Bank failures and rescues

Many of the numerous bank failures that have occurred over the years have not proved harmful to their national economies. Governments have found it necessary, however, to guard against the danger of "systemic failure" resulting from a general loss of confidence in the banking system and have, from time to time, rescued a failing bank in order to avert that danger. There have nevertheless been several instances of banking crises that have done serious damage to national economies, and the banking failures that followed the bankruptcy of Lehman Brothers in September 2008 threatened a collapse of national and international financial systems.

For definitions of the terms shown in italics in this article, see the glossary.

For a detailed list of failures and rescues in their historical sequence, see the Timelines subpage.

Background

The vulnerability of banks

The fact that banks often lend as much as twenty times the value of their share capital makes their continued solvency sensitive to defaults on those loans. "Retail banks", that obtain funds from depositors, are also vulnerable to the risk that fears of insolvency can result in "bank runs". They are also vulnerable to the "contagion" that can occur when depositor "herding" converts the news of a run on one of their number into runs on the others. "Wholesale" or "investment" banks, that obtain their funds by borrowing on the "money markets" and the "interbank markets", can also suffer from contagion resulting from herding by market operators. Before the adoption by central banks of the roles of "lenders of last resort", herding and contagion were believed to have led to the failure of many otherwise solvent banks. The pre-war creation of the Federal Reserve Bank as lender of last resort did not eliminate contagion in US banking in the inter-war years, but there is evidence to suggest that it was no longer common . However, the development in the latter years of the twentieth century of complex systems of "securitisation", added progressively to their vulnerability to contagion by making the banks a component of a complex, tightly-coupled interactive, financial system; and by adding to the difficulty of assessing risks. That development led to the word-wide incidence of banking crises that have been termed "systemic" on a World Bank database because they were so extensive that they threatened the integrity of their national financial systems , a growing number of which had been contagious in the sense of spreading into neighbouring countries. The culmination of that trend was the world-wide crash of 2008.

The case for rescues

There are cogent arguments for not rescuing failing banks. In the first place a rescue could hamper the normal competitive process by which failures are replaced by more efficient competitors - and secondly, its precedent creates a moral hazard by motivating banks to increase their profitability by taking otherwise unwarrantable risks. The contrary argument came to light in 1866 when the collapse of the English Gurney-Overend bank led to the collapse of over 200 companies . The influential commentator Walter Bagehot urged that in a future panic the Bank of England should "advance freely and vigorously to the public out of its reserves", and in 1890 the Bank rescued the failing Barings bank by guaranteeing loans to it by other banks. A similar conclusion by the United States authorities led to the creation of the Federal Reserve System with powers to act as lender of last resort. Those measures were designed to prevent failures caused by contagion, and they were not intended to prevent failures that were the direct result of insolvency. In time, however, it came to be recognised that some financial organisations had become "too big to fail" because their failure would be too damaging to the economy. It came to be understood that the failure of a major bank could trigger a banking crisis, which could result in a major reduction in a country's money supply, known later as a "credit crunch" causing financial problems among non-financial companies as well as contagion effects on other banks . In the late twentieth century the globalisation of financial system had reached the point at which international contagion had become a problem and , after there had been several cases of international contagion there were proposals to turn the International Monetary Fund into an international lender of last resort .

Thus the rescue decision depends upon the often difficult task of balancing its exchequer cost against the possibility of a systemic crisis that could cost a substantial proportion of a year's national income - and taking account of the danger that measures to avert an immediate crisis might increase the long-term likelhood of another. The outcome suggests that mistakes were often made.

Bank regulation

The development of bank regulation is described in the article on banking. The most significant developments were the creation and empowerment of central banks before Word War 1; the introduction of deposit insurance in the inter-war years; the widespread derugulation processes of the 1980s; and the subsequent Basel I and Basel II recommendations of the Bank for International Settlements. Proposals for the future regulation of the banks are discussed in the final paragraph of this article.

The treatment of banking crises

The proliferation of banking crises during the last two decades of the twentieth century led to the development of a variety of preventative and corrective measures . The preventative measures included schemes to insure depositors against loss and the designation of selected organisations as TBTF (too big to fail). Corrective measures taken at the early stages of an incipient systemic failure have included government promotion of the takeover of failing banks by stronger survivors , but action in response to a fully-developed systemic crisis has usually taken the form of injections of capital or the acquisition of equity by government agencies.

The inter-war years

The United States

In the immediate post-war years there was a rapid growth in the number of United States banks, and there were relatively few failures. In 1921, however, there was a surge in the number of bank failures, especially in farming areas, and the number of banks started to decline. The first bank failures after the stock market crash of 1929 occurred toward the end of 1930, triggeed by, and intensifying the Great Depression until the "banking holiday" of 1933. The introduction in that year of the Federal Deposit Insurance Scheme restored investors' confidence, and there were few failures during the remainder of the inter-war period.

Europe

Although the depression put pressure on Europe's banks, there is little evidence to suggest direct contagion from America's banking crisis. However, the 1931 failure (and unsuccessful rescue) of Austria's major Creditanstalt bank led to a wave of bank failures in Germany, Hungary, Czechoslovakia, Hungary and Poland, and led indirectly to the departure of Britain and others from the gold standard.

Post-war developments

1940 to 2007

1940-2007 summary

Of the wave of bank failures that followed the 1980s deregulations, those in the developing countries were the most numerous, but significant failures also occurred in the mature economies, including Switzerland, Spain, the United Kingdom, Norway, Sweden, Japan and the United States. Nearly all of the failures in the mature economy were attributable to credit risk, mainly on real-estate loans. Among the exceptions were the failures of Barings and the BCCI bank, which were attributed to fraud, and the Herstatt failure which was attributed to market risk due to exchange rate movements.

The United States Savings and Loans crisis

Between 1986 and 1995, the deposit insurance organisations closed over a thousand savings and loans institutions with combined assets of over $500 billion , most of which had succumbed to interest rate risks, at a cost of about $150 billion.

The Asian banking crisis

Banking crises in 14 countries in East- and South-East Asia in the period 1980 to 2002 resulted in output losses estimated to average 22 per cent . Japan was the hardest hit. Credit risks stemming mainly from non-performing real-estate loans led to the closure by its deposit insurance authorities of 180 deposit-taking institutions and an output loss estimated as 48 per cent of GDP. Popular opposition made the government reluctant to make direct use of taxpayers money for general assistance to the banking system, and the banking crisis dragged on for over eight years .

The Scandinavian banking crises

The banking crises in Norway, Sweden and Finland in the 1990s have been attributed mainly to credit risks resulting from an increase in non-performing loans as economic conditions deteriorated following sharp tightenings of monetary policy . They resulted in substantial output losses and increases in unemploymentand. but they were eventually resolved by government measures that in many cases included guarantees to bank depositors and creditors as well as injections of capital. The Swedish government's responses, in particular, have been regarded as a model that other governments should emulate .

2007/2009

2007/2009 summary

The major developments of this period were the subprime mortgages crisis in the United States, which triggered the crash of 2008 and the initiation of the recession of 2008. The most significant of the banking failures in the United States were those of Bear Stearns and Lehman Brothers; the former leading to a large-scale rescue, but also a widespread withdrawal from interbank markets, and the latter triggering a collapse of the money markets. A series of rescues of failing banks were undertaken in 2007 and 2008, followed in October 2008 by the widespread adoption of the "Brown Plan" type of wholesale support for banking, interbank and money markets.

The 2008 rescue schemes

The rescue schemes adopted in 2008 by the United States and by most European countries had most or all of the following components:

• the offer to all banks of long term loans of capital;
• the acquisition of equity in selected banks;
• the guaranteeing of all bank borrowing;
• the offer of loans to money market funds; and,
• the conditionality of aid upon conditions that included increases in banks' reserve ratios.

for a summary of measures taken by selected countries, see the addendum subpage

The terms of the loans varied considerably, however: for example, the UK scheme is more market-oriented and less costly to the taxpayer than the US scheme .

Subsequent developments

Actions agreed at the first G20 summit meeting on 15 November 2008 included

• regulators to develop guidance to strengthen banks' risk management practices,
• regulators to ensure that financial firms improve their management of liquidity risk,
• the Basel Committee to help the development of new stress testing models,
• financial institutions to create incentives to promote stability, and avoid rewarding risk taking,
• banks to exercise effective risk management and due diligence over structured products and securitization.