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Reasons for Bank Failure

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					CAUSES OF BANK FAILURE
I. Opinion Survey: Bank Supervisors
Banks are observed to fail under three conditions: 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 failure.

CAUSES OF BANK FAILUREAnother research
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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.

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Interest sensitivity accounted for 48% of large bank failures.

CAUSES OF BANK FAILUREAnother research (cont’d)
Cause of failure Loans Insider loans Rate sensitivity Liquidity Small 83% 31% 14% 35% Large 86% 33% 48% 57%

Causes are shown as a percentage of the number of failures for each size group.

CAUSES OF BANK FAILURE
POOR ASSET QUALITY FACTORS
Research findings suggest eight loan portfolio management practices as important determinants: HEALTHY 0% 29% 0% FACTOR Liberal Lending Practices/ loan growth Excessive financial statement FAILED BANKS 85%

exceptions
Over lending

79%
73%

CAUSES OF BANK FAILURE
POOR ASSET QUALITY FACTORS
HEALTHY 0% 3% 3% 0% 3% (cont‟d) FACTOR FAILED BANKS Excessive collateral documentation exceptions 67% Collateral based lending 55% Excessive growth relative to management, staff, systems and funding 52% Unwarranted concentrations of credit 37% Out of area lending 23%

TWENTY COMMON REASONS FOR LOAN LOSSES
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 ownermanager.
5. Renewing a loan for increasing amounts, with no additional collateral taken. 6. Repeatedly rewriting loan to cover delinquent interest due.

TWENTY COMMON REASONS FOR LOAN LOSSES (cont’d)
7.Not analyzing borrower‟s cash flows and repayment capacity. 8.Failure of officer to review loan‟s status frequently enough. 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.

TWENTY COMMON REASONS 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 procedures. 15. Bank president too dominant in pushing through loan approvals.

TWENTY COMMON REASONS 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 hopeless.

BANK FINANCIAL RATIOS AS INDICATORS OF FAILURE
Analyzed failed banks‟ ratios for a year or more before actual failure to see if the actual failure could be anticipated ?

BANK FINANCIAL RATIOS AS LEADING INDICATORS OF FAILURE 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
Net interest margin (NIM) Provision for loan losses(PLL) NIM net of PLL Total noninterest income Total noninterest expense Net Income 4.60 0.36 4.24 1.54 3.62 1.63%

ROE
3.69 3.05 0.64 1.20 4.73 (0.38) -2.51%

Banks
2.71 6.95 (3.63) 1.04 10.56 (0.01) -13.14%
(cont’d)

Income taxes, extraordinary items 0.52

Financial Ratios of Failed Banks
Top 20% Bottom 20% Failed

ROE
Return on average equity Equity + LL reserves to assets Equity formation rate Net overhead to earning assets Growth rate of total assets 18.11% 9.71 10.84% 2.83 8.50

ROE
-34.28% 7.93 -24.26% 8.04 2.88

Banks
-249.68% 5.19 -98.24% 11.19 -10.20

Nonperforming loans to capital Net charge-offs to loans Recoveries to charge-offs
Brokered deposits to total deposits.

11.93% 0.67 32.05
0.09

64.75% 5.11 9.40
0.35

235.89% 9.09 1.94%

Banks in the bottom 20% ROE group must gauge the severity of their relatively poor performance.

CAMEL RATINGS
C -- CAPITAL ADEQUALCY 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.

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)

Monitoring Of Bank Financial Condition: EWSs to Identify Banks About to Fail

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

Capital
- Retained earnings/Average equity capital - Gross capital/ Adjusted risk assets

Profitability
- 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

Liquidity
-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 expense - 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 income -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 s

High values of risk ratio indicate a low probability or insolvency and vice versa

PUBLIC CONFIDENCE MODEL
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 guarantees L(G) = Liquidity as a function of Govt. guarantees

PUBLIC CONFIDENCE MODEL(cont’d)
 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 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

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 depositors? 11. Have bank regulators recently required the bank to sign administrative agreements or cease-and-desist orders?

MANAGEMENT FACTOR
“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 phases: 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 management 4. Internal management problems, disputes, labor problems

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, politicians,etc 8. Imprudent lending and asset acquisition;

9. Poor internal accounting records; and
10. Poor bank supervision

REGULATION
 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.

SUPERVISION FACTOR
Bank Supervision Weaknesses Leading to Bank Insolvency and Failure

BANK SUPERVISION PROCESS
Regulatory or Off-Site Monitoring Process

I. Licensing Process “Entry Limits Expansion” (PreOperating Requirements);
• Minimum capital requirements, • Fit and proper persons on Board, Chief Executive, Management • Ownership limits 5% of total paid up capital of a bank to individual ownership

SUPERVISION FACTOR(cont’d)
II. Monitoring and Control over the Activities (Rules and Regulations)
            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

Involves  Frequent on-site examination of bank operations to  1. ascertain that the bank is operating in a sound manner;

Bank Examination Process

2. Determine the accuracy of financial reports to the (a) regulator and (b) the public, and
3. ascertain compliance with the law and regulations.

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 investments. 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 institutions. 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.