CAUSES OF BANK FAILURE by fanzhongqing


I. Opinion Survey: Bank Supervisors
  Banks are observed to fail under three
  1. When they grow too fast,
  2. When they engage in collateral lending,
  3. When they hire consultants to tell them how
     to run their business.
  *Fast asset growth is a sure formula for bank
         BNK 701


WEEK 4        LECTURE 5
                Another research
   Loan losses has been the most important reason
    of failure in all sizes of banks (57% to 86%).

   Insider loans that were made for personal gain
    of bank officers, accounted for 31% to 67% of
    the failures.

   Liquidity accounted for 35% to 57% of failures.

   Interest sensitivity accounted for 48% of large
    bank failures.
        Another research (cont’d)
Cause of failure        Small    Large
Loans                   83%      86%
Insider loans           31%      33%
Rate sensitivity        14%      48%
Liquidity               35%      57%

Causes are shown as a percentage of the
number of failures for each size group.
Research findings suggest eight loan portfolio
management practices as important determinants:
HEALTHY         FACTOR                    FAILED BANKS
0%        Liberal Lending Practices/        85%
          loan growth
29%       Excessive financial statement
          exceptions                         79%
0%        Over lending                       73%
     POOR ASSET QUALITY FACTORS              (cont’d)
HEALTHY         FACTOR                 FAILED BANKS
0%        Excessive collateral
          documentation exceptions          67%
3%        Collateral based lending          55%
3%        Excessive growth relative to
          management, staff, systems
          and funding                       52%
0%        Unwarranted concentrations
          of credit                         37%
3%        Out of area lending               23%
1. Collateral overvalued; improperly margined, failure to
   get appraisal.
2. Dispersal of funds before complete documentation.
3. Personal friendship of a loan officer with borrower.
4. Loan to a new business with an inexperienced owner-
5. Renewing a loan for increasing amounts, with no
   additional collateral taken.
6. Repeatedly rewriting loan to cover delinquent interest
     FOR LOAN LOSSES (cont’d)
7.Not analyzing borrower’s cash flows and repayment
8.Failure of officer to review loan’s status frequently
9.Funds not used as represented; diverted to
  borrower’s personal use (no attempt to verify the
  purpose for which the money was applied).
10.Funds used out of the bank’s market area; poor
  communications with borrowers.
     FOR LOAN LOSSES (cont’d)
11. Repayment plan not clear or not stated on the
    face of the note.
12. Failure to receive or infrequent receipt of
    borrower’s financial statements.
13. Failure to realize on collateral because borrower
    raised nuisance legal defenses.
14. Bank’s failure to follow its own written policies and
15. Bank president too dominant in pushing through
    loan approvals.
      FOR LOAN LOSSES (cont’d)
16. Ignoring overdraft situation as a tip-off to borrower’s
    major financial problems.
17. Failure to inspect borrower’s business premises.
18. Lending against fictitious book net worth of
    business, with no audit or verification of borrower’s
    financial statement.
19. Failure to get or ignoring negative credit bureau
    reports or other credit references.
20. Failure to call loan or to move against collateral
    quickly when deterioration becomes obviously
Analyzed failed banks’ ratios for a year or more before actual
failure to see if the actual failure could be anticipated ?
Ratio                                     Effect*
Return on assets                           (- )
Loans to assets                            (+)
Capital to assets                          (- )
Purchased funds to assets                  (+)
Net charge-offs to loans                   (+)
Commercial and industrial loans to assets  (+)
*The ‘EFFECT” sign gives the relationship of the ratio to bank failure.
 Higher returns on assets (ROA) indicates less
  likelihood of failure.
 Larger the bank’s allocation of loans, the more is the
  failure-proneness in the bank.
 Low capital ratio increases the chances of failure.
 Banks with larger purchased funds positions are more
  likely to fail.
 Some researchers concluded that a larger net ratio of
  charge-offs to loans, suggests pending failure.
  However, some others found little statistical evidence
  of this relationship.
 C & I loans to assets ratio indicates failure chances.
   Behavior of Bank Financial Ratios
        as Failure Indicators.

One way to understand the severity of a bank’s financial
ratios is to look at the ratios displayed by banks before
failures. Three categories analyzed- Top 20% ROE,
Bottom 20% ROE, and Failed Banks.

To determine, how closely the bottom 20% ROE banks
resemble banks that later failed, or alternatively, to see
if they are more like the top 20% banks.
  Financial Ratios of Failed Banks.
                                 Top 20% Bottom 20% Failed
                                 ROE     ROE         Banks
Net interest margin (NIM)        4.60     3.69       2.71
Provision for loan losses(PLL)   0.36     3.05       6.95
NIM net of PLL                   4.24     0.64      (3.63)

Total noninterest income         1.54     1.20       1.04
Total noninterest expense        3.62     4.73      10.56
Income taxes, extraordinary items 0.52    (0.38)     (0.01)
Net Income                       1.63%     -2.51%   -13.14%
     Financial Ratios of Failed Banks
                                     Top 20% Bottom 20% Failed
                                     ROE          ROE                Banks
Return on average equity            18.11%        -34.28%         -249.68%
Equity + LL reserves to assets       9.71           7.93              5.19
Equity formation rate               10.84%        -24.26%           -98.24%

Net overhead to earning assets         2.83          8.04             11.19
Growth rate of total assets            8.50          2.88            -10.20

Nonperforming loans to capital         11.93%        64.75%       235.89%
Net charge-offs to loans                 0.67          5.11         9.09
Recoveries to charge-offs               32.05         9.40           -

Brokered deposits to total deposits.     0.09          0.35          1.94%
Banks in the bottom 20% ROE group must gauge the severity of their relatively
poor performance.
              CAMEL RATINGS
           A -- Asset quality
           M --management quality/ ability
           E -- earnings, and
           L -- liquidity
           S -- sensitivity to market risks

Camel ratings grade banks on a five point scale of
performance from 1(best) to 5 (worst). Banks rated 4
and 5 are rated as problem banks.
                  RISK INDEX
RISK INDEX = l, indicates the probability of being a
problem bank, l calculated as follows:
l =.818-.151 (Primary capital/ total assets)
+ .211 (loans more than 90 days past due/ total assets)
+ .265 (non – accruing loans/total assets)
+ .177 (renegotiated loans/total assets)
+ .151 (Net loans charge off/ total assets)
-.347 (Net income/ total assets).
Where all ratios are in percentage terms.
If all ratios are zero, the l equals .818, which is a high
probability of being a problem bank.

Combining the two .I.e, camel rating and the risk
index. If l is positive and the camel rating is 3,5,or 5,
the bank is above normal risk or high risk.
     Monitoring Of Bank Financial
   Condition: EWSs to Identify Banks
              About to Fail
The Early Warning Symptoms (EWSs) may be used to
  identify low performing institutions. The EWS is
  based on financial ratios analysis, following one or
  more of the following procedures:
 Compare the bank’s performance for each ratio relative
  to peer group of banks.
 Compare the bank’s performance for each ratio relative
  to a “critical value” set.
 Form a composite index/score by combining a number of
  ratios and comparing the score with other banks(it could
  be time series or cross section)
The EWS models are cost efficient and convenient.
Studies have shown that these models can identify most
banks about to fail within two years prior to collapse.
                  EWS Financial Ratios
  - Retained earnings/Average equity capital
  - Gross capital/ Adjusted risk assets
  - Net Operating income/Average total assets
  - Net income/ Assets
  - Interest expense on deposits and federal funds
  purchased and borrowings/ Total operating income
            EWS Financial Ratios(cont’d)
Asset Quality
-Gross loan losses/ Net operating income + Provision
-Provision for possible loan losses/ Average assets
-Gross charge-offs – Recoveries/Average loans
-Net borrowings-Mortgages/Cash and due from
banks + Total securities maturing in one year or less
Interest Sensitivity and Liabilities for
Borrowed Money
-$100,000 or more time deposits + Net borrowings/
Total loans
-Interest-sensitive funds/ Total sources of funds
            EWS Financial Ratios(cont’d)
Efficiency Ratios
- Total operating expenses/Total operating income
- Noninterest expense/ Total operating income-Interest
- Cost of savings deposits/ Total savings deposits
- Net interest earnings/Average assets
Change Ratios
- Change in asset mix
- Change in liability mix
- Change in loan mix
- Cash dividends on common and preferred stock/ Net
-Cash dividends/Net income
Other ratios
- Commercial and industrial loans/Total loans,gross
    Estimating the Probability of Insolvency
 s = standard deviation of ROA; the ;lower the
     variability of ROA, the lower the probability of
     insolvency (indicates Risk)
 E (ROA)= expected return on assets
 1/EM= the inverse of EM or the equity capital-to-asset
     ratio (it indicates the degree of safety).
 g = E(ROA) + 1/EM
High values of risk ratio indicate a low probability or
insolvency and vice versa
Public Confidence is the foundation of bank solvency –
The model of confidence may be stated as –
     confidence = f { NW, SOE, IQ, L(G)}
     As    NW = Net worth (Economic)
           SOE = Stability of Earnings
           IQ = Information Quality
           G    = Market value of Government
           L(G) = Liquidity as a function of Govt.
 A distress institution is one with low or negative net
  worth, unstable earnings, unreliable and costly
  information (low quality information). In an
  unregulated environment, such institutions would be
  prime candidates fro failure.
 However, if Government guarantees are perceived by
  the market place as genuine, they an offset or even
  exceed the adverse operating characteristics of the
  insured firm.
      Non-Financial Information Indicators of
        Financial Condition and Quality of
 Non-financial information also indicates a bank’s overall
  financial condition. A checklist of such information was
  developed by Michael Knapp (modified by me)
  summarized below:
   1. Are the bank deposits insured?
   2. Is the bank audited by a reputed CPA firm?
   3. Has the bank recently changed independent auditors?
   4. Have there been significant management changes in
      recent years?
   5. How much banking experience and general business
      experience do the outside directors possess?
   6. Do the outside directors appear to have significant
      influence on the bank’s operations?
       Non-Financial Information Indicators of
         Financial Condition and Quality of
               Management (cont’d)
7. Does the bank have a loan review committee?
8. What is the general quality and financial strength of
   correspondent banks?
9. Does the bank uses a conservative method of defining
   nonperforming loans?
10. Does the bank offer substantial interest rate premiums to
11. Have bank regulators recently required the bank to sign
  administrative agreements or cease-and-desist orders?
“Banks can fail in good times as well as bad”
 Although macro-economic conditions can be ascribed
  as the broad reasons why some banks fail, in general,
  mismanagement plays a large role in Bank Failure.
 Bank mismanagement may be characterized into four
     Technical mismanagement
     Cosmetic mismanagement
     Desperate management, and
     Outright fraud
     The mismanagement leading to a bank’s
        failure can be caused by any or a
       combination of the following factors:
1. Inappropriate macroeconomic problems leading to
  large scale enterprise failures;
2. Sudden changes in market conditions- devaluation,
   national disaster, or market crash;
3. Errors in judgment or market strategy by bank
4. Internal management problems, disputes, labor
5. Inexperienced staff operating in new fields;
6. Violation of regulations;
      The mismanagement leading to a bank
        failures can be caused by any or a
    combination or the following factors(cont’d):
7. Connected lending to interested shareholders,
   managers, bank staff, or government officials,
8. Imprudent lending and asset acquisition;
9. Poor internal accounting records; and
10. Poor bank supervision
 As creators of money, custodians of public savings,
  and operators of payment mechanism, banks have to
  be regulated in public interest.

 The objective of bank regulation is to have a sound,
  secure, and innovative (banking) system that is
  responsive to consumer needs and market forces and
  free from oligopolistic tendencies.
     Bank Supervision Weaknesses Leading to Bank
                  Insolvency and Failure
Regulatory or Off-Site Monitoring Process
I. Licensing Process “Entry Limits Expansion” (Pre-
   Operating Requirements);
  • Minimum capital requirements,
  • Fit and proper persons on Board, Chief Executive,
  • Ownership limits 5% of total paid up capital of a
    bank to individual ownership
II. Monitoring and Control over the Activities (Rules and
     Information disclosure
     Restrictions on business activities
     Controls over changes in operations
     Risk control limits
     Liquidity requirements
     Capital adequacy requirements
     Capital adequacy requirements
     Information pooling and coordination
     Moral suasion
     Preventive
     Measures
     Policy and legal development
     Bank Examination Process
Involves  Frequent on-site examination of bank
           operations to 

     1. ascertain that the bank is operating in a sound
     2. Determine the accuracy of financial reports to
        the (a) regulator and (b) the public, and
     3. ascertain compliance with the law and
   It covers the following activities:
I. Verification of internal control procedures, their
   documentation and compliance;
II. Assessment of management quality;
       1. Covering integrity, training and experience level
          of staff,
       2. Monitoring how tightly management is
          supervised by the Board,
       3. Examine the degree of discretionary powers
          given to management staff and the nature how
          powers are exercised,
       4. Adequacy of staff and staff education and
          training, and
       5. Management succession and dual controls.
   It covers the following activities (cont’d):
III. Ascertain compliance with laws and regulations.
IV. Testing accuracy of books,accounts and records
  (audit traits)
V. Verification of asset quality – Reviews of credit
  policy 
  - proportion of loans to sectors and individuals,
  - types of securities acceptable to the bank,
  - procedures to be followed in valuation,
  - margin of advance
 Central Banking remedial measures to deal
 with the problems of a failing bank.
Depending on the severity of the problem of the failing
bank, the remedial measures open to a central bank
are limited to one or a combination of the following:
 1. Directing that the problem be remedied, with
    follow-up inspections.
 2. Fine the bank or person responsible.
 3. Moral suasion.
 4. Restrictions on branching, loans growth, or
 5. Change of bank management.
 6. Call for capital increase.
   Central Banking remedial measures to deal
   with the problem of failing bank (cont’d).
      7. Assume control of bank
      8. Merge or consolidate institution with stronger
      9. Liquidate the bank.
Bank restructuring or rescue is a different specialization
  from normal bank supervision.
Two aspects in banking restructuring are vital:
       Solvency
       Management.

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