# Bank Failure – Definitions - Modern Banking

Normally, the failure of a profit-maximising firm is defined as the point of insolvency, where the company’s liabilities exceed its assets, and its net worth turns negative. Unlike certain countries that default of their debt, some banks do fail and are liquidated.

In other countries, notably Japan (though it is attempting to move towards a US-type approach) and some European states, relatively few insolvent banks have been closed in the post-war period, because of real or imagined concerns about the systemic aspects of bank failure. Thus, for reasons which will become apparent, most practitioners and policy makers adopt a broader definition of bank failure: a bank is deemed to have ‘‘failed’’ if it is liquidated, merged with a healthy bank (or purchased andacquired1) under central government supervision/pressure, or rescued with state financial support.

There is a wide range of opinions about this definition. Some think a failing bank should be treated the same way as a failing firm in any other industry. Others claim that failure justifies government protection of the banking system, perhaps in the form of a 100% safety net, because of its potential for devastating systemic effects on an economy. In between is support for varying degrees of intervention, including deposit insurance, a policy of ambiguity as to which bank should be rescued, merging failing and healthy banks, and so on.

The debate among academics is reflected in the different government policies around the world. The authorities in Japan (until very recently) and some European states subscribe to the view that virtually every problem bank should be bailed out, or merged with a healthy bank. In Britain, the tradition has been a policy of ambiguity but most observers agree the top four or five commercial banks2 and all but the smallest banks would be bailed out.

The United States has, in the past, tended to confine rescues to the largest commercial banks. However, since 1991, legislation3 has required the authorities to adopt a ‘‘least cost’’ approach (from the standpoint of the taxpayer) to resolve bank failures, which should mean most troubled banks will be closed, unless a healthy bank is willing to engage in a takeover, including taking on the bad loan portfolio or any other problem that got the bank into trouble in the first place.

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 sold. This approach is most frequent in the USA, but even there, as will be observed, some banks have been bailed out.
2. Merge a failing bank with a healthy bank. The healthy bank is often given incentives, the most common being allowing it to purchase the bank without the bad assets. Often this involves the creation of an agency which acquires the bad assets, then attempts to sell them off. A similar type of takeover has emerged in recent years, known as purchase and acquisition(P&A). Under P&A, assets are purchased and liabilities are assumed by the acquirer. Often a state or state-run resolution pays the difference between assets or liabilities. If the P&A is partial, uninsured creditors will lose out.
3. Government intervention, ranging from emergence of lending assistance, guarantees for claims on bad assets or even nationalisation of the bank.

These different forms of intervention are discussed in more detail below.

The question of what causes failure will always be of interest to investors, unprotected depositors and the bank employees who lose their jobs. However, if the state intervention school of thought prevails, then identifying the determinants of bank failure is of added importance because public funds are being used to single out banks for special regulation, bailout/merge banks and protect depositors. For example, the rescue of failing American thrifts in the 1980s is estimated to have cost the US taxpayer between $250 and$300 billion.

In Japan, one reason the authorities shied away from early intervention was a hostile taxpaying public. However, the use of public funds to inject capital into weak banks and nationalise others, together with the need to extend ‘‘temporary’’ 100% deposit insurance well past its ‘‘end by’’ date, had raised the cost of the bailout to an estimated 70 trillion yen(\$560 billion).4 Posen (2002) estimates the direct cost of the Japanese bailout to the year2001 to be 15% of a year’s GDP, compared to just 3% for the US saving and loan debacle.

How to Deal with Failed Banks: The Controversies

Most academics, politicians (representing the taxpayer), depositors, and investors accept the idea that the banking sector is different. Banks play such a critical role in the economy that they need to be singled out for more intense regulation than other sectors. The presence of asymmetric information is at the heart of the problem. A bank’s managers, owners, customers, regulators and investors have different sets of information about its financial health. Small depositors are the least likely to have information and for this reason, they are usually covered by a deposit insurance scheme, creating a moral hazard problem. Regulators have another information set, based on their examinations, and investors will scrutinise external audits.

Managers of a bank have more information about its financial health than depositors, regulators, shareholders or auditors. The well-known principal agent problem arises because of the information wedge between managers and shareholders. Once shareholders delegate the running of a firm to managers, they have some discretion to act in their own interest rather than the owners’. Bank profits depend partly on what managers do, but also on other factors unseen by the owners. Under these conditions, the best managerial contracts owner scan devise will lead to various types of inefficiency, and could even tempt managers into taking on too much risky business, either on- or off-balance sheet.

However, these types of agency problems can arise in any industry. The difference in the banking sector, it is argued, is that asymmetric information, agency problems and moral hazard, taken together, can be responsible for the collapse of the financial system, a massivenegative externality.Put simply, banks pay interest on deposits and lend the funds to borrowers, charging a higher rate of interest to include administration costs, a risk premium and a profit margin for the bank.

All banks maintain a liquidity ratio, the ratio of liquid assets to total assets, meaning only a fraction of deposits is available to be paid out to customers at any point in time. However, there is a gap between socially optimal liquidity from a safety standpoint, and the ratio a profit-maximising bank will choose.

Given that banks, even healthy ones, only have a fraction of their deposits available at any one time, an unexpected sudden surge in the withdrawal of deposits will mean they soon run out of money in the branches. Asymmetric information means rum ours (ill-founded or not) of financial difficulties at a bank will result in uninsured depositors withdrawing their deposits, and investors selling their stock. Contagion arises when healthy banks become the target of runs, because depositors and investors, in the absence of information to distinguish between healthy and weak banks, rush to liquidity.

Governments may also impose a reserve ratio, requiring banks to place a fraction of on-interest earning deposits at the central bank. This is, effectively, a tax on banking activity. The amount paid is the interest foregone multiplied by the volume of funds held as reserves. Since the nominal rate of interest incorporates inflation expectations, the reserve ratio is often loosely thought of as a source of inflation tax revenue. In recent decades many western governments have reduced or eliminated this reserve ratio. For example, in the UK, the reserve ratio has been reduced from a cash ratio of 8% before 1971 to one of just 0.4% today. In developing and emerging markets, the reserve ratio imposed on banks can be as high as 20%, as an inexpensive form of government revenue.

Asking all banks to set aside capital as a percentage of their assets (capital assets ratio) or risk weighted assets (the ratio of capital to weighted risk assets) is now the preferred method for ensuring banks have a cushion against shocks to credit, market and operational risks which could threaten the viability of the bank.

In the absence of intervention by the central bank to provide the liquidity necessary to meet the depositors’ demands, the bank’s liquidity problem (unable to meet its liabilities as they fall due) can turn into one of insolvency, or negative net worth. Normally, if the central bank and/or other regulators believe that but for the liquidity problem, the bank is sound, it will intervene, providing the necessary liquidity (at a penalty rate) to keep the bank afloat. Once depositors are satisfied they can get their money, the panic subsides and the bank run is stopped. However, if the regulators decide the bank is insolvent and should not be rescued, the run on deposits continues, and it is forced to close its doors.

If the authorities do intervene, but fail to convince depositors the problem is confined to the one bank, contagion results in systemic problems affecting other banks, and perhaps all banks, putting the sector in danger of collapsing. In the extreme, the corresponding loss of intermediation and the payments system could reduce the country to a barter economy. A ‘bank holiday’’ may be declared in an effort to stop the run on banks, using the time to meet with the stricken banks and decide how to curb the withdrawals, usually by an agreement to supply unlimited liquidity to solvent banks when their doors open after the holiday.

If the bank holiday agreement fails to reassure depositors, or no agreement is reached, the outcome is a classic negative externality because what began as a run on one bank (or a few small banks) can lead to the collapse of the country’s financial system. The economic well-being of all the agents in an economy has been adversely affected by the actions of less than perfectly informed depositors and investors, who, with or without good reason, decided their bank was in trouble and sought to get their funds. The negative externality is a type of market failure, as is the presence of asymmetric information. Market failure is a classic argument for a sector to be singled out for government intervention and regulation.

The evidence on whether bank contagion is a serious matter is mixed and controversial.

Close supervision by regulators, and perhaps intervention too, contributes to managerial incentives to gamble. Senior management is normally the first to recognize their bank is, or will be, in serious trouble. They have the option of taking no action, letting it fail, and losing their jobs. However, if they are the only ones with information on the true state of the bank, downside risk is truncated. If a gamble fails, the bank fails with a larger net loss, but bad as this event is for managers, its marginal effect on them is zero. If a gamble succeeds, the bank, and their jobs, are saved. Returns are convexities, encouraging gambling to increase their survival probability and resurrect the bank. Thus, they will undertake highly risky investments, even with negative expected returns. Likewise, ‘‘looting’’ may be seen as a way of saving the bank, and if not, providing a comfortable payoff for the unemployed managers. Given the presence of contagion in the sector, such behaviour should be guarded against through effective monitoring.

Lack of competition will arise in a highly concentrated banking sector and can also be a source of market failure. Depositors are paid less interest and borrowers are charged more than marginal operating costs could justify. However, anti-competitive behavior occurs in other sectors, and is usually monitored by official bodies with the power to act, should the behaviour of a firm (or firms) be deemed insufficiently competitive.

To summarise, the banking system needs to be more closely regulated than other markets in the economy because of market failure, which can be caused by asymmetric information and negative externalities. The special regulation can take a number of forms, including deposit insurance (funded by bank premiums being set aside in an insurance fund), capital requirements (e.g. Basel 1 and Basel 2), the licensing and regular examination of banks, intervention by the authorities at an early stage of a problem bank, and lifeboat rescues.

In fact, the transition from the failure of an individual bank to the complete collapse of a country’s banking/financial system is rare. The US (1930–33) and British (1866) cases have already been discussed in some detail. Proponents of special regulation of banks, and timely intervention if a bank or banks encounter difficulties, would argue that the presence of strict regulation of the banking sector has prevented any serious threats to financial systems of the developed economies Unfortunately, there is a downside to the regulation of banks.

In banking, moral hazard arises in the presence of deposit insurance and/or if a central bank provides liquidity to a bank in difficulties. If a deposit is backed by insurance, then the depositor is unlikely to withdraw the deposit if there is some question raised about the health of the bank. Hence, bank runs are less likely, effectively putting an end to the possibility of systemic failure of the banking system. Blanket (100%) coverage of depositors (in some cases, creditors too)is often deemed necessary to stop bank runs. However, deposit insurance is costly, and normally governments limit its coverage to the retail depositor, on the grounds that this group lack the resources to be fully informed about the health of a bank.

Restricted forms of deposit insurance do not eliminate the possibility of bank runs because wholesale depositors and others (e.g. non-residents, or those holding funds in foreign currencies) are usually excluded. For example, in 1998 the Japanese authorities had to extend the insurance to 100% coverage of most deposits because of its persistent banking problems, which reduced depositor confidence and caused runs The next section gives the background to the rescue of Continental Illinois Bank in 1984. This bank was heavily dependent on the interbank markets, and suffered from a withdrawal of funding by uninsured wholesale depositors. may be seen as a way of saving the bank, and if not, providing a comfortable payoff for the unemployed managers. Given the presence of contagion in the sector, such behaviour should be guarded against through effective monitoring.

Lack of competition will arise in a highly concentrated banking sector and can also be a source of market failure. Depositors are paid less interest and borrowers are charged more than marginal operating costs could justify. However, anti-competitive behaviour occurs in other sectors, and is usually monitored by official bodies with the power to act, should the behaviour of a firm (or firms) be deemed insufficiently competitive.

To summarise, the banking system needs to be more closely regulated than other markets in the economy because of market failure, which can be caused by asymmetric information and negative externalities. The special regulation can take a number of forms, including deposit insurance (funded by bank premiums being set aside in an insurance fund), capital requirements (e.g. Basel 1 and Basel 2), the licensing and regular examination of banks, intervention by the authorities at an early stage of a problem bank, and lifeboat rescues.

In fact, the transition from the failure of an individual bank to the complete collapse of a country’s banking/financial system is rare. The US (1930–33) and British (1866) cases have already been discussed in some detail. Proponents of special regulation of banks, and timely intervention if a bank or banks encounter difficulties, would argue that the presence of strict regulation of the banking sector has prevented any serious threats to financial systems of the developed economies Unfortunately, there is a downside to the regulation of banks. The key problem is one of moral hazard. In banking, moral hazard arises in the presence of deposit insurance and/or if a central bank provides liquidity to a bank in difficulties. If a deposit is backed by insurance, then the depositor is unlikely to withdraw the deposit if there is some question raised about the health of the bank. Hence, bank runs are less likely, effectively putting an end to the possibility of systemic failure of the banking system. Blanket (100%) coverage of depositors (in some cases, creditors too)is often deemed necessary to stop bank runs. However, deposit insurance is costly, and normally governments limit its coverage to the retail depositor, on the grounds that this group lack the resources to be fully informed about the health of a bank.

Restricted forms of deposit insurance do not eliminate the possibility of bank runs because wholesale depositors and others (e.g. non-residents, or those holding funds in foreign currencies) are usually excluded. For example, in 1998 the Japanese authorities had to extend the insurance to 100% coverage of most deposits because of its persistent banking problems, which reduced depositor confidence and caused runs The next section gives the background to the rescue of Continental Illinois Bank in 1984. This bank was heavily dependent on the interbank markets, and suffered from a withdrawal of funding by uninsured wholesale depositors.

This section reviewed the controversies related to the methods used to rescue banks in the event of a banking crisis. Proponents of government intervention are by far the majority, though some researchers argue that intervention is only justified if the benefits should exceed any costs. The work by Hoggarthet al. (2003) and Bordoet al. (2001) suggests the type of intervention is important. Their results indicate deposit guarantees have no impact on output, whereas liquidity support reduces output. These findings indicate the type of bank rescue needs to be carefully considered, keeping in mind that while intervention may have fiscal costs, the absence of any support also has consequences – conceivably, systemic meltdown.

Failed Bank Resolution Strategies and Who Loses