the UK, which led to gilts being issued with coupons over 15%, in some key respects were milder than that faced by the US and other nations today.
It can only result in debt traps being sprung on government finances, and a shift from credit creation by commercial banks to central banks. The visible debasement of the most senior form of credit will only exacerbate the problems for government funding, increasing their welfare costs, collapsing tax revenues, and escalating borrowing costs.