Table 7.1 Failed Bank Resolution Strategies and Who Loses
Resolution
Shareholders –
Creditors –
Taxpayers –
Managers –
Employees –
options
Lose Money
Lose Money5 Government
Lose Jobs
Lose Jobs
Injection
Capital injection by
Yes – in the
No
No
Yes – likely Possibly if
shareholders
short term,
sharehold-
but could be
ers demand
made up if
cost cuts
the bank
recovers
Government injection1
Likely
Likely
Yes
Likely
Likely
M&A – state funded2
Partly
Possibly
Yes
Yes
Likely
M&A – private
Likely
Likely
No
Yes
Yes
P&A3
Yes
Yes – if
Possibly
Yes
Yes
uninsured
Bridge
Yes
Possibly
Yes
Yes
Possibly
bank/nationalisation4
Liquidation
Yes
Yes – if
No
Yes
Yes
uninsured
Notes:
1 Government injection usually comes with conditions for bank restructuring which are likely to cause managers and some employees to lose their jobs. Some creditors could lose out in any financial restructuring.
2 Some merger or acquisitions involve the state agreeing to take on the dud assets and/or inject funds.
3 P&A: purchase and acquisition. Assets are purchased and liabilities are assumed by the acquirer. Often the state/state run resolution pays the difference between assets or liabilities. If the P&A is partial, uninsured creditors will lose out.
4 The state will take over the bank temporarily (the bridge bank) until a strategy for resolving the bank’s problems is agreed. The bank is later sold, though it may be several years later. Uninsured creditors may lose out, depending on the option, unless a government issues a blanket guarantee for depositors and creditors.
Source: Hoggarth et al. (2003), table 1.
Hoggarth et al. (2003) provide a useful table summarising the different options available for troubled banks, and the trade-offs involved. The table is reproduced here (Table 7.1), with some adaptations.
At the other extreme are the free bankers, discussed in Chapter 4. Those who support special regulation of the banking sector expect governments/regulators to use the determinants of bank failure to achieve an optimum where the marginal benefit of regulation/rescue is equal to its marginal cost. Even free bankers have an interest in what causes a bank to fail, if only because investors and depositors lose out when a bank goes under. Either way, it is an important question, and the next few sections attempt to answer it.
7.3. Case Studies on Bank Failure
Bank failures, broadly defined, have occurred in virtually every country throughout history. In the 14th century the Bardi family of Florentine bankers was ruined by the failure of
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Edward III to meet outstanding loan obligations – the only time in history, to date, that an English government failed to honour its debts. Some failures seriously undermine the stability of the financial system (as happened, for example, in the UK in 1866 and the USA in 1933). Others do not. In some cases, state support of problem banks proves costly. For example, the taxpayers’ bill for the US thrift bailout is put at around $250 – $300 billion, while recent problems with the Japanese banking system has cost the taxpayer about $560 billion to date. In this section, bank failures are examined on a case by case basis, the objective being to identify the qualitative causes of bank failure. After a brief historical review, the main focus is on modern bank failures, commencing with the failure of Bankhaus Herstatt in 1974.
7.3.1. Historical Overview
This subsection is a selective, brief review of well-known bank failures in Victorian England and between 1930 and 1933 in the USA. In England, there were two major bank failures in the 19th century: Overend Gurney and Company Ltd7 in 1866, and Baring Brothers in 1890. Overend Gurney originated as a discount house but by the 1850s was a prosperous financial firm, involved in banking and bill broking. After changes in management in 1856 and 1857 it began to take on bills of dubious quality, and lending with poor collateral to back the loans. By 1865 the firm was reporting losses of £3 – £4 million. In 1866, a number of speculative firms and associated contracting firms, linked to Overend Gurney through finance bills, failed. London-based depositors began to suspect Overend was bankrupt; the consequence was a drawing down of deposits and a fall in the firm’s stock market price. On 10 May 1866 the firm sought assistance from the Bank of England, which was refused. The bank was declared insolvent the same afternoon.
Overend Gurney was a large bank: by balance sheet it was about ten times the size of the next largest bank in the country – the Midland.8 Its failure precipitated the collapse of a number of country banks and firms associated with it. Contagion spread: country banks withdrew deposits from other London banks and finance houses, which in turn caused a run on the Bank of England. Several banks and finance houses, both unsound and healthy, failed. The 1844 Bank Charter Act was suspended to enable the Bank of England to augment a note supply, which was enough to allow the panic to subside. Overend Gurney was liquidated, and though the Bank Act was not amended, the episode made it clear that henceforth the Bank of England was to intervene as lender of last resort in situations of severe panic.
Baring Brothers was a large international merchant bank which failed in 1890. Barings had been founded in 1762, largely to finance the textile trade in Europe. After the Napoleonic wars, Barings began to finance for public projects in foreign countries; initially the long-term lending to foreign governments was concentrated in Europe and North America, but in 1821 – 22 the loan portfolio was expanded to include Mexico and Latin America, notably Chile, Colombia and Brazil. Even though these loans were non-performing, Barings granted
7 Legislation passed in 1858 allowed limited liability and Overend Gurney became a limited liability company in 1862.
8 Wood (2003), p. 69.
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additional, large loans to the governments of Argentina and Uruguay between 1888 and 1890. By the end of 1890, these loans made up three-quarters of Barings’ total loan portfolio. Problems with key banks in Argentina and Uruguay led to suspended payments and bank runs. Barings’ Argentine securities dropped in value by one-third; the firm also faced a drop in income from loan repayments and liabilities arising from a failed utility. Barings borrowed heavily from London banks in an effort to contain the problem, but in November 1890 was forced to report the crisis to the Bank of England. The Governor of the Bank of England organised subscriptions to a fund – London’s key merchant banks contributed, and the fund guaranteed Barings’ liabilities for three years. Eight days after Barings reported its problems to the Bank, its illiquidity had become public knowledge. But there was no run of any significance, and no other banks failed. Though put into liquidation, Barings was refloated as a limited liability company, with capital from the Baring family and friends.
Both banks underwent notable changes in bank management in the years leading up to the failures. The collapse of the banks was due largely to mismanagement of assets, leading to a weak loan portfolio in the case of Barings, and for Gurneys, the issue of poor quality finance bills. Batchelor (1986, pp. 68 – 69) argued that, unlike Barings, the Gurney failure caused a serious bank run because the public lacked crucial information about the state of the bank’s financial affairs. The Latin American exposure of Barings was well known, but there was no run because of its historical reputation for financial health in the banking world.
One of the most important series of bank failures occurred in the USA between 1930 and 1933.9 The stock market crash of October 1929 precipitated a serious depression and created a general climate of uncertainty. The first US banking crisis began in November 1930, when 256 banks failed; contagion spread throughout the USA, with 352 more bank failures in December. The Bank of the USA was the most notable bank failure. It was the largest commercial bank, measured by deposits. It was a member of the Federal Reserve System, but an attempt by the Federal Reserve Bank of New York to organise a ‘‘lifeboat’’ rescue with the support of clearing house banks failed. It was followed by a second round of failures in March 1931.
Other countries also suffered bank failures, largely because the depression in the USA had wide-reaching global effects. The largest private bank in Austria, Kreditanstalt, failed in May 1931, and in other European states, particularly Germany, banks were closed. Meanwhile, in the USA, another relapse followed a temporary recovery, and in the last quarter of 1932 there were widespread bank failures in the Midwest and Far West of the USA. By January 1933 bank failures had spread to other areas; by 3 March, half the states were required to declare bank holidays to halt the withdrawals of deposits. On 6 March 1933, President Roosevelt declared a nation-wide bank holiday, which closed all banks until some time between the 13th and 15th of March, depending on location. There were 17 800 commercial banks prior to the bank holiday period, but fewer than 12 000 were allowed to open, under new federal/state authority licensing requirements. About 3000 of the unlicensed banks were eventually allowed to remain open, but another 2000 were either
9 The details of US bank failures in the early 1930s are taken from Friedman and Schwartz (1963), pp. 332–349, 351–353.
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liquidated or merged with other banks. The suspended operations and failures caused losses of $2.5 billion for stockholders, depositors and other creditors. Friedman and Schwartz (1963) argued a poor quality loan book and other bad investments was the principal cause of some bank failures in 1930,10 but later on, the failures were due largely to bank runs, which forced banks to divest their assets at a large discount.
7.3.2. Bankhaus Herstatt
This West German bank collapsed in June 1974 because of losses from foreign exchange trading, which were originally estimated at £83 million but rose to £200 million. At the time it was unclear how the bank had managed to run up such losses. The bank’s failure is famous because it exposed a weakness in the system related to liquidity risk. Bankhaus Herstatt was due to settle the purchase of Deutsche marks (DMs, in exchange for dollars) on 26 June. On that day, the German correspondent banks, on instruction from the American banks, debited their German accounts and deposited the DMs in the Landes Central bank (which was acting as a clearing house). The American banks expected to be repaid in dollars, but Bankhaus Herstatt was closed at 4 p.m., German time. It was only 10 a.m. on the US east coast, causing these banks to lose out because they were caught in the middle of a transaction. The US payments system was put under severe strain. The risk associated with the failure to meet interbank payment obligations has since become known as Herstatt risk. In February 1984, the chairman of the bank was convicted of fraudulently concealing foreign exchange losses of DM 100 million in the bank’s 1973 accounts.
7.3.3. Franklin National Bank
In May 1974 Franklin National Bank (FNB), the 20th largest bank in the USA (deposits close to $3 billion), faced a crisis. The authorities had been aware of the problem since the beginning of May, when the Federal Reserve refused FNB’s request to take over another financial institution and instructed the bank to retrench its operations because it had expanded too quickly. A few days later, FNB announced it had suffered very large foreign exchange losses and could not pay its quarterly dividend. It transpired that in addition to these losses, the bank had made a large volume of unsound loans, as part of a rapid growth strategy.
These revelations caused large depositors to withdraw their deposits and other banks refused to lend to the bank. FNB offset the deposit outflows by borrowing $1.75 billion from the Federal Reserve. Small depositors, protected by the FDIC, did not withdraw their deposits, otherwise the run would have been more serious. In October 1974, its remains were taken over by a consortium of seven European banks, European American.
10 Friedman and Schwartz (1963), pp. 354–355 distinguish between the ex ante and ex post quality of bank assets. Ex ante, banks’ loan and other investment decisions were similar in the early 1920s and the late 1920s. The key difference was that the loans/investments of the late 1920s had to be repaid/matured in the Great Depression. Thus, they argue, with the exception of foreign lending, the number of bank failures caused by poor investment decisions is debatable.
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FNB had been used by its biggest shareholder, Michele Sindona, to channel funds illegally around the world. In March 1985 he died from poisoning, a few days after being sentenced to life imprisonment in Italy for arranging the murder of an investigator of his banking empire.
7.3.4. Banco Ambrosiano
Banco Ambrosiano (BA) was a commercial bank based in Milan and quoted on the Milan Stock Exchange. It had a number of foreign subsidiaries and companies located overseas, in Luxembourg, Nassau, Nicaragua and Peru. The Luxembourg subsidiary was called Banco Ambrosiano Holdings (BAH). The parent, Banco Ambrosiano, owned 69% of BAH. BAH was active on the interbank market, taking eurocurrency deposits from international banks which were on-lent to other non-Italian companies in the BA group.
The parent bank, BA, collapsed in June 1982, following a crisis of confidence among depositors after its Chairman, Roberto Calvi, was found hanging from Blackfriars Bridge in London, 10 days after he had disappeared from Milan. Losses amounted to £800 million, some of them linked to offshore investments involving the Vatican’s bank, the Institute for the Works of Religion. The Bank of Italy launched a lifeboat rescue operation; seven Italian banks provided around $325 million in funds to fill the gap left by the flight of deposits, and BA was declared bankrupt by a Milan court in late August 1982. A new bank, Nuovo Banco Ambrosiano (NBA), was created to take over the bank’s Italian operations. The Luxembourg subsidiary, BAH, also suffered from a loss of deposits, but the Bank of Italy refused to launch a similar lifeboat rescue operation, causing BAH to default on its loans and deposits.
The main cause of the insolvency appears to have been fraud on a massive scale, though there were other factors whose contribution is unclear. The BA affair revealed a number of gaps in the supervision of international banks. The Bank of Italy authorities lacked the statutory power to supervise Italian banks. Nor was there a close relationship between senior management and the central bank, as in the UK at the time. It appears that Sig. Calvi’s abrupt departure may have been precipitated by a letter sent to him by the surveillance department of the Bank of Italy seeking explanations for the extensive overseas exposure, asking for it to be reduced and requesting that the contents of the letter be shown to other directors of the bank. This activity suggests the regulatory authorities were aware of the problem. The Bank of Italy refused to protect depositors of the subsidiary in Luxembourg because BA was not held responsible for BAH debts; it owned 69% of the subsidiary. The Bank of Italy also pointed out that neither it nor the Luxembourg authorities could be responsible for loans made from one offshore centre (Luxembourg) to another (Panama) via a third, again in Latin America.
In 1981, the Luxembourg Banking Commission revised some of its rules to relax bank secrecy and allow the items on the asset side of a bank’s balance sheet to be freely passed through the parent bank to the parent authority, though bank secrecy is still upheld for non-bank customers holding deposits at Luxembourg banks. The authorities in Luxembourg also obtained guarantees from the six Italian banks with branches in Luxembourg that they would be responsible for the debts of their branches. The 1975 Basel Concordat was revised in 1983 (see Chapter 5) to cover gaps in the supervision of foreign branches and
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subsidiaries. In July 1994 the former Prime Minister of Italy, Bettino Craxi, was convicted of fraud in relation to the collapse of Banco Ambrosiano.
Over 20 years later, questions relating to the death of Roberto Calvi continue. The first Coroner’s Inquest judged the death to be suicide, but the family has always protested this verdict, pointing to evidence such as bricks stuffed in the pockets of the deceased. A second inquest recorded an open verdict. The City of London police decided to investigate and in 2003, one woman was arrested on suspicion of perjury and conspiring to pervert the course of justice.
In March 2004,11 four people went on trial in Rome for the murder of Roberto Calvi. One of them, a former Mafia boss, is already in prison. A member of the Mafia turned informer named the four accused. The prosecution claims the Mafia ordered his murder because Mr Calvi bungled attempts to launder bonds stolen by the Mafia and was blackmailing associates with links to Vatican and Italian society. A masonic lodge (P2) where Mr Calvi was a member also appears to be involved.
7.3.5. Penn Square and Continental Illinois
As will become apparent, the collapse of these two banks was connected. Penn Square Bank, located in Oklahoma City, had opened in 1960, as a one-office retail bank.12 On 5 July 1982, the bank collapsed, with $470.4 million in deposits and $526.8 million in assets. It embarked on an aggressive lending policy to the oil and gas sector – its assets grew more than eightfold between 1977 and 1982. It sold the majority interest in these loans to other banks, but remained responsible for their servicing. From the outset, loan documentation was poor and loan decisions were based solely on the value of the collateral (oil and gas) rather than assessing the borrower’s ability to repay. From May 1977 onward, the Office of the Comptroller of Currency (OCC), the main regulatory authority, expressed concern about a host of problems: poorly trained staff, low capital, lack of liquidity, weak loans and increasing problems with the loan portfolio. The external auditors signed qualified opinion in 1977 and 1981.
The way Penn Square’s failure was dealt with marked an apparent change in FDIC policy. Of the 38 banks that failed since 1980, only eight were actually closed with insured depositors paid off. The other 30 had been the subject of purchase and assumption transactions, whereby the deposits, insured and uninsured, were passed to the acquiring institution. Of the $470.4 million in deposits at Penn Square, only 44% were insured. The uninsured deposits were mainly funds from other banks. The FDIC paid off the insured depositors, and in August 1983 the Charter National Bank purchased the remaining deposits.
At the time of its collapse, Continental Illinois National Bank (CI) was the seventh largest US bank and the largest correspondent bank, involving about 2300 banks.13 Though its problems were well known by regulators, they were caught out by the speed of the bank’s collapse. In the summer of 1984, a number of CI customers were having trouble repaying
11‘‘Four go on Trial for the Murder of God’s Banker’’, The Guardian, 17 March 2004.
12At the time, branching was prohibited in the State of Oklahoma. The details on Penn Square come from FDIC (2001). Penn Square was one of the early failures – one of many between 1980 and 1994. See below.
13Kaufman (1994, 2002).
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their loans because of the drop in oil prices. The decline in oil prices also undermined the value of the collateral securing these loans, much of it in real estate in centres of oil production.
Penn Square had a close connection to Continental Illinois. The bank was one of five large banks around the country that purchased participations in oil and gas loans. Shortly after the collapse of Penn Square, CI announced a second-quarter loss of $63.1 million and revealed its non-performing loans had more than doubled to $1.3 billion. In subsequent quarters, the bank was slow to recover and its non-performing loans held steady at approximately $2 billion, even though the non-performing loans related to the Penn Square connection had declined.
The first-quarter results of 1984 (17th April) revealed the bank’s non-performing loans had risen to $2.3 billion, representing 7.7% of its loans. Increasingly, CI had been relying on the overseas markets to fund its domestic loan portfolio. On the eve of the crisis, 60% of its funds were being raised in the form of short-term deposits from overseas. This reliance on uninsured short-term deposits, along with its financial troubles, made it especially vulnerable to a run.
Rumours about the solvency of the bank were rife in the early days of May 1984, thereby undermining the ability of the bank to fund itself. On 10 May the rumours were so serious that the US OCC took the unusual step of rebutting the rumours, though the normal procedure was a terse ‘‘no comment’’. The statement merely served to fuel more anxiety and the next day, CI was forced to approach the Chicago Reserve Bank for emergency support, borrowing approximately $44.5 billion. Over the weekend, the Chairman of Morgan Guaranty organised US bank support for CI: by Monday 14 May, 16 banks made $4.5 billion available under which CI could purchase federal funds on an overnight basis. However, the private lifeboat facility was not enough. The run on the bank continued and the bank saw $6 billion disappear, equivalent to 75% of its overnight funding needs.
On 17 May the Comptroller, the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve Bank announced a financial assistance programme. The package had four features. First, there was a $2 billion injection of capital by the FDIC and seven US banks, with $1.5 billion of this coming from the FDIC. The capital injection took the form of a subordinated demand loan and was made available to CI for the period necessary to enhance the bank’s permanent capital, by merger or otherwise. The rate of interest was 100 basis points above the one-year Treasury bill rate. Second, 28 US banks provided a $5.5 billion federal funds back-up line to meet CI’s immediate liquidity requirements, to be in place until a permanent solution was found. It had a spread of 0.25% above the Federal funds rate. Third, the Federal Reserve gave an assurance that it was prepared to meet any extraordinary liquidity requirements of CI. Finally, the FDIC guaranteed all depositors and other general creditors of the bank full protection, with no interruption in the service to the bank’s customers.
In return for the package, all directors of CI were asked to resign and the FDIC took direct management control of the bank. The FDIC bought, at book value, $3.5 billion of CI’s debt. The Federal Reserve injected about $1 billion in new capital. The bank’s holding company, CI Corporation, issued 32 million preference shares to the FDIC, that on sale converted
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into 160 million common shares in CI and $320 million in interest-bearing preferred stock. It also had an option on another 40.3 million shares in 1989, if losses on doubtful loans exceeded $800 million. It was estimated they exceeded $1 billion. Effectively, the bank was nationalised, at a cost of $1.1 billion. A new team of senior managers was appointed by the FDIC, which also, from time to time, sold some shares to the public. By 1991 it was back in private hands, and in 1994 it was taken over by Bank America Corp. (Kaufman, 2002,
p.425).
Continental Illinois got into problems for a number of reasons. First, it lacked a rigorous
procedure for vetting new loans, resulting in poor-quality loans to the US corporate sector, the energy sector and the real estate sector. This included participation in low-quality loans to the energy sector, bought from Penn Square. Second, CI failed to classify bad loans as non-performing quickly, and the delay made depositors suspicious of what the bank was hiding. Third, the restricted deposit base of a single branch system forced the bank to rely on wholesale funds as it fought to expand. Fourth, supervisors should have been paying closer attention to liability management, in addition to internal credit control procedures.
Regulators were concerned about CI’s dependence on global funding. This made it imperative for the FED and FDIC to act as lender of last resort, to head off any risk of a run by foreign depositors on other US banks. Continental Illinois was also the first American example of regulators using a ‘‘too big to fail’’ policy. The three key US regulatory bodies were all of the view that allowing CI to go under would risk a national or even global financial crisis, because CI’s correspondent bank relationships left it (and the correspondent banks) highly exposed on the interbank and Federal funds markets. The regulators claimed the exposure of 65 banks was equivalent to 100% of their capital; another 101 had between 50% and 100% of their capital exposed. However, Kaufman (1985, 1994) reports on a Congressional investigation of the collapse, which showed that only 1% of Continental’s correspondent banks would have become legally insolvent if losses at CI had been 60 cents per dollar. In fact, actual losses turned out to be less than 5 cents on the dollar, and no bank suffered losses high enough to threaten its solvency. The Economist (1995) argues that regulators got their sums wrong, and reports that some privately believed the bank did not need to be rescued. However, it is worth noting that the correspondent banks were not privy to this information at the time of the crisis, and would have been concerned about any losses they incurred, even if their solvency was not under threat. Given the rumours, it was quite rational for them to withdraw all uninsured deposits, thereby worsening the position of CI.
Furthermore, the episode did initiate a too big to fail policy, which was used sporadically throughout the 1980s. Some applications were highly questionable. For example, in 1990 the FDIC protected both national and off-shore (Bahamas) depositors at the National Bank of Washington, D.C., ranked 250th in terms of asset size. The policy came to an end with the 1991 FDIC Improvement Act (FDICIA), which required all regulators to use prompt corrective action and the least cost approach when dealing with problem banks. However, the ‘‘systemic risk’’ exception in FDICIA has given the FDIC a loophole to apply too big to fail.14
14 See Chapter 5 for more detail on FDICIA.
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7.3.6. Johnson Matthey Bankers
Johnson Matthey Bankers (JMB) is the banking arm of Johnson Matthey, dealers in gold bullion and precious metals. JMB was rescued in October 1984, following an approach to the Bank of England by the directors of JM, who believed the problems with JMB might threaten the whole group. The original lifeboat rescue package consisted of the purchase of JMB and its subsidiaries by the Bank of England for a nominal sum (£1.00), and wrote off a large proportion of their assets. The bullion dealer, Johnson Matthey, was required to put up £50 million to allow JMB to continue trading. Charter Consolidated, a substantial investor in JM, contributed £25 million. Other contributors were the clearing banks (£35 million), the other four members of the gold ring (£30 million), the accepting houses which were not members of the gold ring (£10 million) and the Bank of England (£75 million).
On 7 November 1984 an agreed package of indemnities was announced to cover the possibility that JMB’s loan losses might eventually exceed its capital base of £170 million. In May 1985 the Bank of England declared that provisions of £245 million were necessary to cover the loan losses. With this increase in loan provisions, all lifeboat contributions were raised to make up the shortfall; the Bank of England and other members of the lifeboat contributing half the amount of the shortfall each. On 22 November 1984, the Bank of England made a deposit of £100 million to provide additional working funds.
JMB got into trouble because it managed to acquire loan losses of £245 million on a loan portfolio of only £450 million, so it had to write off over half of its original loan portfolio. Compare this to the case of Continental Illinois, where non-performing loans were only 7.4% of its total loans. Press reports noted that most of these bad loans were made to traders involved with Third World countries, especially Nigeria, suggesting a high concentration of risks. The Bank of England’s guideline on loan concentration (banks should limit loans to a single borrower or connected group of borrowers to 10% of the capital base) appears to have been ignored. The Bank of England was aware of some problems in 1983 but did not act until the full extent of the problems emerged after a special audit in 1984.
The auditors also appeared to be at fault. Under the UK Companies Act, their ultimate responsibility lies with the shareholders and they are required to report whether the accounts prepared by the bank’s directors represent a ‘‘true and fair view’’. In assessing the bank, the auditor reviews the internal audit and inspections systems, and on a random basis examines the record of transactions to verify that they are authentic, and discusses with the directors decisions made in highly sensitive areas such as provisions against bad and doubtful debts. Auditors are not permitted to discuss the audit with bank supervisors, without the permission of the clients. The auditors can either agree with the directors that the accounts represent a true and fair view, or they can disagree with the directors, in which case they must either resign or qualify the accounts. The auditors at JMB signed unqualified reports, implying all was well. On the other hand, if the auditors had signalled problems by signing a qualified report or resigning, it might have precipitated a bank run, and the authorities may not have had enough time to put together a lifeboat operation.
As was noted in Chapter 5, the Bank of England’s system of supervision was flexible. However, the JMB affair revealed two gaps in the reporting system. First, auditors had no formal contact with the Bank of England and were unable to register their concerns, unless they either resigned or qualified their reports. Second, the statistical returns prepared for
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the Bank of England, based on management interviews, were not subject to an independent audit. The 1987 amendment to the Banking Act addressed these problems partially; auditors were encouraged to warn supervisors of suspected fraud, and were given greater access to Bank of England information.
The JMB affair prompted the establishment of a committee involving the Treasury, Bank of England officials and an external expert, to review the bank supervisory procedures, especially the relationship between the auditor and supervisor. The result of the review of the affair was an amendment of the Banking Act (1987). However, the effectiveness of private auditing was again questioned after the BCCI closure (see below).
The JMB case illustrated the use of a lifeboat rescue by the Bank of England, and is a rare example of where the too big to fail doctrine was extended to protect non-banking arms of a financial firm. The main point of a rescue is to prevent the spread of the contagion effect arising from a collapsed bank. Johnson Matthey was one of the five London gold price fixers. Obviously, the Bank of England was concerned that the failure of the banking arm would spread to JM, thereby damaging London’s reputation as a major international gold bullion dealer. The episode suggests the Bank is prepared to engage in a lifeboat rescue effort to protect an entire conglomerate, provided it is an important enough operator on global financial markets.
7.3.7. The US Bank and Thrift Crises, 1980–94
Between 1980 and 1994 there were 1295 thrift failures in the USA, with $621 billion in assets. Over the same period, 1617 banks, with $302.6 billion in assets, ‘‘failed’’ in the sense that they were either closed, or received FDIC assistance. These institutions accounted for a fifth of the assets in the banking system. The failures peaked between 1988 and 1992, when a bank or thrift was, on average, failing once a day.15 This section will begin with a review of the thrift failures, followed by the commercial bank failures.16
Failing thrifts
Thrifts are savings and loan (S&L) banks, either mutuals or shareholder owned, though by the end of the crisis, the majority were stock owned. Until 1989, they were backed by deposit insurance provided by the Federal Savings and Loan Insurance Corporation (FSLIC). The FSLIC was in turn regulated by the Federal Home Loan Bank Board. Both institutions were dissolved by statute in 1989.
In 1932, Congress passed the Federal Home Loan Bank Act. The Act created 12 Federal Home Loan Banks, with the Federal Home Loan Bank Board (FHLBB) as their supervisory agent. The aim was to provide thrifts with an alternative source of funding for home mortgage lending. In 1933, the government became involved in the chartered savings
15These figures are from FDIC (2001). ‘‘Failure’’ includes thrifts that were either closed by the Federal Savings Loan Insurance Corporation (FSLIC) or the Resolution Trust Corporation (RTC), or received financial assistance from the FSLIC. For a detailed account of the crisis, see White (1991).
16The author’s account used two excellent publications by the Federal Deposit Insurance Corporation, FDIC (1997) and FDIC (1998).
