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# Bank Failures

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## Nhi Sung

on 23 June 2010

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#### Transcript of Bank Failures

Bank Failures 7.5 Bank Failure: Quantitative Models Standard Definition of failure (insolvency) =

- All unhealthy banks (bailed out)
- “bad banks” (unhealthy assets = responsibility of the state)
- Merger of the remaining parts with a healthy banks
2 Econometric Methods commonly used:

1. Discriminant analysis
2. Logit/probit analysis
Multiple Discriminant Analysis = based on assumptions that quantifiable, pertinent data may be placed in two or more statistical populations

Discriminant Analysis = estimates a function (‘rule’) which can assign an observation to the correct population.
E.g. Bank failure assigned insolvent population or healthy one.
~historical econ data is used to derive the discriminant function that will discriminate against banks by placing they in 1 or the 2 populations.
Since Martin (1977) discriminant analysis is a special case of logit analysis ~most studies use multinominal logit model.
Logit model has a binary outcome
Bank fails, p=1 or does not, p=0
Standard equation:
(need to get from the book)
Logit model = 2-dimensional sigmold shaped curve.
Probability of failure on vertical axis and explanatory variable (capital adequacy) on the horizontal axis Standard Definition of failure (insolvency) =

- All unhealthy banks (bailed out)
- “bad banks” (unhealthy assets = responsibility of the state)
- Merger of the remaining parts with a healthy banks
Addresses the question of whether there is something unique to the group of bank failures.
Heffernan (2003) showed that the mulitnomial logit model is superior to the conditional logit model where the i are different for the failed and healthy groups.
Many variables when calculating:
Countries vary (size, gov’t, etc.)
Difficult in testing for effects of macroecon. Variables when 1 country is studied.
Potential for multicollineranty problems (lack of independence among variables)
Numerous measures of profitability, liquidity, capital adequacy and loan quality.
More on pg 401
Found lower loan growth rates made banks easier to fail:
D side: Borrowers from the banks, poorer screening by failed banks.
S side: Weaker banks writing off past loans, concentrating staff resources on firms in trouble rather than actively seeking loans, or problems with funding.
Banks set aside reserves are explicitly acknowledging loan loss problems and take appropriate action, thereby avoiding failure.
Other variables are found to be significant sign: increased liquidity reduces the probability of bank failure ~larger the banks the lower likely hood of failure.
1997 report 48 variables tested from 1985-1988, significant variables changed each year ~how should it be monitored?
Problem might be small, but because regulators are tracking such larger measures less likely to see.
If you add 1 more country, it is difficult to test influence of macroecon. variables.
Cebula (1999) overscomes this problem, uses % of bank failures ober several years as the dependent variable.
Heffernan (2003) test several macroecon. Variables in logit model data set was international, with banks from 8 countries.
7.6 Conclusion Chapter conducted qualitative and quantitative
analyses of troubled banks
Identifying chief determinants of bank failure
Defined liquidation
Merger with healthy bank
Government supervision
Rescue (bailout)
Principal causes of failure usually reflected by poor quality loan portfolio.

Managerial deficiencies = hard to distinguish between incompetence and fraud.

Clustering phenomenon suggestive of contributory macroecon. factors. ~Short period of time = contagion effect.
7.4 # of studies used logit model to identify variables that are significant in explaining the probability of bank failure.

Heffernan (2003) Fitch banking
rating variable = important

Econometric Studies (“too big to fail”)
Fraud
Moral Hazard
Regulatory forbearance and lotting
Falling profitability (Net Income:Total Assets)
Rising loan losses
Greater illiquidity
Macroecon. Indicators (inflation, real interest/exchange/GDP rates increase) 7.3. Case Studies on Bank Failure
7.1 Introduction

What do Bank managers, investors, policy makers and regulators share in common?

Why do they care?

How do we explain the causes of bank failure?

Why should we care about Bank Failures?

Bank Failure - Definitions

Range of key bank failures - case studies (Overend Gurney in 1866 -> Bank of Credit and Commerce International and Barings bank)

Econometric studies on bank failures and how they use logit model

7.2 Bank Failure - Definitions

Normally - the failure of profit-maximizing firm is defined as the point of insolvent:

- liabilities > assets
- net worth < 0

Ex. USA -> prompt corrective action with least-cost approach (FDIC) if banks fail to meet capital requirement criterias.

Japan -> few insolvent banks have been closed in post-war

Broader Definition of Bank failure (practicioners and policy makers)

- Liquidation
- Merged with healthy bank
- Rescued with state financial support

1. Some think Banks = Firms
2. Others claim bank failure justifies protection (100% safety net)
3. In between - varying level of intervention, such as deposit insurance, a policy of ambiguity as to which bank should be rescued, merging failing + healthy banks, etc...
7.3.1. Historical Overview Victorian England US between 1930 and 1933 Overend Gurney and Company Ltd (1866) 1857- The bank began to take on bills of dubious quality, and lending with poor collateral to
back the loans.
1865 – The bank started reporting loses of £3–£4 million.
1866 – A number of firms linked to Overend Gurney through finance bills, failed London-based
depositors began to suspect Overend was bankrupt
10 May 1866 – Overend sought assistance from the Bank of England, which was refused
Same afternoon – Overend was declared insolvent
Baring Brothers (1890) 1821–22 Baring's loan portfolio was expanded to include Mexico and Latin America

1888- 1890 Baring granted additional, large loans to the governments of Argentina and Uruguay
Problems with key banks in Argentina and Uruguay led to suspended payments and
bank runs follwowed by Barings’ Argentine securities dropping in value by one-third

1890 Barings reported the crisis to the Bank of England
Eight days after its illiquidity had become public knowledge BUT there was no run of
any significance, and no other banks failed
The stock market crash of October 1929 precipitated a serious depression and created a general climate of uncertainty. 1930 - An attempt by the Federal Reserve Bank of New York to organise a ‘‘lifeboat’’ rescue with
the support of clearing house banks failed

1932 -There were widespread bank failures in the Midwest and Far West

1933 - President Roosevelt declared a nation-wide bank holiday. The suspended operations and
failures caused losses of \$2.5 billion for stockholders, depositors and other creditors

a poor quality loan book and other bad investments was the principal cause of some bank failures but later on, due largely to bank runs, which forced banks to divest their assets at a large discount Both banks underwent notable changes in bank management in the years leading up to the failures.

The collapse of the banks was due largely to mismanagement of assets, leading to a weak loan portfolio in the case of Barings, and for Gurneys, the issue of poor quality finance bills.

The Gurney failure caused a serious bank run because the public lacked crucial information about the state of the bank’s financial affairs. The Latin
American exposure of Barings was well known, but there was no run because
of its historical reputation for financial health in the banking world. 7.3.2. Bankhaus Herstatt This West German bank collapsed in June 1974 because of £200 million losses from foreign exchange trading The risk with the failure to meet interbank payment obligations become known as Herstatt risk 1984 - The chairman of the bank was convicted of fraudulently concealing foreign exchange losses of DM 100 million in the bank’s 1973 accounts 7.3.3. Franklin National Bank 1974 - The Federal Reserve instructed FNB to retrench its operations because it had expanded too quickly.
FNB announced it had suffered very large foreign exchange losses and could not pay its dividend.
The bank had made a large volume of unsound loans, as part of a rapid growth strategy
The bank' remains were taken over by a consortium of seven European banks, European American
FNB had been used by its biggest shareholder, Michele Sindona, to channel funds illegally around the
world. 7.3.4. Banco Ambrosiano BA, collapsed in June 1982, following a crisis of confidence among depositors after its Chairman, Roberto Calvi, was found hanging from Blackfriars Bridge in London

The main cause of the insolvency appears to have been fraud on a massive scale 7.3.5. Penn Square and Continental Illinois CI lacked a rigorous procedure for vetting new loans, resulting in poor-quality loans to the US corporate sector, the energy sector and the real estate sector.
CI failed to classify bad loans as non-performing quickly, and the delay made depositors suspicious of what the bank was hiding.
The restricted deposit base of a single branch system forced the bank to rely
on wholesale funds as it fought to expand.
Supervisors should have been paying closer attention to liability management, in addition to internal credit control procedures. 7.3.6. Johnson Matthey Bankers JMB is the banking arm of Johnson Matthey, dealers in gold bullion and precious metals.
JMB got into trouble because it managed to acquire loan losses of £245 million on a loan portfolio of only £450 million
The auditors also appeared to be at fault*
7.3.7. The US Bank and Thrift Crises, 1980–94 Failing thrifts Failing US commercial banks Bush Plan highlights

New restrictions on the investment powers of S&Ls, requiring them to specialise more in mortgage lending, thereby reversing the earlier policy. Under the qualified thrift lender (QTL) test, at least 65% of their assets must be mortgage related.

An attempt to stop the regulatory forbearance witnessed in the 1980s by abolishing the institutions which promoted it. The Act dissolved the FSLIC and established the Savings Association Insurance Fund (SAIF) under the auspices of the FDIC. The Federal Home Loan Bank Board was closed and replaced with the Office of Thrift Supervision (OTS), under the direction of the Secretary of the Treasury.

Thrifts are required to meet capital requirements at least as stringent as those imposed on commercial banks, and the Act set out new rules on higher minimum net worth.

The Resolution Trust Corporation (RTC) was established to take over the case-load of insolvent thrifts. The RTC was allocated funds to pay off the obligations incurred by the FSLIC, and subsequently received \$50 billion in additional funding, to be used by the Corporation to take over 350 insolvent thrifts, and either liquidate or merge them.

Commercial banks were allowed to acquire healthy thrifts – prior to this Act, they could only take over failing savings and loans. The first signs of trouble came in the mid-1960s, when inflation and high interest
rates created funding problems. Regulations prohibited the federally insured savings and loans from diversifying their portfolios, which were concentrated in long-term fixed rate mortgages.

The thrift industry suffered as a result of concentration of credit risk in the
real estate market and exposure to interest rate risk through long-term fixed interest loans and mortgage backed securities, valued on their books at the original purchase price.
Rising interest rates reduced the value of these securities and forced the thrifts to bear the burden of fixed interest loans.

The problem was compounded by policies of regulatory forbearance
because the FSLIC and the Bank Board had a vested interest in keeping the thrifts afloat.

Though the cost of resolving the crisis was considerable, the success of the RTC and FDIC in the management and disposal of the assets was instrumental in significantly reducing these costs.

Some of the duties of the Resolution Trust Corporation have become a model for the ‘‘good bank/bad bank’’, and one of the standard tools for resolving bank crises.
Phase 1: The early 1980s -The main problem arose because of interest rates. Many of the failing or problem banks had high quality loan portfolios, but were hit by adverse economic conditions. Phase 2: 1984–91. In 1984, there was a shift in bank failures to some southern states, Arkansas, Louisiana, New Mexico, Oklahoma and Texas, officially defined as the south-west
by the FDIC (1997, 1998).
First, volatile oil prices
Problem banks were not spotted early enough because bank examinations were infrequent
Increased competition from deregulated S&Ls, and an increase in the number of new banks Phase 3: 1991–94. In this phase, the concentration of troubled banks shifted from the south-west to the north-east, i.e. New England, New Jersey and New York State. Bank of New England failed in 1991 due to a large number of non-performing loans On 6 January, the OCC appointed the FDIC as receiver. The FDIC announced that three new ‘‘bridge banks’’ had been chartered to assume the assets and liabilities of the three insolvent banks

All depositors of the three BNEC banks (independent of deposit size) were protected, but shareholders and bondholders suffered heavy losses.

The House of Representatives Banking Committee expressed concern that this decision was disadvantageous for savers at small banks, and undermined incentives for depositors to monitor their banks’ activities.

When the FDIC Improvement Act was passed in 1991 this ‘‘too big to fail’’ episode was one of the incidents which influenced legislators to impose tighter restrictions to limit the protection of uninsured depositors. 7.3.8. UK Small Bank Failures and Liquidity Problems, 1991–9333 in 1993, The Bank of England decided to take action because it believed
contagion was the main culprit, which could spread to larger banks if not kept in check.

Not all banks survived. Auditors of the National Mortgage Bank could not sign it off as healthy because of concerns about its illiquidity.

In total, 25 small banks failed in the first half of the 1990s,
but there was no contagion or systemic crisis, no doubt due to the willingness of the Bank to support the small banks that were illiquid but solvent. 7.3.9. The Secondary Banking Crisis, 1973 A tightening of monetary and fiscal policy in 1973, together with the first OPEC oil price hike, caused interest rates to increase and declines in property prices and the stock market. The Bank of England organised a lifeboat rescue: 26 secondary banks were given £1.3 billion in loans, 90% of which came from the major UK clearing banks. The lessons from the crisis were reflected in the UK’s first major piece of banking legislation, passed in 1979 (see Chapter 5), which included a deposit insurance scheme and tighter restrictions on bank licensing 7.3.10. Barings Brought down by a rogue trader but also by bad senior management:
Mr Leeson controlled simultaneously the front and the back offices allowed him to hide losses in the 88888 account
Senior management authorized a huge outflow of £569 million of capital from Barings, London to Barings, Singapore whereas its total capital was only £540 million.
Bonus driven behavior could have been avoided 7.3.11. Daiwa Bank In September 1995, a senior bond trader, Mr Toshihide Iguchi, lost just over \$1.1 billion, over a 10-year period, while working for the New York branch of Daiwa Bank. He covered up the trading losses through the sale of securities stolen from customer accounts, which
were replaced by forged securities. Daiwa had agreed to reorganise the bank to ensure separation of back and front offices but did not comply 7.3.12. Sumitomo Corporation One of Sumitomo’s copper traders, Yasuo Hamanaka, hid losses of \$1.8 billion, which eventually rose to \$2.6 billion

Tried in Tokyo in 1997, Hamanaka pleaded guilty to charges of fraud
and forgery. 7.3.13. Allied Irish Bank/Allfirst Bank On 6 February 2002, Allied Irish Bank (AIB) announced it was to take a one-off charge of
\$520 million to cover losses from a suspected fraud of \$750 million involving currency trades of John Rusnak, who joined the bank in 1993

Mr Rusnak pleaded guilty to one charge of bank fraud in October
2002, and was jailed for 7.5 years. There is no evidence he gained financially from these
frauds (apart from bonus payments that were bigger than they would otherwise have
been) – he was using them to cover up ever-increasing losses The most lasting effect of these failures is the consternation rogue trading caused among members of the Basel Committee, and their subsequent attempt to include an explicit measure for operational risk in the Basel 2 risk assets ratio All three banks suffered from rogue traders, which resulted
in the UK’s oldest merchant bank failing, eventually being reduced to a tiny part of the operations of a multinational bank 7.3.14. Canadian Bank Failures During the autumn of 1985, five out of 14 Canadian domestic banks found themselves in difficulty. The problems was that the loans portfolio were concentrated in the real estate and energy sectors.
A rescue package (CDN \$225 million) was put together, the six largest banks contributing \$60 million but failed to restore the confidence of depositors and contagion spread to other smaller regional banks in Canada
Some depositors returned after the bank launched a campaign to restore confidence, which included an examination of its loan portfolio by 25 officials from the big six banks.
Nhi Sung Paolo Lising Sarah Phillips 3 ways Regulators can deal with the problem:

1. Put the bank in receivership and liquidate it. (Assets sold and insured depositors paid off – most frequent in USA)
2. Merge failing bank with healthy bank
- Most common to allow healthy bank to purchase failing bank without the bad assets
- Recently Purchase and Acquisition (P&G), assets are purchased and liabilities are assumed by acquirer
3. Government intervention (exm: lending assistance, guarantees for claims on bad assets, or even nationalization of banks)
7.2.1 How to Deal with Failed Banks: The Controversies

1. 3 main concerns for any industry:
- asymmetric information
- agency problems
- moral hazard
In the banking sector these 3 together can be responsible for the collapse of the financial system

7.4. The Determinants of Bank Failure:
A Qualitative Review
7.4.1. Poor Management of Assets Weak assets management = weak loan book, usually because of excessive exposure in one or more sectors

Numerous examples of excessive loan exposures that regulators failed to control 7.4.2. Managerial Problems e.g. The case of Barings
Failure due to uncovered exposure in the derivatives market Exposure in the Far East
The case of Continental Illinois
Failure due to the collateral backing the loan The case of Barings

Brought down by a rogue trader but also by bad senior management where Mr Leeson controlled simultaneously the front and the back offices allowed him to hide losses in the 88888 account 7.4.3. Fraud An explosive problem that is difficult to prevent or to detect.

Most frequent cause of bank failures

Many thrift managers bought junk bonds to profit from short-term high interest payments, when they knew default was likely in the longer term.

Line between Fraud and bad management is thin (Barings case) 7.4.4. The Role of Regulators Bank examiners, auditors and other regulators missed important signals and/or were guilty of regulatory forbearance
A policy of leniency or indulgence in enforcing a collectable claim against another party
BCCI case: Communication difficulties between the auditor (PWC) and the Bank of England. 7.4.5. Too Big to Fail Pros
Prevent runs and systemic failure of the banking system
Cons
Moral Hazard Problems
Aggravates looting tendencies
Contribute to regulatory forbearance.
Creates competitive disparities between large and small institutions 7.4.6. Clustering Bank Failures in a country tend to be clustered around a few years, rather than being spread evenly through time
Examples:
Norway: 22 banks were the subject of state intervention between 1988 and 1991, after a post-war period free of bank failures
Japan: banking problems coincided with the worst depression in the post war area
Secondary banking crisis (1973-1974) and the small bank crisis (1991-1994) are consistent with the clustering 7.4.7. Miscellaneous Factors Ownership structure can affect the probability of bank failure Since the reserves from part of the funds used to finance risky ventures, investment in risky loans offer an attractive risk reward combination
Mutuals are more likely to play safe, and know more about their borrowers
Over 60% of the soon to fail thrifts were shareholders owned compared just to 25% of mutuals Examples :
Bankhaus Herstatt and Franklin National Bank
The US thrifts Lack of experience with relatively new financial products Bank Run Commence:
1.Bank core function – intermediation (banks pay interest on deposits and lend funds to borrows but at a higher interest rate to include admin costs, a risk premium and profit margin for banks)

2.Banks need to maintain liquidity ratio (liquid assets/total assets) -> only a fraction of deposits is available to be paid out to customers at any point in time.

3.Gap between socially optimal liquidity from a safety standpoint and the ratio a profit-maximising bank will choose.

4.Given banks (healthy ones) Because of asymmetric information this can lead to a sudden surge in the withdrawal of deposits by uninsured depositors and investors selling their stock. -> Contagion effect leading to potential systemic run.

Methods to counter Runs/cushion shocks to credit:

1 Reserve ratio (place a fraction of non-interest earning deposits at the central bank – basically a tax on banking activity) -> reduced this reservse ratio

2 Now preferred method: set aside a capital charge against the risk weighted assets (Credit, Market, Operational) – Basel 1 & 2

Central Bank

1 Absence of intervention to provide liquidity: bank’s liquidity problems -> insolvency or negative net worth

2 Intervention but with two outcomes:

- Climate of trust: able to convince depositors problem is confined to one bank then this will stop the bank run

- No climate of trust: unable to convince depositors -> contagion -> systemic problems affecting other banks and perhaps all banks.

Kaufman (1994) findings for contagion theories

1 Bank contagion spreads faster in banking sector versus non-banking

2 Bank contagion is both industry and/or firm specific; depositors tend to be less well informed about performance of bank and banking sector. Evidence to suggest that Bank contagion and bank runs are firm specific, and depositor and investors can differentiate healthy vs unhealthy -> cost of failure also appear to be lower.

3 Bank failure results in larger number of failures b/c of contagion

4 Contagion results in larger losses for depositors but < losses to creditors

5 Little evidence to support view that runs on banks cause insolvency among solvent banks, nor does it spread to other parts of the financial sector or rest of macroeconomy.

Summarize to prevent reduce Bank Failures

1 Banking system needs to be more closely regulated than other markets because of market failure from asymmetric information and negative externalities.

2 Special regulations: deposit insurance, capital charge requirement (Basel 1 & 2), regular examinations of banks, intervention by authorities at early stage of problems, and lifeboat rescues.
a. Advantages: timely intervention and special regulations will prevent any serious threats to financial systems in developed countries (chapter 8 – exception Japan & Scandinavia)

b. Does not hold true for emerging and developing countries (contagion responsible for spread of threat of financial crisis – Thailand, Korea, Indonesia, Malaysia, Philippines, Russia, Brazil, and others)

c. Disadvantages: Moral hazards arise in the presence of deposit insurance and/or if a central bank provides liquidity to a bank.

3. Final argument - Reducing moral hazard
Banks pay the insurance premia to fund the deposits

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