Essay

Luciano Figari Graduate Diploma in Economics 2013-2014

What features of banking may cause bank failures?

This essay will describe the features of banking that may cause bank failure and will give some examples of the market. In order to do so, an examination will be made of some of the main sources of the negative characteristics that eventually led to the failure of several banks across the USA during the financial crisis of 2008. The first examples will tend to generalise, but as the text moves forward a diverse range of causes that generate bank failure are explained; some examples of bank failure in the market are also included. The essay concludes with some thoughts about the consequences of the findings.

A relevant starting point is the approach of Cullen (2010: 1), who states that the last straw that forces regulators to close an institution is undercapitalization. He explains that of the 322 banks that failed from 2008 to 2010 in the United States of America (USA), 293, or 91%, were undercapitalized or worse the quarter before they were seized (2010: 6-7). Cullen (2010: 7) broadens the impact of undercapitalization in bank failure using a figure of capitalization the quarter before failure of several banks in the USA, as shown in Figure A: below.

Figure A:

The assertion that critical undercapitalization is one of the last straws of bank failure leads to the need to ask an important question: How does a financial institutions capital become depleted?
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Cullen (2010: 11) quotes the top eight causes for capital depletion and eventual bank failure in the USA during the financial crisis of 2008-2010; these are shown in Figure B below.

Figure B:

It is important to notice that in 75.74% of cases, one of the reasons for failure was poor credit administration practices. This means that three out of four banks failed during the economic crisis because of imprudent loan management. As loans are the largest assets on a banks balance sheet, they consequently have the greatest potential to negatively impact a depository institutions capital if they go bad, argues Cullen (2010: 12). In fact, his research reveals that 97.5% of the 322 banks that failed in the USA between 2008 and 2010 had loan quality problems.

These problem loans were accumulated through high levels of organic growth achieved by sacrificing credit quality, purchasing risky loan participations, and initiating out-of-territorylending, Cullen states. He adds that the failed banks also developed concentrations in commercial real estate and construction and development loans, products that performed the worst during 2008-2010 in the USA.

Considering the deep impact that loans assets make on a balance sheet, it is interesting to analyze the following table produced by Clarke (1988: 24), which presents loan portfolio management techniques of both healthy and failed banks operating in the USA in the 80s.

Clarke (1988: 7) also found that failed banks in the USA frequently exhibited a range of other kinds of particular behaviours related to loan management, such as inappropriate lending policies or excessive loan growth:

- Inappropriate lending policies: liberal repayment terms, collection practices, or credit standards (found in 86% of failed banks).

- Excessive loan growth in relation to the abilities of management staff control systems or funding sources (51%).

- Undue reliance on volatile liabilities - e.g., deposits greater than $100 thousand, but not necessarily brokered (41%).

- Inadequate liquid assets as a second source of liquidity (38%).

Other frequent behaviours that Clarke (1988: 9) found in failed banks and that critically determined their bankruptcy fate were:

- Excessive credit exceptions - i.e., missing financial statements or income information about borrowers or poor collateral documentation/perfection (found in 81% of the failed banks).

- Overlending - i.e., high loan amount relative to debt service ability of the borrower (73%).

- Collateral-based lending and insufficient cash flow analysis (55%).

- Unwarranted concentrations of credit to one industry (37%).

Another of the reasons that may lead to bank failure is fraud. Fraud is the only non-financial reason for failure, according to Cullen (2010: 7). He says that fraud accounted for at least six bank failures between 2008 and 2010 in the USA.

Cullen highlights the way in which fraud has the effect of misrepresenting the financial condition of a bank, such as in the case of the La Coste National Bank. In this example, the bank was well capitalized according to Call Report data and had no active enforcement actions; however, once it was discovered that the banks president was falsifying the books, the bank was immediately closed, Cullen explains.

Cullen (2010: 18-19) also presents another example of bank failure caused by fraud. The Westbound Bank, headquartered in Bremerton, Washington, was one of the fastest growing banks of the USA in the 2000s. From 2004 to 2007, the bank experienced an average yearover-year asset growth rate of over 65%. During the same period, their peer groups assets were growing at around 9.6%. One loan officer received $1.2 million, of which around 90% was incentive-based compensation, for originating construction loans from 2005 to 2007. The employee originated risky loans to individuals whose incomes turned out to be vastly overstated. Of the 124 construction loans originated by this one loan officer, every single loan turned out to be

adversely classified, accounting for 83% of the dollar value of the banks total adversely classified loans, Cullen reported. Thus, Westbound was able to become the fastest growing bank in the Pacific Northwest at the expense of loan quality. The bank was still well capitalized, but their loss allowance was less than 15% of their non-current loans. On May 8, 2009, the bank was closed by regulators.

Kaufman (1995: 2) provides another point of view, pointing out that banks are viewed as more fragile for three reasons. The first one, is that they have low capital-to assets ratios (high leverage), which provides little room for losses. The second, are low cash-to assets ratios (fractional reserve banking), which may require the sale of earning assets to meet deposit obligations. The third reason are high demand debt and short-term debt-to-total debt (deposits) ratios (high potential for a run), which may require hurried asset sales of opaque and non-liquid earning assets with potentially large fire-sale losses to pay off running depositors. Dwyer and Hafer (2001: 3), on the other hand, estimate the riskiness of banks bond portfolios in order to predict banks fates. They also take into account their leverage and their exposure to runs on notes.

Clarke (1988: 6) found that 60% of failed banks in the USA had directorates that either lacked the necessary banking knowledge or were uninformed or passive in the supervision of their banks affairs. He suggests that these failures may in part be the result of the inability of the board and management to understand important changes in the deregulated financial environment, like, for example, risk and return issues as compared to costs of funds.

Clarke (1988: 8) also states that 63% of the failed banks had CEOs who clearly lacked the capability, experience or integrity necessary to make their banks successful. A wide variety of characters who operated five years ago as CEOs may in fact still be in charge of important financial institutions today. We should be more aware of this possibility because these people have not been reliable in the past and therefore may not be reliable in the future.

Clarke (1988: 7) remarks that failed banks consistently lacked the necessary policies, systems and controls to guide their staff in performing the tasks required to maintain a well managed and income producing loan portfolio through both good and bad economic times. This leads
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us to conclude that these bankers were planning their operations by considering only a hypothetical present comprising good conditions. This is again an example of the risky behaviour of bankers, which, in this case, probably resulted from shareholder pressure to meet economic expectations.

Kaufman (1995: 1) states that the regulators have often increased both the probability of bank failure and the costs of such failures. The process of regulation has tended to socialize the costs of failure by shifting them from private depositors of the failed banks to general taxpayers. In relation to the policies of regulations and institutions, Kaufman (1995: 14) adds that they have frequently been incentive incompatible and counterproductive and have unintentionally introduced both moral hazard behaviour by the banks and principal-agent problems by the regulators that have intensified the risk and costs of banking breakdowns. He adds that the two periods of by far the largest number and greatest cost of bank failures in U.S. history occurred after the introduction of policies intended specifically to reduce cascading failures.

To assess how this policy of socializing losses may influence the behaviour of bankers, the report of Michel (2013: 1) can be examined. He remembers how in 2008 everyone thought that Lehman Brothers was going to be rescued by the Government. The Bear Stearns bailout set the expectation that Lehman would also be bailed out, setting up investors and creditors for a fall. At the very least, those with a stake in Lehman surely expected the government to minimize their losses, he explains.

Michel also reviews some of the factors that led to Lehman Brothers bankruptcy, aside from the turmoil, indicating how Lehman bankruptcy was just one of the symptoms, rather than a cause, of the financial crisis:

By the first quarter of 2007, defaults on subprime mortgages had risen to a four-year high.

By the last quarter of 2007, almost exactly one year prior to the Lehman collapse, both personal consumption expenditures and civilian employment for the U.S. began downward trends.

The difference between key interest rates spiked during the last half of 2007. The rise in these spreadsa commonly used measure of perceived riskindicates that market participants saw trouble in 2007.
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The Federal Housing Finance Agency placed Fannie Mae and Freddie Mac in government conservatorship on September 7, 2008, one week before the Lehman bankruptcy filing.

Cullen (2010: 32-33) points out that earnings can be manipulated due to the ability of a bank to decide how much and when to provision. This manipulation can be great due to the fact that loan and lease loss provisioning is often the biggest driver of net income. Figure T demonstrates that when provisioning expense is added back, there is a dramatic change in the percent of banks that were unprofitable. Almost half as many banks for certain quarters were reporting losses after provisioning expense was added back. Cullen adds that because of this sizeable impact, banks like La Jolla can report positive earnings even if failure is imminent. In fact, there were 19 failed banks that were reporting positive quarterly net incomes the immediate quarter before failure.

Cullen (2010: 38) says that 91% of all failed banks were undercapitalized or worse the quarter before failure. He adds that although capital is the last straw, its predictive power is poor due to a banks ability to decide how much and when to provision for loan and lease losses. Cullen believes that this problem is best solved by implementing a percentage of originated loan type provisioning methodology.

Wesrnhagen (2004: 66) comments that, for example, Spain, Norway, Sweden and the U.S. had very similar experiences when they liberalised their financial systems. In addition, in countries where there were a significant number of failures, real estate lending played a major role. The failure of large individual banks tended to be much more idiosyncratic.

This basically means than deregulation and financial liberalisation lead to bank failures.

The Treasury Select Committees report on bank pay blamed the bonus culture for the banking crisis, a journalist of The Daily Telegraph reported (2009: 1). The mega-bonus pay culture among banks encouraged a lethal combination of reckless and excessive risktaking, according to MPs. The committee also slammed bonus schemes for encouraging risk-taking at the expense of shareholder interests and the long-term health of the banks themselves. Somerset Webb (2012: 1) argues that the huge increase in bonuses linked to short-term measures of performance, such as returns to shareholders and return on equity, has naturally encouraged the observed changes, including an increased willingness to sack labour, combined with a disinclination to lower prices and a preference for share buy-backs over investment. Conclusion I suggest that there should be stronger regulation to punish the greedy and irresponsible behaviour of bankers, especially those from failed banks, because we, the taxpayers, will be paying for their mistakes with money from all our pockets for years. Public austerity measures have been established, including restricted budgets for health and education, because a large proportion of the government budget has been spent on banks. This banking crisis directly affected the welfare of the citizenship. The bonus culture, encouraged by the financial institutions, must come to an end because it created a criminalistic environment that encouraged greedy and irresponsible behaviour towards investment. Concentration on risk was commonplace and no regulation prevented this behaviour. If limits had existed regarding the concentration on certain types of sectors, like real estate, then the story would have been different. Therefore I adhere to the thesis that there has to be more regulation in the financial system in order to maintain its stability.

There should also be greater penalties for the bankers of failed institutions. They made all of us poorer, so now they should have no luxuries. They should without doubt experience austerity for themselves, especially those who committed fraud; these people are basically criminals. Considering that the financial system is connected with the real economy, we should make these changes quickly in order to stop the continuation of operations in risky areas.

References

Bdard, M. (2013). Contagious Bank Failures in a Free Banking System: A Belated Comment. Available at SSRN 2336954.

Caprio, G., & Klingebiel, D. (1996, April). Bank insolvency: bad luck, bad policy, or bad banking?. In Annual World Bank conference on development economics (Vol. 79). Washington: The World Bank.

Christensen, I., Meh, C., & Moran, K. (2011). Bank leverage regulation and macroeconomic dynamic. CIRANO-Scientific Publications 2011s-76.

Cullen, A. (2011). Why do banks fail? A look at characteristics of failed institutions from 2008 to 2010. Working paper.

Dwyer, G., & Hafer, R. (2001). Bank failures in banking panics: Risky banks or road kill?.

Ferguson, C. (2010). Inside Job.

Graham, F. C., & Horner, J. E. (1988). Bank failure: an evaluation of the factors contributing to the failure of national banks. In Federal Reserve Bank of Chicago Proceedings (pp. 405435).

Government Accountability Office. (2013). Causes and consequences of recent bank failures.

Journalist (2009). Bonus culture to blame for banking crisis, say MPs. The Telegraph. Available at: http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5328193/Bonus-cultureto-blame-for-banking-crisis-say-MPs.html (Accessed 24 November).

Kaufman, George G. (1996). Bank failures, systemic risk, and bank regulation. Cato J. 16 (1996): 17.

Michel, N. (2013). Lehman Brothers Bankruptcy and the Financial Crisis: Lessons Learned. The Heritage Foundation. Available at: http://www.heritage.org/research/reports/2013/09/lehman-brothers-bankruptcy-and-thefinancial-crisis-lessons-learned. (Accessed 22 November).

Rolnick, A. J., & Weber, W. E. (1984). The causes of free bank failures: A detailed examination. Journal of Monetary Economics, 14(3), 267-291.

Russia Today. (2013). La adiccin de los banqueros a la cocana puede ser la causa de la crisis mundial (The addiction of bankers to cocaine may have been the cause to the world crisis). Available at: http://actualidad.rt.com/economia/view/91834-cocaina-causa-crisisbanca-nutt. (Accessed 23 November) Somerset, M. (2012). How the bonus culture caused the financial crisis and how we can stop it happening again. Money Week. Available at: http://moneyweek.com/merrynsblog/how-the-bonus-culture-caused-the-financial-crisis-and-how-we-can-stop-it-happeningagain-20300/

Wesrnhagen, N. (2004). Bank failures in Mature Economies. Bank for International Settlements. Basel Committee.

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