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This classroom-ready tutorial reviews the sources of bank failures and the tools that regulators use to restructure failed banks
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Slideshow for your Classroom fromEd Dolan’s Econ Blog
A Tutorial on Bank Failureand Bank Rescue
March 2013
Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.
Protest Against Rescue of Anglo Irish BankPhoto source: Joe Higgins Euro Election Campaign via http://commons.wikimedia.org/wiki/File:Protest_against_bailout_of_Anglo_Irish_Bank.jpg
Big Banking Problems in Countries Large and Small
Ireland, Iceland, and Cyprus are all small countries that have had big banking problems
Big countries can have banking crises too—US, UK, Russia and others
Questions: What causes bank failures? What tools do regulators have for
rescuing failed banks? Who wins and who loses when banks
fail? Who wins and who loses when they are
rescued? Protest Against Rescue of Anglo Irish BankPhoto source: Joe Higgins Euro Election Campaign via http://commons.wikimedia.org/wiki/File:Protest_against_bailout_of_Anglo_Irish_Bank.jpg
March 2013 Ed Dolan’s Econ Blog
Stylized Balance Sheet of a Typical Bank
A bank’s assets are all the things of value that it owns, including reserves of cash, loans, and securities
Its liabilities are all of its obligations to other parties, including . . . Deposits Borrowing in the form of short-term
interbank loans, bonds, etc. By definition, capital, which
represents shareholders’ stake in the bank, is equal to assets minus liabilities
March 2013 Ed Dolan’s Econ Blog
Capital = Assets - Liabilities
Solvency and Insolvency
A bank is solvent if its assets exceed its liabilities, as is the case for this balance sheet
If the value of its assets decreases, for example, because a borrower fails to repay a loan in full or because a change in market condition forces it to sell securities for less than their book value, its capital decreases
When its capital falls to zero or below, the bank becomes insolvent
March 2013 Ed Dolan’s Econ Blog
Insolvency: An example
In this example, suppose a borrower defaults on a $100 loan, reducing the bank’s total assets by that amount
The bank still owns $700 to depositors and $200 to other creditors from whom it has borrowed
The loan loss brings the bank’s capital to zero, and it becomes insolvent
March 2013 Ed Dolan’s Econ Blog
Items that change are shown in color
Danger! Zombie Banks!
Normally an insolvent bank must cease operation
If regulators allow an insolvent bank to keep its doors open, it becomes a zombie bank
Risks of zombie banks: Because owners have nothing left to lose,
the bank may take huge risks to try to restore solvency
Insiders may be tempted to steal the bank’s remaining assets and disappear before regulators close the bank
Even if managers act in good faith, continued losses will raise the cost of any future rescue
March 2013 Ed Dolan’s Econ Blog
Banks can be Zombies, Too!Photo source: Kenny Louie via http://commons.wikimedia.org/wiki/File:Unleashed_%284925630503%29.jpg
How Runs Can Contribute to Bank Failure
A bank run occurs when many depositors at once try to withdraw their funds because they fear the bank will fail
In order to meet the demands of depositors, the bank may be forced to sell loans, securities, or other assets at “fire-sale prices” below the value they are listed on the bank’s books
The loss in the value of the banks assets reduces its capital
The fear of insolvency that caused the run then becomes self-fulfilling
March 2013 Ed Dolan’s Econ Blog
Depositors Line Up During a Run on Northern Rock Bank, 2007
Photo source: Lee Jordan via http://commons.wikimedia.org/wiki/File:Birmingham_Northern_Rock_bank_run_2007.jpg
Example: How a Bank Run can Lead to Insolvency
Suppose a bank run leads to withdrawal of $300 worth of deposits
The bank covers the first $50 from its reserves of cash
To raise the balance, it sells securities, but in this case, market conditions are unfavorable so the bank has to sell all of its remaining securities, which previously had a book value of $350, to raise the remaining $250 it needs to cover withdrawals
The end result: The bank’s liabilities have fallen by $300 but its assets have fallen by $400, so the bank is now insolvent
March 2013 Ed Dolan’s Econ Blog
Items that change are shown in color
Liquidation
Bank regulators may try to find another bank to take over what is left of the failed bank
If they cannot do so, they will have to liquidate the failed bank by selling its remain assets to pay off depositors and other creditors
If the bank’s $600 of loans can be sold at their book value, then all depositors and other creditors can be paid in full
Nothing is left for shareholders, who are wiped out
March 2013 Ed Dolan’s Econ Blog
Items that change are shown in color
Liquidation with a Haircut
Sometimes sale of the bank’s assets does not raise enough cash to pay off all creditors
Suppose selling the bank’s remaining loans (original book value $600) raises only $500 in cash
That is enough to pay depositors in full, but only enough to pay other creditors half of the $200 that the bank has borrowed
In financial jargon, we say that creditors are forced to take a haircut of 50 percent
In a more extreme case, unsecured creditors may be wiped out and even depositors may be forced to take a haircut
March 2013 Ed Dolan’s Econ Blog
Items that change are shown in color
Too Big to Fail
Sometimes regulators decide not to liquidate a bank because they think it is too big to fail (TBTF)
The reason may be economic . . . Failure of a big bank might start a panic that
damages the whole financial system Nonfinancial businesses might lose a key
source of credit . . . or political
Cronyism or revolving-door appointments between banks and government
Bribery, campaign contributions, or other forms of corrupt influence
If the bank is TBTF, regulators may try to restructure it to keep it in business
March 2013 Ed Dolan’s Econ Blog
Picture source: Caitlin via http://commons.wikimedia.org/wiki/File:Elephant_%281%29.jpg
Restructuring Tool 1: Emergency Loans to the Bank
In some cases emergency government loans may be enough to save the bank by giving it time to sell assets at a better price
If the loans are made at a below-market interest rate, they may help restore profitability
Loans to a bank increase its assets and liabilities by equal amounts, so they do not directly increase its capital
They are likely to work best for banks that are weak but not completely insolvent
March 2013 Ed Dolan’s Econ Blog
Walter Bagehot, a 19th century financial writer, thought that the government
should act as a lender of last resort, but only to banks that are solvent
Photo source: Popular Science Monthly via http://commons.wikimedia.org/wiki/File:PSM_V12_D400_Walter_Bagehot.jpg
Restructuring Tool 2: A Carve-Out of Bad Loans
A second tool of bank restructuring is for the government to swap good assets, like government bonds, for bad assets, like nonperforming loans
This operation is called a carve-out If the terms of the carve out are favorable, it
will increase the bank’s capital The restructuring agency will suffer a loss
when it eventually sells the bad assets for whatever price they will bring
March 2013 Ed Dolan’s Econ Blog
Restructuring Tool 3: A Capital Injection
A third tool is for the government to nationalize the bank, in whole or in part, by exchanging good assets like government bonds for equity in the bank in the form of shares of stock
This operation is called a capital injection Eventually the government can try to resell
its shares in the bank to private investors, possibly at a loss, but if it is lucky, at a profit
March 2013 Ed Dolan’s Econ Blog
When a Restructuring Becomes a Bailout
Sometimes a restructuring is done in such a way that the original shareholders are completely wiped out
In other cases, the original shareholders of an insolvent bank may retain full or part ownership in the restructured bank, suffering only a partial loss of their investment, or none at all
In the latter case, we say that the restructuring has become a bailout
March 2013 Ed Dolan’s Econ Blog
An astronaut undergoes emergency bailout training
Photo source: NASA via http://commons.wikimedia.org/wiki/File:Astronaut_Julie_Payette_during_emergency_bailout_training.jpg
Bailout vs. Bail-In
If the unsecured creditors of a failed bank avoid losses because of the restructuring, then they, too, are bailed out
Instead, regulators may insist that unsecured creditors accept haircuts as a condition of the restructuring plan
The decrease in the creditors’ claims on the bank helps to recapitalize it
In this case, we say that the creditors are bailed in instead of being bailed out
In extreme cases, depositors may also be bailed in with forced haircuts
March 2013 Ed Dolan’s Econ Blog
HMS Candytuft sinking after a U-boat attack, Nov. 1917
Photo source: UK government via http://commons.wikimedia.org/wiki/File:HMS_Candytuft_sinking_1917_IWM_SP_470.jpg
The Bottom Line: Someone Must Always Bear the Costs
It would be wrong to think that bank losses are only “paper losses” that can be resolved with some accounting trick
Bank losses reflect real waste of resources, for example, construction of unwanted homes that are financed by bank loans during a housing bubble
Someone must always bear the cost If the government bails out bank owners,
creditors, and depositors, then taxpayers end up paying for the bad investments
March 2013 Ed Dolan’s Econ Blog
Unfinished housing development, Dunfanaghy UK, 2009
Photo source: Ross via http://commons.wikimedia.org/wiki/File:Unfinished_housing_development,_Dunfanaghy_-
_geograph.org.uk_-_1426980.jpg
If you liked this slideshow, you may also want to see these:• What is Basel III and Why Should we Regulate Bank Capital?• More
on Financial Regulation and Basel III: Regulating Bank Liquidity
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