Bank Failures and Case Studies

PAK-AIMS

April 3, 2014 Bank Failures and Case Studies

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


Table of Contents

Introduction Reasons for bank failure Related Case Studies The remedial measures Conclusion References


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.


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.

http://en.wikipedia.org/wiki/Creditor

http://en.wikipedia.org/wiki/Depositor

http://en.wikipedia.org/wiki/Bank


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.


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.


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.


1998 2000 2002 2004 2006 2008 2010 2012 2014 20160

20

40

60

80

100

120

140

160

180Banks Failure analysis in US economy

no of banks failed

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.

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


References

Bank Failures and Case Studies

Economy & Finance

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