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Bank Failures and Case Studies
1. April 3, 2014 Bank Failures and Case Studies
PAK-AIMS
Submitted To: Mam Shehla Sohail
Project Of: Banking Laws & Practice
Submitted By:
Muhammad Tallal Khan (123214)
Muhammad Zeeshan Azam (123220)
Azeemullah Wyne (123215)
Date Of Submission: 03/04/14
2. April 3, 2014 Bank Failures and Case Studies
Table of Contents
Introduction
Reasons for bank failure
Related Case Studies
The remedial measures
Conclusion
References
3. April 3, 2014 Bank Failures and Case Studies
Introduction
Bank failures are not common, nor limited to a few countries. The cost of bank failure can
be high, and if this causes instability in the financial system, which in turn affects the
nation’s growth rate, then it consequently causes governments or the central bank to
intervene in order to organize a rescue package for the failing banks. The cost of these
rescue packages is high and such packages are difficult to organize, especially in a
competitive environment. Although bank failures are more commonly observed in those
countries that have deregulated or liberalized their financial market, they are not
uncommon where banks have made bad loans and carried a high proportion of non-
performing loans in those countries where the financial markets were once highly
regulated and only survived due to government subsidies. Thus, the question is: why do
banks fail?
Following the experience of the Great Depression, it has been commonly argued that the
banking crisis, or bank failures, principally arose due to depositors’ panic, which caused a
run on the banks.
In order to investigate this important topic, it is first necessary to recognize that there are
two important elements entering into the operation of the banking sector. These are the
‘credit standard’ and ‘credit risk.’
It will be argued in this paper that in the competitive atmosphere under which banks
operate, it is not possible for banks to secure their entire loan portfolio by the credit
standard. Thus, an element of fragility always remains within this sector. In recent years,
however, this fragility has increased as a result of financial liberalization. Financial
liberalization has increased the intensity of the competitive atmosphere within the
financial sector, which in turn has often caused banks to undermine the importance of the
credit standard in order either to maintain their existing market share or to increase it. In
the process, it has exposed banks’ loan capital to high credit risk. This may have been the
principal contributing factor to much of the bank failure that has been observed in the last
two decades.
This paper is divided into three sections. In the first section, we briefly investigate why
banks introduce the credit standard as a determining factor for the allocation of loans
rather than interest rate or price. In the second section, we investigate why banks cannot
maintain this credit standard and the additional measures they take with the intention of
protecting their loanable funds, should the borrowers default on loans. In the third section
we investigate why banks fail.
4. April 3, 2014 Bank Failures and Case Studies
Why do Banks Fail?
A bank failure occurs when a bank is unable to meet its obligations to its depositors or other
creditors because it has become insolvent or too illiquid to meet its liabilities. There are many
reasons for bank failure:
1. Bad loans:
Loans comprise a large part of the traditional banking business, along with holding
depositor money. Before the later part of the 20th century, banks primarily made loans to
individuals to buy homes and to businesses to enable them to grow. Credit analysis skills
are critical to this line of business. In this regard, most large banks have huge training
programs dedicated to the development of new lending officers, who are taught how to
assess the risks of borrowers and protect the bank’s assets and profitability. When credit
standards are lowered, to attract more lucrative business, loan losses inevitably increase
and create financial problems. In the past, risky loans to foreign countries, real estate
investment trusts, and mortgage companies have created severe problems for banks and
ultimately caused some to fail.
2. Funding issues:
Banks have balance sheets that carry huge amounts of assets. These assets are generally
financed with a combination of short-term credit, bonds and equity. When a bank has
problems refinancing its debt or repaying it, the bank may fail. Funding problems are
sometimes related to general market conditions, but more often occur because investors
lose faith in the bank for some reason.
3. Asset/liability mismatch:
When a bank’s assets are unmatched to the liabilities supporting them, severe problems
can arise. The simplest example is a floating rate liability financing a fixed rate loan. If
interest rates rise, the bank pays greater and greater interest on its liability while the fixed
rate loan pays the same rate. This mismatch can result in a huge loss. When a large portion
of a bank’s portfolio is mismatched, the results can be devastating.
5. April 3, 2014 Bank Failures and Case Studies
4. Regulatory issues.
Central banks regulate rules and regulations regarding transfer of money from one country
to other. Sometimes. Sometimes banks can be failed because the bank is located in a rogue
country or the bank could be engaged in illegal activities such as money laundering.
5. Proprietary trading.
This newest and soon to be banned bank business created huge exposures for banks. For
the most part, proprietary businesses generated large profits. But regulators believe the
possibility of large losses more than offsets the profit potential. Basically, the business
included investment in unhedged derivatives, large blocks of marketable securities, exotic
instruments and illiquid investments.
6. Non-bank activities.
Over the years, banks have experimented in non-traditional businesses looking to improve
profitability. Experiments with real estate investment trusts, leasing companies, consumer
finance companies and non-bank foreign subsidiaries were mostly unsuccessful and
resulted in huge losses.
7. Risk management decisions.
All large banks have extensive risk management groups that constantly quantify the
absolute level of risk in the bank’s portfolios. They measure risk from every conceivable
perspective including interest rate risk, foreign debt risk, investment risk and much more.
When miscalculations occur in conjunction with a significant market movement, huge
losses are possible.
8. Inappropriate loans to bank insiders.
In the 1980s, many savings and loan banks made risky loans to directors and insiders for
real estate and many other projects that were ill-conceived. These transactions resulted in
huge losses and many bank failures.
9. Rogue employees.
Rogue traders who are unable to cover losses and bypass internal controls have brought
down a number of financial institutions or set them back significantly. The JPMorgan
hedging debacle may turn out to have some of these same characteristics.
6. April 3, 2014 Bank Failures and Case Studies
10.Runs on banks.
Depositors do not subject banks in the U.S. to runs because the Federal Deposit Insurance
Company guarantees deposits up to a certain amount. But, in other places (like Europe),
the risk still exists. If depositors all demand their money, a bank will likely fail.
Bank Failures Case Studies of different regions
In Pakistan
Mehran Bank: Mehran bank was incorporated in privatization fanfare in Pakistan on 31st
October, 1991 as a public limited company and its shares were quoted in Karachi and Lahore
stock exchanges. The bank began its formal operations from 22nd January, 1992 in the business
of banking and operated as ”Scheduled Bank” as defined by the Banking Companies Ordinance,
1962. Mehran banks paid up capital was Rs 300 million (US $ 10 million), assets of Rs 2.9 billion
and stock market capitalization of Rs 500 million. It had six branches all over Pakistan located in
Karachi, Lahore, and Mirpur khas, Peshawar, Quetta and Rawalpindi (Annual Report 2004).
Mr. Yunus Habib was the founder and Chief Operating officer of the Bank.
Mehran Bank Scandal:
The Mehran bank scandal also known as Mehrangate, was a major political scandal in the history
of Pakistan between 1990-1994 in which senior politicians and political parties were found to
have been induced by Pakistan Army and intelligence officers, from ISI, to prevent the re-
election and to destabilize the government of the Pakistan People’s Party. On Dec 14, 1995,
Younus Habib was convicted of fraud and deception and given a sentence of 10 years hard
imprisonment by the Special Court for Offences in Banks in Sindh.
Younus Habib admitted that he took 1.4 billion rupees from the Bank and distributed 200
million among different politicians. The rest of the money went to different organizations and
bank accounts ran by Pakistan Army which needs to be investigated. Nawaz Sharif, Aftab Khan
Sherpao, Javed Hashmi, Jam Sadiq, Ghulam Mustafa Jatoi, Pir Pagara, Ijaz ul Haq and Abida
Hussain are few prominent names from this list of Mehran Bank scandal case.
7. April 3, 2014 Bank Failures and Case Studies
In United Kingdom
Bank of Credit and Commerce International (BCCI)
In July 1991, the Bank of Credit and Commerce International (BCCI), one of the 300 or
so branches and subsidiaries of foreign banks operating in London, failed because of
widespread fraud. BCCI had branches in over 70 countries with the UK offices being
branches of the Luxembourg subsidiary. Its principal shareholders were in Abu Dhabi.
Description of Crisis
It is now believed that BCCI’s financial statements had been falsified from its
establishment in 1972. A scheme of deception was developed to support BCCI’s rapid
growth and to conceal lending losses. To achieve this, BCCI failed to record deposit
liabilities and created fictitious loans that generated substantial but fictitious profits.
Fraud also took place within BCCI’s treasury operations. Rather than using its own
funds for proprietary trading, BCCI used depositors’ money to fund their trading
activities, when this trading resulted in large losses they were covered up with more
fictitious loans.
In circumstances such as this, where financial statements do not reflect true financial
health, reported capital ratios will also be misleading to investors that said, in cases
such as this, the process of ongoing supervision may encourage banks to assess and
improve their systems and controls.
In United States Economy:
The US economy has faced many economic fluctuations in different regions. The
famous recessions of 1929-1930, 1980-1990, 1999-2001, and 2008-2009 are very well
known in the US economy. Since the country faced recession, it also had faced a large
number of bank failures in the economy. We have a graphical representation on the
number of banks failed due to financial crisis in US economy.
8. April 3, 2014 Bank Failures and Case Studies
In Spain
During the past three decades, there have been a number of episodes of bank failures in Spain.
First, a banking crisis of considerable proportions spread during the period 1978-1983.
Subsequently, the first half of the 1990s saw the failure of some very small banks and
eventually, in 1993, of Banesto, at that time the fourth largest Spanish bank by volume of
deposits.
The 1978-1983 banking crisis affected more than 50 banks, around half of the commercial
banks then existing and representing over a quarter of their total assets. The crisis began with
the failure of small institutions and then, as time elapsed, it affected increasingly large banking
groups. Finally, in 1983, the Rumasa crisis arose. Rumasa was a holding company that had 20
banks and a much larger number of non-financial companies among its holdings.
The causes of this crisis, which was of systemic proportions, have generally been attributed to
three factors: the economic crisis, poor bank management and a lack of adequate regulation
The important factor explaining the banking crisis of the period 1978-1983 was the deficient
regulation and supervision of the institutions. The root of the problems laid in the said entry of
new banks during the 1960s. The high extraordinary profits being obtained attracted large
numbers of entrepreneurs, many without any prior experience in banking, who wanted to
participate in a highly profitable and stable business.
-20
0
20
40
60
80
100
120
140
160
180
1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Banks Failure analysis in US economy
no of banks failed
9. April 3, 2014 Bank Failures and Case Studies
The Remedial Measures
The banking sector requires the following steps to reduce the chances of failure:
Proper system of recruitment for the banking systems
Inspections on the liabilities as well
Proper inspections on the banking systems as well to make improvement
Reduction in the fraudulent regarding banking operations
Banking obligations and business of banks should be properly defined in every
country
Proper lending and borrowing operations
Conclusions
Failures can be classified in many ways, including by risk type, the type of shock that
precipitated the failures or crisis, the state of the banking system, what portion of the banking
system was affected, how the crisis was resolved, and whether the failures resulted in
regulatory changes. While each country’s experience has unique characteristics, looking across
all of the banking crises can help reveal patterns of bank failures. For example, Spain, Norway,
Sweden and the U.S. had very similar experiences when they liberalized 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 characteristic.
The Barings and BCCI failures both had significant fraud. Mehran bank has its own story of
fraudulent.
The banking system is much improved, but there are some systems which are to be improved to
show the proper gain or loss of the bank. A proper system is needed to introduce where the
exact position of the bank is to be mentioned
10. April 3, 2014 Bank Failures and Case Studies
References