Study on the Main Determinants of Bank Failure Finance Essay

During the last decade, banking industry has become highly competitive, resulting in many banks to use aggressive strategies in order to survive or maintain their respective share in the market. This tendency of these financial institutions to become more aggressive when confronted with competitive pressures has led many banks to fail. Banking industry has gone through significant changes and is continuing to undergo major structural alterations. This dynamic structure results in an uncertain environment for the industry. The recent financial crisis has raised a large number of concerns about the strength of the current banking system to provide stability to the financial markets. Banks taking too much risk are highly prone to fail. Banks may fail if equity is insufficient to provide a safe cushion to write down any non-performing loans. Before recent financial turmoil, banks were more concerned about their profitability. They attempted to maximize profits to increase shareholders wealth by increasing their financial leverage. A large deposit base provided for high financial leverage for banks, while their equity cushion continued to diminish. Most banks were using a ratio of more than twenty times debt compared to their equity. Low level of equity provided a very small cushion for the banks in case of a financial turmoil. A bank with three percent equity could suffer a loss of all its shareholders wealth if it lost just a minor fraction of its loan assets. For example, bank with an equity base of 10 billion pounds and a loan base of as high as 300 billion pounds, would have lost all its equity with a decrease of 3.33 % in the value of its loan assets. Banks need to manage their liquidity risk with extreme caution. A bank that maintains to little liquid reserves can go bankrupt if it fails to meet its obligations on time. These obligations include payment on demand deposits and interest payments to depositors holding cash in their saving accounts. If the bank is holding too little cash, it can usually borrow money through inter-bank borrowing at the federal funds rate. However, at times of financial crisis the liquidity of the market could be low. In the recent financial crisis rumours about bank failures resulted in a run on banks. Depositors wanted to withdraw their money before a suspected bankruptcy. On a usual day banks only anticipate a certain maximum percentage of funds to be withdrawn and hence they maintain cash to meet regular operational needs. However, in case of a run on banks all depositors simultaneously appear at bank counters to withdraw their deposits. Such a panic situation can result in bankruptcy of any financially sound bank in a matter of hours. Liquidity risk requires active management, as too much liquidity can be as much of a problem as is too little liquidity. Banks operate in a highly competitive environment and they are always competing for deposits. Those banks that provide higher interest rates relative to competition are able to attract more deposits and thereby expand their operations. Those that provide low interest rates suffer the risk that depositors will withdraw their funds to banks, which pay a higher return. To provide a higher return a bank needs to make profitable loans to other parties. Extending loans for businesses and for consumers restrict the liquidity of the banks. Therefore, there is a trade-off involved and the management has to choose the optimum level between return and liquidity. An economic crisis results in high levels of unemployment and can cause the non-performing loans to increase significantly. Lack of diversification into various asset classes in financing loans can result in major bank failures. During the recent banking crisis, subprime lending was at its peak. A component that lacks diversification was the subprime mortgage lending. A large number of mortgagees were speculating on housing prices and did not have sufficient means to pay the dues. Banks were lending on zero down payment options where the mortgage holder had a call option to exercise. If housing prices increase, the mortgagee can sell the house, pay the mortgage amount and make a profit without any investment. However, if housing prices go down the mortgagee only lost the payments made already, which acted as an option premium. As the housing market collapsed, the losses were to be borne by the banking industry. Mortgages are pooled together to form collateralized mortgage obligations. These securities make mortgages from illiquid investments into liquid securities that sell in the secondary market. The high interest rates paid on mortgages and the liquidity feature of the securities attracted investors to invest trillions. The high demand for mortgage-backed securities in turn resulted in too much capital availability to create excessive low quality mortgages. As economy staggered and unemployment increased a high rate of mortgage default created the subprime crisis resulting in many banks to fail. As competitive pressures, increase only banks with high level of efficiency can survive. Larger banks enjoy both economies of scale and economies of scope. In an economic downturn, small and medium banks cannot maintain their net interest margins and tend to respond weakly to competitive pressures. Therefore, in an attempt to survive banks initiate mergers and acquisitions. Through mergers, these banks aim to improve efficiencies and reduce costs in order to improve their net interest margins and survive the hard times. Mergers do not always attain their desired goals. Many times the managements do not get along well, at other times the estimated synergies of the merger tend to be overestimated. Also, valuation models could have been erroneous resulting in huge write down of goodwill assets in the years to come. This can also wipe away the equity of the bank and eventually cause a bank to fail. Banks seek to maintain an active match between their assets and liabilities. A large gap between assets and liabilities can result in adverse movements. If a bank has a positive gap, its assets are more interest rate sensitive than its liabilities. The goal of banks is to maintain minimum interest rate exposure and keep the gap at a minimum. At times bank management can get more ambitious and take bets on interest rate movements. In this case, an unexpected movement in interest rates can be disastrous for a bank. In conclusion, a bank can fail due to various reasons mostly because of poor risk management techniques. Banks could be lending aggressively and create a large pool of subprime assets or they could maintain too little liquidity to meet their obligations during a financial crisis. All these reasons together can cause a bank to fail.

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