Sapienza Università di Roma

International Banking

Lecture Nine

Bank Failures

Prof. G. Vento

Agenda

• Bank failures: some definitions• US approach to bank failures • Regulation of failing banks• Contagion theories• Failed bank resolution strategies• The determinants of bank failure• The Icelandic banks’ failure

April 2013

1. Bank failure: some definitions• Normally the failure of a firm is defined as the point of

insolvency, where the company’s liabilities exceed its assets and its net worth turns negative.

• In US there were cases of banks failures, whereas in Europe and Japan these are very rare.

• Bank failure: a bank is deemed to have failed if it is liquidated, merged with a healthy bank under central government/supervision pressure, or rescued with state financial support

• Some think a failing bank should be treated the same way as a failing firm in any other industry; others claim that failure justify government protection because of its potential systemic effect on an economy

April 2013

2. USA approach to bank failures• In the US legislation, since 1991, has

required the authorities to adopt a least cost approach, from the standpoint of the taxpayer, to resolve bank failures

• According to this, most troubled banks have to be closed, unless a healthy bank is willing to engage in a takeover

• Takeover includes taking on the bad loan portfolio or any other problem that got the bank into trouble in the first place

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2. 2008-2010 bank failure in USA• Twenty-five banks failed and were taken over by the Federal

Deposit Insurance Corporation (FDIC) in 2008, while 140 failed in 2009. In contrast, in the five years prior to 2008, only 11 banks had failed.

• The FDIC seizes a bank's assets when its capital levels are too low, or it cannot meet obligations the next day. After seizing a bank's assets, the FDIC acts in two capacities

1. it pays insurance to the depositors, up to the deposit insurance limit, for assets not sold to another bank.

2. as the receiver of the failed bank, it assumes the task of selling and collecting the assets of the failed bank and settling its debts, including claims for deposits in excess of the insured limit.

• Updated list of US failed banks: http://www.fdic.gov/bank/individual/failed/banklist.html

April 2013

2. Deposit insurance and failures in US

• The FDIC insures up to $250,000 per depositor, per insured bank, as a result of the Emergency Economic Stabilization Act 2008, which raised the limit from $100,000. This will revert to $100,000 in 2014.

• The receivership of Washington Mutual Bank by federal regulators on September 2008, was the largest bank failure in U.S. history.

• Shareholders of various failed banks have alleged that the government regulatory agencies acted in an arbitrary and capricious manner and seized banks for political reasons or in order to benefit other banks that could then purchase them for very small amounts of money.

• Washington Mutual shareholders have claimed that as of the date of the takeover, the bank had enough liquidity to meet all its obligations and was in compliance with the business plan, but was nevertheless taken over and sold off to JPMorgan Chase at a fraction of its market value.

April 2013

3. Regulation of failing banks

• There are three ways regulators can deal with the problem of failing banks:

1. Put the bank in receivership and liquidate it. Insured depositors are paid off and assets are sold

2. Merge a failing bank with an healthy bank. The healthy bank is often given incentives, like purchasing the bank without bad assets; often it involves the creation of an agency which acquires the bad assets

3. Government intervention, ranging from emergence of lending assistance, guarantees for claims on bad assets or even nationalisation of the bank

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4. Contagion theories

• Contagion arises when healthy banks become the target of runs, because depositors and investors, in the absence of information to distinguish between healthy and unhealthy banks, rush to liquidity.

• Bank contagion spreads faster in the banking sector compared to other sectors

• Bank’s contagion and bank runs are largely firm-specific and rational: depositors and investors can differentiate between healthy and unhealthy banks

• Bank contagion results in a larger number of failures• Little evidence that runs of bank cause insolvency among

solvent banks

April 2013

5. Failed bank resolution strategies and who loses

Resolution option

Shareholders – lose money

Creditors – lose money

Taxpayers – Government injection

Managers – lose jobs

Employees – lose jobs

Capital injection by shareholders

Yes, in the short term

No No Yes, likely Possibly, in case of cost cuts

Government injection

Likely Likely Yes Likely Likely

M&A – state funded

Partly Possibly Yes Yes Likely

M&A – private Likely Likely No Yes Yes

Purchase & Acquisition

Yes Yes if uninsured

Possibly Yes Yes

Bridge bank/ nationalisation

Yes Possibly Yes Yes Possibly

Liquidation Yes Yes if uninsured

No Yes Yes

April 2013

6. The determinants of bank failure: poor management of assets

• Weak asset management, consisting of a weak loan book, usually because of excessive exposure in one or more markets, although regulators set exposure limits

• Weak asset management often extends to the collateral of security backing the loan, because the value of the collateral is highly correlated with the performance of the borrowing sector

• Example: Barings collapse in 1995 due to uncovered exposure in the derivative market.

April 2013

6. The determinants of bank failure: managerial problems

• Deficiencies in the management of failing banks is a contributing factor in virtually all cases

• i.e. ‘bonus driven behaviour’ may have serious consequences in financial sector because of the maturity structure of the assets: what looks profitable today may not be so in the future.

• Example Credit Lyonnais in 1993 had severe problems because the president wanted to grow at any cost, regardless the asset quality.

April 2013

6. The determinants of bank failure: fraud

• Benston noted that 66% of US bank failures from 1959 to 1961 were due to fraud and irregularities; the percentage raised to 88% in the period 1960-74, according to Hill

• The FDIC reported that about a quarter of bank failures in the period 1931 – 1958 were due to financial irregularities by bank officers.

• There are links between frauds and bad management

• Internal auditing should prevent frauds

April 2013

6. The determinants of bank failure: the role of regulators

• Regulatory forbearance: putting the interests of the regulated bank ahead of the taxpayer

• There are lacks of communication between external auditors and supervisory authorities

• Most failures depended on cross border activities, which are difficult to be supervised

• Financial groups are more and more internationally based, thus ‘college of supervisors’ have been created

April 2013

6. The determinants of bank failure: “Too BIG to fail”

• In France and in Japan safety net is close to 100%, rarely letting any but the smallest banks fail, and nationalising any large one that are effectively insolvent.

• In UK the regulators operate a policy of deliberate ambiguity with respect to bank rescues (see Northern Rock case).

• In US the “least cost approach” has been introduced for dealing with bank failures.

• One of the biggest US companies referred to as too big to fail is American International Group (AIG).

April 2013

6. The determinants of bank failure: clustering

• Bank failures in a country tend to be clustered around a few years, rather than being spread evenly through time.

• A possible reason for clustering may be the failure of timely intervention by the government/regulatory authorities

• Also macroeconomic environment may play a role.

April 2013

6. The determinants of bank failure: miscellaneous factors

• Ownership structures affects the probability of bank failure. The decline in mutual ownership of thrifts could be a partial explanation for thrift industry crisis in US.

• Banking structure/competition is a second possible factor.

• 100% deposit insurance creates moral hazard problems because banks have an incentive to assume greater risks than they would in absence of deposit insurance and depositors have less reason to monitor banks.

April 2013

7. The Icelandic bank’s failures

• The 2008–2009 Icelandic financial crisis is a major on going economic crisis in Iceland that involves the collapse of all three of the country's major banks following their difficulties in refinancing their short-term debt and a run on deposit in the UK.

• Relative to the size of its economy, Iceland’s banking collapse is the largest suffered by any country in economic history

• Bank Glitnir was placed in receivership.

April 2013

FINANCIAL CRISESNext Lecture:

April 2013