The present paper is concerned with the analysis of microstructural instabilities in granular materials and with their relation to both macroscopic localized and diffuse failure modes. A discrete-element (DEM) computer simulation of deformations in an idealized two-dimensional frictional particle assembly subject to various biaxial loadings—notably drained compression and proportional strain paths—is proposed as a prototype model to investigate the underlying physics of material failure. Based on the transfer of the second-order work criterion to the microscopic level, we seek for contacts tagged as   within the granular assembly that undergo instabilities during loading history. The DEM computations yield a description of failure as a microstructural self-organization process by which   contacts aggregate into clusters which can either grow or breakdown as the network of contacts adjusts itself to externally applied loads during deformation history. It is proposed here that there is a close relation between the clustering of   contacts and the resulting failure mode based on cluster size and spatial distribution. Localized deformations are found to correlate well with sustained growth of the above clusters, while diffuse failure has more to do with smaller clusters experiencing suppressed development. A comprehensive statistical analysis on the clusters lends support to this conclusion.