Tutorial on Bank Failures and Bank Rescues

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This classroom-ready tutorial reviews the sources of bank failures and the tools that regulators use to restructure failed banks

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Tutorial on Bank Failures and Bank Rescues

  1. Slideshow for your Classroom from Ed Dolan’s Econ Blog A Tutorial on Bank Failure and Bank Rescue March 2013 Protest Against Rescue of Anglo Irish Bank Photo source: Joe Higgins Euro Election Campaign via http://commons.wikimedia.org/wiki/File:Protest_against_bailout_of_Anglo_Irish_Bank.jpg Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.
  2. Big Banking Problems in Countries Large and Small Ireland, Iceland, and Cyprus are all small countries that have had big banking problems Big countries can have banking crises too—US, UK, Russia and others Questions:  What causes bank failures?  What tools do regulators have for rescuing failed banks?  Who wins and who loses when banks fail?  Who wins and who loses when they are rescued? Protest Against Rescue of Anglo Irish Bank Photo source: Joe Higgins Euro Election Campaign via http://commons.wikimedia.org/wiki/File:Protest_against_bailout_of_Anglo_Irish_Bank.jpg March 2013 Ed Dolan’s Econ Blog
  3. Stylized Balance Sheet of a Typical Bank A bank’s assets are all the things of value that it owns, including reserves of cash, loans, and securities Its liabilities are all of its obligations to other parties, including . . .  Deposits  Borrowing in the form of short-term interbank loans, bonds, etc. By definition, capital, which represents shareholders’ stake in the Capital = Assets - Liabilities bank, is equal to assets minus liabilities March 2013 Ed Dolan’s Econ Blog
  4. Solvency and Insolvency A bank is solvent if its assets exceed its liabilities, as is the case for this balance sheet If the value of its assets decreases, for example, because a borrower fails to repay a loan in full or because a change in market condition forces it to sell securities for less than their book value, its capital decreases When its capital falls to zero or below, the bank becomes insolvent March 2013 Ed Dolan’s Econ Blog
  5. Insolvency: An example In this example, suppose a borrower defaults on a $100 loan, reducing the bank’s total assets by that amount The bank still owns $700 to depositors and $200 to other creditors from whom it has borrowed The loan loss brings the bank’s capital to zero, and it becomes insolvent Items that change are shown in color March 2013 Ed Dolan’s Econ Blog
  6. Danger! Zombie Banks! Normally an insolvent bank must cease operation If regulators allow an insolvent bank to keep its doors open, it becomes a zombie bank Risks of zombie banks:  Because owners have nothing left to lose, the bank may take huge risks to try to restore solvency  Insiders may be tempted to steal the bank’s remaining assets and disappear before regulators close the bank  Even if managers act in good faith, continued losses will raise the cost of any Banks can be Zombies, Too! Photo source: Kenny Louie via future rescue http://commons.wikimedia.org/wiki/File:Unleashed_%284925630503%29.jpg March 2013 Ed Dolan’s Econ Blog
  7. How Runs Can Contribute to Bank Failure A bank run occurs when many depositors at once try to withdraw their funds because they fear the bank will fail In order to meet the demands of depositors, the bank may be forced to sell loans, securities, or other assets at “fire- sale prices” below the value they are listed on the bank’s books The loss in the value of the banks assets reduces its capital The fear of insolvency that caused the run then becomes self-fulfilling Depositors Line Up During a Run on Northern Rock Bank, 2007 Photo source: Lee Jordan via http://commons.wikimedia.org/wiki/File:Birmingham_Northern_Rock_bank_run_2007.jpg March 2013 Ed Dolan’s Econ Blog
  8. Example: How a Bank Run can Lead to Insolvency Suppose a bank run leads to withdrawal of $300 worth of deposits The bank covers the first $50 from its reserves of cash To raise the balance, it sells securities, but in this case, market conditions are unfavorable so the bank has to sell all of its remaining securities, which previously had a book value of $350, to raise the remaining $250 it needs to cover withdrawals The end result: The bank’s liabilities have fallen by $300 but its assets have fallen by Items that change are shown in color $400, so the bank is now insolvent March 2013 Ed Dolan’s Econ Blog
  9. Liquidation Bank regulators may try to find another bank to take over what is left of the failed bank If they cannot do so, they will have to liquidate the failed bank by selling its remain assets to pay off depositors and other creditors If the bank’s $600 of loans can be sold at their book value, then all depositors and other creditors can be paid in full Nothing is left for shareholders, who are wiped out Items that change are shown in color March 2013 Ed Dolan’s Econ Blog
  10. Liquidation with a Haircut Sometimes sale of the bank’s assets does not raise enough cash to pay off all creditors Suppose selling the bank’s remaining loans (original book value $600) raises only $500 in cash That is enough to pay depositors in full, but only enough to pay other creditors half of the $200 that the bank has borrowed In financial jargon, we say that creditors are forced to take a haircut of 50 percent In a more extreme case, unsecured creditors may be wiped out and even depositors may be forced to take a haircut Items that change are shown in color March 2013 Ed Dolan’s Econ Blog
  11. Too Big to Fail Sometimes regulators decide not to liquidate a bank because they think it is too big to fail (TBTF) The reason may be economic . . .  Failure of a big bank might start a panic that damages the whole financial system  Nonfinancial businesses might lose a key source of credit . . . or political  Cronyism or revolving-door appointments between banks and government  Bribery, campaign contributions, or other forms of corrupt influence If the bank is TBTF, regulators may try to Picture source: Caitlin via http://commons.wikimedia.org/wiki/File:Elephant_%281%29.jpg restructure it to keep it in business March 2013 Ed Dolan’s Econ Blog
  12. Restructuring Tool 1: Emergency Loans to the Bank In some cases emergency government loans may be enough to save the bank by giving it time to sell assets at a better price If the loans are made at a below-market interest rate, they may help restore profitability Loans to a bank increase its assets and liabilities by equal amounts, so they do not directly increase its capital They are likely to work best for banks that Walter Bagehot, a 19th century financial are weak but not completely insolvent writer, thought that the government should act as a lender of last resort, but only to banks that are solvent Photo source: Popular Science Monthly via http://commons.wikimedia.org/wiki/File:PSM_V12_D400_Walter_Bagehot.jpg March 2013 Ed Dolan’s Econ Blog
  13. Restructuring Tool 2: A Carve-Out of Bad Loans A second tool of bank restructuring is for the government to swap good assets, like government bonds, for bad assets, like nonperforming loans This operation is called a carve-out If the terms of the carve out are favorable, it will increase the bank’s capital The restructuring agency will suffer a loss when it eventually sells the bad assets for whatever price they will bring March 2013 Ed Dolan’s Econ Blog
  14. Restructuring Tool 3: A Capital Injection A third tool is for the government to nationalize the bank, in whole or in part, by exchanging good assets like government bonds for equity in the bank in the form of shares of stock This operation is called a capital injection Eventually the government can try to resell its shares in the bank to private investors, possibly at a loss, but if it is lucky, at a profit March 2013 Ed Dolan’s Econ Blog
  15. When a Restructuring Becomes a Bailout Sometimes a restructuring is done in such a way that the original shareholders are completely wiped out In other cases, the original shareholders of an insolvent bank may retain full or part ownership in the restructured bank, suffering only a partial loss of their investment, or none at all In the latter case, we say that the restructuring has become a bailout An astronaut undergoes emergency bailout training Photo source: NASA via http://commons.wikimedia.org/wiki/File:Astronaut_Julie_Payette_during_emergency_bailout_training .jpg March 2013 Ed Dolan’s Econ Blog
  16. Bailout vs. Bail-In If the unsecured creditors of a failed bank avoid losses because of the restructuring, then they, too, are bailed out Instead, regulators may insist that unsecured creditors accept haircuts as a condition of the restructuring plan The decrease in the creditors’ claims on the bank helps to recapitalize it In this case, we say that the creditors are bailed in instead of being bailed out In extreme cases, depositors may also be bailed in with forced haircuts HMS Candytuft sinking after a U-boat attack, Nov. 1917 Photo source: UK government via http://commons.wikimedia.org/wiki/File:HMS_Candytuft_sinking_1917_IWM_SP_470.jpg March 2013 Ed Dolan’s Econ Blog
  17. The Bottom Line: Someone Must Always Bear the Costs It would be wrong to think that bank losses are only “paper losses” that can be resolved with some accounting trick Bank losses reflect real waste of resources, for example, construction of unwanted homes that are financed by bank loans during a housing bubble Someone must always bear the cost If the government bails out bank owners, creditors, and depositors, then taxpayers end up paying for the bad investments Unfinished housing development, Dunfanaghy UK, 2009 Photo source: Ross via http://commons.wikimedia.org/wiki/File:Unfinished_housing_development,_Dunfanaghy_- _geograph.org.uk_-_1426980.jpg March 2013 Ed Dolan’s Econ Blog
  18. If you liked this slideshow, you may also want to see these:• What is Basel III and Why Should we Regulate Bank Capital?• More on Financial Regulation and Basel III: Regulating Bank Liquidity Click here to learn more about Ed Dolan’s Econ texts Follow @DolanEcon on Twitter

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