and loans firms. The Home Owner’s Loan Act was passed, authorising the Federal Home Loan Bank Board (FHLBB) to charter and regulate the savings and loan associations. The National Housing Act, 1934, created a deposit insurance fund for savings and loan associations, the Federal Savings and Loan Insurance Corporation (FSLIC). Unlike the FDIC, which was established as a separate organisation from the Federal Reserve System, the FSLIC was placed under the auspices of the FHLBB. S&L depositors are insured for up to $100 000.
The first signs of trouble came in the mid-1960s, when inflation and high interest rates created funding problems. Regulations prohibited the federally insured savings and loans from diversifying their portfolios, which were concentrated in long-term fixed rate mortgages. Deposit rates began to rise above the rates of return on their home loans. In 1966, Congress tried to address the problem by imposing a maximum ceiling on deposit rates, and thrifts were authorised to pay 0.25% more on deposits than commercial banks (regulation Q), thereby giving them a distorted comparative advantage. Unfortunately, the difference was not enough because market interest rates rose well above the deposit rate ceilings. The system of interest rate controls became unworkable and aggravated the thrifts’ maturity mismatch problems.
The 1980 Depository Institutions Deregulation and Monetary Control Act (DIDMCA) took the first significant step towards reforming this sector. The DIDMCA allowed interest rate regulations to be phased out, and permitted thrifts to diversify their asset portfolios to include consumer loans other than mortgage loans, loans for commercial real estate, commercial paper and corporate debt securities. But lack of experience meant diversification contributed to a widespread loan quality crisis by the end of the 1980s.
DIDMCA came too late for thrifts facing the steep rise in interest rates that began in 1981 and continued in 1982. Federally chartered S&Ls had not been given the legal authority to make variable rate mortgage loans until 1979, and then only under severe restrictions. Variable rate mortgages could not be freely negotiated with borrowers until 1981. By that time, deposit rates had risen well above the rates most thrifts were earning on their outstanding fixed rate mortgage loans. Accounting practices disguised the problem because thrifts could report their net worth based on historic asset value, rather than the true market value of their assets.
Policies of regulatory forbearance aggravated the difficulties. Kane and Yu (1994) defined forbearance as:
‘‘a policy of leniency or indulgence in enforcing a collectable claim against another party’’
(p. 241)
To repeat the definition used in other chapters, regulatory forbearance occurs when the supervisory/regulatory authorities put the interests of the firms they regulate ahead of the taxpayer. In the case of the thrifts, supervisory authorities adopted lenient policies in the enforcement of claims against thrifts, because they had a vested interest in prolonging the S&Ls’ survival: fewer thrift failures reduced the demands on the FSLIC’s fund. In 1981 and 1982, the FHLBB authorised adjustments in the Regulatory Accounting Principles, thereby allowing thrift net worth to be reported more leniently than would have been the case had Generally Accepted Accounting Principles (GAAP) been applied. In 1980 and 1982, the
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FHLBB lowered minimum net worth requirements. These changes reduced the solvency threshold and meant thrifts could record inflated net worth values.
The FSLIC also introduced an income capital certificates programme, to counter any crisis of confidence. Thrifts could obtain income certificates to supplement their net worth – they were reported as a part of equity. Since the FSLIC did not have the funds to cover the certificates, it usually exchanged its own promissory notes for them. S&Ls included these notes as assets on their balance sheets. Effectively, the FSLIC was using its own credit to purchase equity in an insolvent thrift. The certificates reduced the number of thrift failures, but heightened the FSLIC’s financial interest in preventing troubled thrifts from failing.
The Garn-St Germain Depository Institution Act of 1982 created a net worth certificate programme, a derivative of the income capital certificates. The net worth certificates differed from the income capital certificates in that they did not constitute a permanent equity investment but were issued only for a set time period, authorised by the legislation. These certificates could not be used to reorganise insolvent thrifts or to arrange mergers, because they were not transferable. The Act also allowed troubled savings and loans with negative net earnings to obtain interest-free loans from the FSLIC.
The Garn-St Germain Act also liberalised the investment powers of federally chartered thrifts – they were allowed to offer money market accounts at an interest rate competitive with money market funds. Additionally, some states (for example, California) took the initiative to deregulate savings and loans even further. Though many of these changes disappeared with two new acts, FIRREA (1989) and FDICIA (1991). With the benefit of hindsight, it is now acknowledged that granting new powers to the FSLIC allowed thrifts to expand into areas where they had little expertise worsened the crisis.
From late 1982, interest rates were lower and less volatile, but this failed to reduce the difficulties because of increasingly poor credit quality. For example, by 1984 asset quality problems explained 80% of the troubled thrifts. In 1985, the FHLBB introduced a ‘‘Management Consignment Program’’, designed to stem the growing losses of insolvent thrifts. Usually, it resulted in a thrift’s management being replaced by a conservator selected by the Bank Board. It was to be a temporary measure, until the FSLIC could sell or liquidate the thrifts. However, it became increasingly apparent to financial market participants that the FSLIC lacked the resources to deal with the heavy losses accumulating in the troubled savings and loan industry. They became reluctant to accept the promissory notes which backed the income capital certificates. By 1985, the deteriorating condition of the insolvent thrifts strained the resources of the FSLIC to the point that it needed outside funding. Despite efforts to recapitalise it, the FSLIC’s deficit was estimated to exceed $3 billion at the end of 1986. The 1987 Competitive Equality Banking Act (CEBA) authorised the issue of $10.8 billion in bonds to recapitalise the FSLIC, but in 1988 its deficit stood at $75 billion. The possibility of a taxpayer-funded bailout of the FSLIC appeared in the financial press. All of these events heightened concern about the creditworthiness of the FSLIC’s promissory notes.
In 1988, the General Accounting Office (GAO) estimated that the cost of dealing with more than 300 insolvent thrifts (that the FSLIC had yet to place in receivership) was $19 billion. By the end of 1988, the estimate was raised to over $100 billion, as the GAO
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recognised the problem was far more extensive than had first been thought. The final bill was approximately $150 billion. Unlike the commercial bank failures (see below), the thrift failures were more evenly spread throughout the country. Texas (18%), California (9.8%), Louisiana (7%), Florida and Illinois (6.5%) each, New Jersey (4.55) and Kansas (3%) accounted for 55% of the failures from 1989 to 1995. The rest were spread throughout the states and just six (including DC) had no failures.17
To deal with the crisis, the Bush Plan was unveiled on 6 February 1989, and became the model for the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA), 1989, which was discussed in Chapter 5. The parts of the Act relevant to the thrift crisis include:
žNew restrictions on the investment powers of S&Ls, requiring them to specialise more in mortgage lending, thereby reversing the earlier policy. Under the qualified thrift lender (QTL) test, at least 65% of their assets must be mortgage related.
žAn attempt to stop the regulatory forbearance witnessed in the 1980s by abolishing the institutions which promoted it. The Act dissolved the FSLIC and established the Savings Association Insurance Fund (SAIF) under the auspices of the FDIC. The Federal Home Loan Bank Board was closed and replaced with the Office of Thrift Supervision (OTS), under the direction of the Secretary of the Treasury.
žThrifts are required to meet capital requirements at least as stringent as those imposed on commercial banks, and the Act set out new rules on higher minimum net worth.
žThe Resolution Trust Corporation (RTC) was established to take over the case-load of insolvent thrifts. The RTC was allocated funds to pay off the obligations incurred by the FSLIC, and subsequently received $50 billion in additional funding, to be used by the Corporation to take over 350 insolvent thrifts, and either liquidate or merge them.
žCommercial banks were allowed to acquire healthy thrifts – prior to this Act, they could only take over failing savings and loans.
FIRREA left a number of problems unresolved. Requiring savings and loans to specialise more in mortgage lending limited opportunities for diversification. Though capital requirements became more stringent, risks have been concentrated in home loans. However, as the experience in the 1980s showed, greater diversification could only be profitable if staff had the experience and training to manage a more diversified portfolio. No measures were introduced to prevent the massive fraud that occurred throughout the industry from recurring.
The Federal Deposit Insurance Corporation Improvement Act (FDICIA), 1991, addressed the issues of closing insolvent institutions more promptly and of funding the FDIC. The Act requires the FDIC to undertake prompt corrective action and a least cost approach to problem and/or failing thrifts. The Act was quite specific in what action the FDIC must undertake. A risk based deposit insurance premium was also introduced, to ensure adequate funding of the FDIC and to give banks and S&Ls an incentive to manage their risks better. See Chapter 5 for more detail.
17 Source: FDIC (1998), table 1.3-11, p. 108.
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Perhaps the most notable contribution of FIRREA was the creation of the Resolution Trust Corporation because it introduced the concept of a good bank/bad bank.18 The RTC was the first to apply this idea, which involves a separate corporation dealing with the bad assets of a problem bank. Usually the problem loans of the troubled bank are sold, at a discount to the corporation (the ‘‘bad’’ bank or asset management company), which has the responsibility of disposing of the assets for the best possible price. This cleans up the balance sheet of the troubled bank (it becomes the good bank), which might then recover or be sold to a healthy bank. Though its initial remit was to deal with 350 insolvent thrifts, the RTC, by the end of 1990, had become conservator of 531 thrifts, with $278.3 billion in assets. The statutory duties of the RTC included:19
1.Dealing with all the insolvent thrifts which had been insured by the FSLIC, for which a conservator or receiver was appointed between January 1989 and August 1992, later extended to June 1995.
2.To ensure they got maximum value when the failed thrifts and their assets were disposed of. FIRREA required the RTC to sell property for at least 95% of its market value. The Act had to be amended to reduce this to 70% because of low sales and the rising costs of maintenance for property on the RTC’s books. However, some of the commercial real estate loans proved very difficult to sell – they were valueless.
3.To ensure 2 had a minimal effect on the local property market and financial markets.
4.To use some of the houses acquired by the RTC to provide low income housing units.
These obligations conflicted with each other, posing a real challenge for the RTC. When other countries adopted this approach, the role of the asset management company (as they came to be known) focused on the second objective – obtaining the maximum net present value of the disposed assets.
The RTC used private asset management and disposal firms to help with disposal of the assets. National sales centres were established to sell certain assets and it securitised assets, which at the time were considered unconventional, such as commercial loans. It also would sell packages of good and bad loans to deal with the problem that some assets, especially in commercial real estate, were valueless. All of these techniques helped the RTC to dispose of a very large volume of assets at reasonable prices. By the time the RTC was wound down (31 December 1995) it had dealt with 750 insolvent thrifts, disposed of more than $400 billion in assets (just $8 billion in assets were transferred to the FDIC) and sold over 100 000 of units of low cost housing. The RTC received a total of $90.1 billion in funding, though Ely and Varaiya (1996) argue the cost could be as high as $146 billion once the opportunity cost of using taxpayers’ funds is taken into account. However, the RTC’s (and the FDIC’s) management and disposal of assets appears to have been good value for money, because they reduced the cost of resolving the crisis. Initial estimates ranged from $350 to $500 billion, but in the end, though still staggering, it was resolved at a cost of $250 – $300 billion.
However, the cost of the crisis is likely to rise still further following Supreme Court judgement that the reversal of accounting rules in 1989 effectively moved the goal posts
18See Box 8.1 for a discussion of the pros and cons of this approach.
19This account is taken from FDIC (1998), chapters 1, 4.
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for investors who were persuaded to inject new capital or merge a healthy thrift with a new one. As a result of the ruling more than 120 thrifts or failed thrifts are suing the US government for compensation.
To summarise, the thrift industry suffered as a result of concentration of credit risk in the real estate market and exposure to interest rate risk through long-term fixed interest loans and mortgage backed securities, valued on their books at the original purchase price. Rising interest rates reduced the value of these securities and forced the thrifts to bear the burden of fixed interest loans. The problem was compounded by policies of regulatory forbearance because the FSLIC and the Bank Board had a vested interest in keeping the thrifts afloat. Though the cost of resolving the crisis was considerable, the success of the RTC and FDIC in the management and disposal of the assets was instrumental in significantly reducing these costs. Some of the duties of the Resolution Trust Corporation have become a model for the ‘‘good bank/bad bank’’, and one of the standard tools for resolving bank crises. In the USA, the RTC was a public corporation (though private firms assisted), but other countries have opted for a private firm or a mix of public and private. The good bank/bad bank approach is critically assessed in the section on financial crises (see Box 8.1 in Chapter 8).
Failing US commercial banks
During 1980 – 94, more banks (over 1600) than thrifts failed, but less than half the assets (by value) were involved. The key point is that the bank failures were concentrated in regions of the USA at different points in time, as Chart 7.1 illustrates. The crisis can be divided into three phases.
Chart 7.1 US Bank Failures in the Northeast and Southwest, 1986–1995. copyright FDIC.
200
Banks
150
ofFailed
100
Number
50
0
1987
1988
1989
1990
1991
1992
1993
1994
1995
1986
Northeast
0
4
1
5
16
52
43
4
4
1
Southwest
54
110
214
167
120
41
36
10
0
0
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Phase 1: The early 1980s. Between 1980 and 1984, there were 192 bank failures, about 12% of the total between 1980 and 1994. The main problem arose because of interest rates. Many of the failing or problem banks had high quality loan portfolios, but were hit by adverse economic conditions. Since they were few in number, regulatory forbearance was used to see them through the crisis period.
Phase 2: 1984 – 91. In 1984, there was a shift in bank failures to some southern states, Arkansas, Louisiana, New Mexico, Oklahoma and Texas, officially defined as the south-west by the FDIC (1997, 1998). 1985 marked the beginning of the shift, but the problem was most acute between 1986 and 1990. In 1986, 37% of bank failures in the USA took place in the south-west, rising every year to a peak of 81% in 1989, falling to 71% in 1990. By 1991, it was down to 32%. Within this region, by far the greatest number took place in Texas (522),20 followed by Oklahoma (122) and Louisiana (70).21 During this phase, the number of bank failures was so high that forbearance was no longer an option. The FDIC, used to dealing with a few bank failures each year, suddenly found itself dealing with well over a 100 per year, peaking at 279 in 1988.
There were several contributory factors. First, volatile oil prices. They rose very rapidly between 1973 and 1981, fell between 1981 and 1985, with a steep decline of 45% in 1986. During the boom years of the 1970s and early 1980s, banks were keen to lend to firms in the energy related sectors, backed by what was thought to be safe collateral – real estate.
Once oil prices began to fall in the 1980s, the banks also increased direct lending to the commercial real estate sector, apparently oblivious to the idea that if the oil economy was in trouble, property prices there would soon be affected. The property boom prompted building and more buying – pushing up property prices and encouraging more lending, especially between 1981 and 1988. What the (Texan) banks saw as a ‘‘win win’’ situation quickly became ‘‘lose lose’’, i.e. loan quality deteriorated and so did the value of collateral when the property market, following the energy sector, slumped. Between 1986 and 1989, there was a 25% office vacancy rate in Texan cities.
The problems were aggravated by bank regulations. Problem banks were not spotted early enough because bank examinations were infrequent.22 Laws placed severe limits on branching by Texan banks and prohibited out of state banks from purchasing Texan banks. The former limited expansion into the retail sector (and hence narrowed the funding base for banks); the latter discouraged mergers in the early days of the problem loans. As soon as there was a hint of problems, uninsured wholesale depositors switched to safer banks, further restricting growth.
Another problem was increased competition from deregulated S&Ls,23 and an increase in the number of new banks. Bank charters in the ‘‘SW’’ rose from 62 in 1980 to 168 by 1984, and the vast majority of these were in Texas. A third of these banks were to fail between 1980 and 1994, compared to 21% of the established banks. But among the long-standing banks, the largest in the state failed. The percentage of non-performing loans to total loans
20For a discussion of the Texan banking crisis, see O’Keefe (1990).
21These last three figures are for the period 1980–94.
22FDIC (1998), p. 85.
23The 1982 Garn-St Germain Depository Institutions Act allowed the S&Ls to expand into new areas.
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Table 7.2 Large Bank Failures in the South-West, 1980–90
Bank
Failure Date
State
Assets
Resolution Cost
($m)
As a % of Assets
Penn Square
5.7.82
OK
436
14.9
Abilene National
6.8.82
TX
437
0 (open bank assistance given)
First National Bank of Midland
14.10.83
TX
1 410
37.3
First Oklahoma
11.7.86
OK
1 754
9.6
BancOklahoma
24.11.86
OK
468
16.9
BancTexas
17.7.87
TX
1 181
12.7
First City Bancorp
20.4.88
TX
12 374
8.9
First Republic
29.7.88
TX
21 277
12
Mcorp
29.3.89
TX
15 641
18.2
Texas American
20.7.89
TX
4 665
21.1
National Bancshares
1.6.90
TX
1 594
13.4
TX: Texas; OK: Oklahoma.
Source: FDIC (1997), table 9.2. The FDIC defines a bank as large if its assets exceed $400 million.
grew steadily, peaking at over 10% in 1987. Likewise, the percentage of banks reporting negative net income rose from 8% in 1982 to 39% in 1987.24 Table 7.2 reports the largest bank failures in the south-west between 1980 and 1990 – seven banks were from Texas; the other three from Oklahoma.
Note the failure of the bigger Texan banks took place relatively late. First Republic Bank was the biggest bank in Texas, and called in the FDIC for restructuring talks in March 1988. Other Texas state banks also required large amounts of federal support, namely First City (1988) and MCorp (1989).
Phase 3: 1991 – 94. In this phase, the concentration of troubled banks shifted from the south-west to the north-east (see Chart 7.1), i.e. New England,25 New Jersey and New York State. In 1989, there were just five failed banks in the north-east, compared to 167 in the south-west. Though proportionately much smaller in the NE, by 1991, with 52 bank failures, it overtook the SW (41), and also remained higher in 1992. In 1994, there were four failures in the NE, none in the SW. It appears that these banks did not take the opportunity to learn the lessons of the SW.
Rapid economic growth in the northeast region until the late 1980s resulted in booming retail and commercial property markets, though the subsequent problems with loan quality was largely due to difficulties in the commercial market. The banks were only too happy to participate in the bonanza. The median ratio of real estate loans to total loans rose from 25% in 1983 to 51% in 1989.26
24Source of these figures: FDIC (1997), p. 329.
25The FDIC report defined ‘‘New England’’ to include the states of Connecticut, Maine, Massachusetts, New Hampshire, Rhode Island and New York.
26Source: FDIC (1997), p. 338.
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One reason some of the banks could expand their asset base relatively quickly was because of the change in the status of mutual banks in this region. Between 1985 and 1990, 40% of mutual savings banks converted to joint stock ownership. Conversion increased their capital, and loan growth was an obvious way to maintain returns on equity. As mutuals, the banks had concentrated on retail property loans and mortgages but post-conversion, seeking new opportunities for asset growth, they moved into commercial real estate, an area where their managers had little experience. This strategy was a contributing factor to the problem of excessive exposure in the commercial property markets.
In 1986 a major tax reform removed tax concessions on property. However, even the property markets remained healthy through 1987. By 1988, the region was in a slump, reflected by increasingly high vacancy rates and falling property prices. The recession of 1990 – 91 halted construction altogether. Heavily exposed in real estate, banks in the NE experienced a sharp decline in the quality of their loan portfolios and collateral. Between 1990 and 1992, the percentage of non-performing loans peaked at just over 8%, well above the average (3– 4%) for other US banks. This was reflected
in the percentage of banks
with
negative net income,
peaking at 40.2% in 1990,
up from 9.2% in 1988. In
1989,
only five NE banks
failed, representing 2.4% of
the total. In 1990, this figure rose to 9.5%, then jumped to 50% in 1991 and 35% in 1992.
In 1991, 52 NE banks failed, making up 78% of failing assets and responsible for 91% of FDIC resolution costs. Between 1990 and the end of 1992, 111 FDIC insured banks in the NE failed. Though they made up 27% of total bank failures, these banks represented 67% of the total assets of failing banks and 76% of the FDIC resolution costs. By this time, the toll on FDIC finances was increasingly evident. For the first time in its history, the fund had a deficit of $7 billion in 1991.27
The Bank of New England
Several large savings banks failed in the New York area, but it was the Bank of New England group that was the most spectacular. At one point, the Bank of New England was the 15th largest in the USA, but it failed in 1991 due to a large number of non-performing loans. The Bank of New England Corporation (BNEC) was formed in 1985 through a merger of the Bank of New England (BNE) with Connecticut Bank and Trust. With $14 billion in assets, analysts were optimistic about the merger because it combined the Bank of New England’s expertise in property lending with retail banking, the Connecticut bank’s speciality. A remarkable growth spurt meant that by 1989, BNEC had $32 billion in assets, and eight subsidiary banks. However, the decline in the real estate markets hit the BNEC subsidiary banks hard. At the Bank of New England, one of the subsidiaries, non-performing loans climbed to 20% by the end of 1990. There was a run on the BNE on 4 January 1991 – depositors withdrew $1 billion. Two days later the OCC declared BNE and
27 The FDIC had set aside $13.3 billion for future bank failures. Source: FDIC (1998).
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two other subsidiaries bankrupt.28 BNEC’s failure was the third largest, after First Republic Bank and Continental Illinois.29
On 6 January, the OCC appointed the FDIC as receiver. The FDIC announced that three new ‘‘bridge banks’’ had been chartered to assume the assets and liabilities of the three insolvent banks, and they would run a normal banking business on Monday 7th January. All depositors of the three BNEC banks (independent of deposit size) were protected, but shareholders and bondholders suffered heavy losses. The House of Representatives Banking Committee expressed concern that this decision was disadvantageous for savers at small banks, and undermined incentives for depositors to monitor their banks’ activities.30 When the FDIC Improvement Act was passed in 1991 this ‘‘too big to fail’’ episode was one of the incidents which influenced legislators to impose tighter restrictions to limit the protection of uninsured depositors.
The Senate Banking Committee asked the General Accounting Office to investigate the causes of BNEC’s failure. The GAO identified the extremely rapid growth in assets, liberal lending policies, and a concentration of commercial property loans as the main factors behind its demise. Though the OCC was continually monitoring BNE from September 1989, the GAO concluded losses would have been lower had the OCC conducted more intensive examinations of the bank’s assets when it was growing so rapidly.31
In April 1991, the FDIC announced that the bridge banks would be purchased by Fleet/Norstar Financial group, and by investment managers KKR (Kohlberg, Kravis, Roberts & Co.). This was another ‘‘first’’: a non-bank financial institution providing capital to purchase a failed commercial bank.
Freedom National Bank
A small community bank based in Harlem, founded to give American blacks their own bank, Freedom National Bank was one of the largest minority owned banks in the country. On 9 November 1990, it was closed by the OCC, with $78 million in deposits and $102 million in assets. The FDIC liquidated the bank; account holders with deposits in excess of $100 000 only got 50% of their deposits back, prompting accusations of racism, because in the Bank of New England failure, all depositors were paid in full.
Bank of Credit and Commerce International
On Friday, 5 July 1991, the Bank of England (which had responsibility for bank regulation and supervision at the time), together with the Luxembourg and Cayman Islands authorities,
28The BNE’s failure triggered the collapse of Connecticut Bank and Trust (CBT) and the Maine National Bank of Portland (MNB). The CBT had loaned $1.5 million in federal funds to the BNE, which it could not recover, and the FDIC charged the loss against CBT’s capital accounts, resulting in negative equity of $49 million. MNB was unable to make a payment to the FDIC equal to the amount the FDIC was expected to lose as the BNE’s receiver. This was an application of cross guarantee provision of the 1991 Financial Institutions Reform, Recovery and Enforcement Act, which makes a bank liable for losses incurred by the FDIC if another bank fails and they are part of a commonly controlled set of insured banks (FDIC, 1997, pp. 375–376).
29Source: FDIC (1997), p. 377.
30As reported by the FDIC (1997), p. 376.
31FDIC (1997), p. 377.
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closed all branches of the Bank of Credit and Commerce International (BCCI) and froze all deposits. Though BCCI was not incorporated in the UK, once the winding-up order was made, sterling deposits in branches of the UK were eligible for compensation from the Deposit Protection Fund, which then covered 75% of a deposit, up to a maximum of £15 000. The first reaction of many of the Asian community with deposits and loans was that the Bank of England was being unduly harsh, and its closure prompted accusations of racism because it was the first developing country bank to become a global concern. It was also widely claimed that the regulatory authorities had failed to act early enough.
In 1972 BCCI was founded by the Pakistani financier Agha Hasan Abedi and incorporated in Luxembourg, with a small amount of capital, $2.5 million (below the Bank of England’s £5 million requirement). The Bank of America took a 25% stake. By the time it was wound up, its debts amounted to £7 billion. BCCI, which has come to be known as the ‘‘Bank of Cocaine and Criminals International’’, had a long history of fraud and illegal dealings. In 1975 the US authorities blocked BCCI’s attempt to take over two New York banks, criticising Abedi for failing to disclose details about the company. In 1977, Abedi and BCCI joined forces with a Saudi billionaire, Ghaith Pharon. BCCI launched a hostile takeover bid for Washington’s largest bank, Financial General Bankshares. The bid was blocked by the US Securities and Exchange Commission. In 1981, Bankshares was taken over by Middle East investors closely associated with BCCI, though the authorities were assured there was no connection between the banks.
In 1983, BCCI bought a Colombian bank, with branches in Medellin and Cali, centres for the cocaine trade and money laundering. Manuel Noriega, the Panamanian dictator, was a prominent customer of the bank from 1985 to 1987. It later transpired that the bank had laundered $32 million of drug money. BCCI was indicted in Florida for laundering drug money in 1988. In London, one of the branches was raided by British customs, who seized evidence of Noriega’s deposits, and by 1989 BCCI was announcing losses from bad loans amounting to nearly $500 million. In 1988, senior BCCI executives in Florida were charged with money laundering and in 1990 five of them were imprisoned after they pleaded guilty. The bank was fined $15 million and taken over by Sheikh Zayed Bib Sultan al-Nahyan, ruler of Abu Dhabi. An audit showed large financial irregularities. Bankshares reported a loss of $182 million – it had come to light that BCCI was the secret owner of Bankshares in 1989. In January 1991, John Bartlett of the Bank of England was sent a copy of the ‘‘Project Q’’ interim report. The report identified a core group of 11 customers and 42 accounts linked to the international terrorist, Abu Nidal. No immediate action was taken, but in March the Bank ordered a section 41 investigation by the auditors.
A number of regulatory gaps and problems came to light as a result of the BCCI scandal. In 1979, the Bank of England granted BCCI licensed deposit taking (LDT) status, preventing it from having a branch network in England. When the Banking Act was amended in 1987, the distinction between banks and LDTs was eliminated – BCCI now had full banking status. The change gave BCCI the opportunity to extend the branch network, giving the bank access to less sophisticated personal and small business customers, who used the bank to make deposits and obtain loans. A countless number of innocent, but ill-informed small firms such as newsagents banked at BCCI and lost access to their deposits when it failed. Some local authorities had also placed the proceeds of the council tax on deposit at BCCI
