Modern Banking
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Allfirst responded by sacking six Allfirst employees. Allfirst’s President resigned a few months later, but offers of resignation by the CEO and Chairman were rejected by the Board of Directors. A number of changes were announced, including:
žCessation of proprietary dealing in subsidiaries, to be centralised in Dublin.
žA new post was created to ensure risk was effectively managed across the AIB group.
žTreasury management to be centralised in Dublin.
In a plea bargain deal, Mr Rusnak pleaded guilty to one charge of bank fraud in October 2002, and was jailed for 7.5 years. There is no evidence he gained financially from these frauds (apart from bonus payments that were bigger than they would otherwise have been) – he was using them to cover up ever-increasing losses.
Though AIB’s solvency was never in question, the losses represented 17.5% of their tier 1 capital, and reduced earnings by 60%. In September 2002, Allfirst was sold to M&T Banking Corporation for $886 million and a 22.5% stake in M&T. To appease shareholders angered by the fraud, half the cash from the sale was to be used to buy back AIB shares.
Barings, Daiwa, Sumitomo and AIB/Allfirst all suffered from rogue traders, which resulted in the UK’s oldest merchant bank failing, eventually being reduced to a tiny part of the operations of a multinational bank, and another respected Japanese bank being barred from operating in the USA. Management was criticised for dereliction of duty of one sort or another. Perhaps the most lasting effect of these failures is the consternation rogue trading caused among members of the Basel Committee, and their subsequent attempt to include an explicit measure for operational risk in the Basel 2 risk assets ratio (see Chapter 4).
7.3.14. Canadian Bank Failures
During the autumn of 1985, five out of 14 Canadian domestic banks found themselves in difficulty. Two banks (Canadian Commercial and Northland) had to close. The problems of Canadian Commercial Bank (CCB), based in Edmonton, originated with its loan portfolio, which was concentrated in the real estate and energy sectors. A formal inspection in early 1982 revealed two-thirds of uncollected interest was on property loans and another 16% on energy related loans. In the summer of 1985 (after CCB had approached the authorities), government investigations revealed that 40% of the loan portfolio was marginal or unsatisfactory. To attract deposits, CCB had to pay above-average rates, as did other regional banks.
In March 1985, CCB informed the authorities it was in danger of collapse. Despite indications of trouble, the inspection system failed to identify the serious problems. A rescue package (CDN $225 million) was put together, the six largest banks contributing $60 million. This action failed to restore the confidence of depositors and contagion spread to other smaller regional banks in Canada; depositors (for example, municipal treasurers) who had been attracted by their higher interest rates began to withdraw their deposits on a large scale, as did the big banks that had participated in the rescue package. The Bank of Canada responded by granting short-term loans to cover these deposit withdrawals but soon had to extend this facility to the Calgary based Northland Bank, because of contagion
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induced runs on this bank. The Northland Bank had been receiving liquidity support from the major private banks since 1983, but the agreement ran out and the bank turned to the Bank of Canada for support at the same time as the CCB. The two banks were forced to close in September 1985, after the Bank of Canada withdrew its support because of a supervisory report (by the Inspector General of Banks), which indicated insolvency at both banks because of weak loan portfolios.
Two other banks, Mercantile and Morguard, were merged with larger institutions. Mercantile Bank was a Montreal based bank, in which Citicorp had a 24% interest. This bank was involved in wholesale bank business. The bank began to experience trouble attracting deposits. The Bank of Canada did not intervene but persuaded the six large banks to provide short-term loans to Mercantile. A few weeks later, it was purchased by the Montreal based National Bank. In November 1985, Morguard Bank was taken over by California’s Security Pacific Bank.
A fifth Canadian bank, Continental, experienced a serious run on deposits. Although this bank had a healthy loan portfolio, it had suffered from low rates of profitability: the return on assets was 0.29% in the 12 months to 31 October 1985. The Bank of Canada and the six largest banks granted Continental CDN $2.9 billion in standby credit lines when it experienced a run, which proved to be short-lived. Some depositors returned after the bank launched a campaign to restore confidence, which included an examination of its loan portfolio by 25 officials from the big six banks.
7.4. The Determinants of Bank Failure: A Qualitative
Review
The previous section reviewed the details of a large number of bank failures from around the world. These cases make it possible to make a qualitative assessment of the causes of bank failure. The list of causes as they appear below is for ease of exposition – it is rare to find a single cause for bank failure; rather, there are a number of contributing factors. For example, poor management can be the source of a weak loan portfolio or sloppy supervision, and regulatory forbearance can make conditions ripe for rogue traders and fraud.
7.4.1. Poor Management of Assets
Weak asset management, consisting of a weak loan book, usually because of excessive exposure in one or more sectors, even though regulators set exposure limits. When these are breached, the regulators may not know it or may fail to react. Examples of excessive loan exposures that regulators failed to control effectively are numerous. Perhaps the most glaring example is the failure of US commercial banks in the south-west, with a similar episode a few years later in the north-east which regulators (and managers) failed to spot, despite a similar build-up of bad loan portfolios in the south-west a few years earlier.
It is possible to look at almost any western country and find examples of excessive exposure by banks in one particular market, which eventually led to failure. In other cases, such as the collapse of Barings (February 1995), the failure was not caused by the excessive loan exposure, but by uncovered exposure in the derivatives market. Usually, the regulatory
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authorities knew guidelines (or rules) on exposure were being exceeded but took no action. Internal and external auditors also failed to detect any problem. All of these countries tightly regulate their banking sectors, yet no system has managed to resolve this problem. In the USA, the case of the thrifts illustrates how far regulators are prepared to go to protect a sector, even though such action prolongs the pain and raises resolution costs. Japan (discussed in Chapter 8) provides another example where, in the early stages of the crisis, the regulator actually made things worse. In other countries, such as Canada, the authorities seemed to be successful in containing the problem, so it was limited to just a few banks.
Weak asset management often extends to the collateral or security backing the loan, because the value of the collateral is highly correlated with the performance of the borrowing sector. In the case of the Continental Illinois Bank, new loans had been secured by leases on underdeveloped properties, where oil and gas reserves had not been proven. Texan state banks are another example. Key Texan banks – namely First Republic Bank (1988), First City (1988) and MCorp (1989) – required large amounts of federal support; some were merged with healthy banks. Though there were other contributory factors to their problems, a key one was banks lending to the Texan oil and gas industry and accepting Texan real estate as collateral, and, to add insult to injury, increasing lending to the property sector when energy prices began to decline. Banks (and regulators) seemed oblivious of the fact that if the energy sector collapsed, plummeting real estate prices would soon follow. The lessons of the south-west appeared to have been ignored by banks in the north-east, resulting in some notable bank failures in that region.
7.4.2. Managerial Problems
Deficiencies in the management of failing banks is a contributing factor in virtually all cases. The Credit´ Lyonnais case is a classic example of how poor management can get a bank into serious trouble. It was not discussed in the previous section because it is the subject of a case study in Chapter 10, but a brief review is provided here. Jean Yves Harberer was a typical French meritocrat. He earned an excellent reputation at the Treasury, heading it in his forties. In 1982, after the newly elected socialists had nationalised key banks, President Mitterand asked Harberer to take charge of Paribas, where he was responsible for one of the worst fiascos in Paribas’ history. Removed from office when Paribas was re-privatised in 1986, Harberer was appointed chief executive of Credit´ Lyonnais (CL), a bank which had been state owned since the end of the Second World War. Harberer’s principal goal was growth at any cost, to transform the bank into a universal, pan-European bank. This rapid growth caused CL to accumulate a large portfolio of weak loans, which could not survive the combination of high interest rates and a marked decline in the French property market. By 1993, Harberer had been dismissed and made the head of Credit´ National, but the post was terminated after the CL 1993 results were published later that year.
Though weak management was the key problem, it is difficult to disentangle it from government interference in the operations of the bank. The government, through its direct and indirect equity holdings, had a tradition of intervention by bureaucrats in the operational affairs of state owned firms, commonly known as dirigisme. It is consistent with French industrial policy where a proactive government role in the economy is thought to
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be better than leaving it to the mercy of free market forces. Credit´ Lyonnais did not escape; the most well-known example was when Prime Minister Cresson asked CL to invest FF 2.5 billion in Usinor-Sacilor, in exchange for a 10% stake in the ailing state owned steel company. By late 1992, 28% of CL’s capital base was made up of shares in state owned firms, many of them in financial difficulty.43 The problem escalated over time because the bank’s fate was linked to the deteriorating performance of these firms.
By March 1994, the first of four rescue plans was announced, and the government is committed to privatising Credit´ Lyonnais by 2000.44 It is difficult to calculate the total cost of the bailout because of other aspects of the rescue plans, including creating a ‘‘bad bank’’, which took on CL’s bad loans, thereby removing them from the bank’s balance sheet. However, estimates of the total cost of resolving CL’s problems range between $20 and $30 billion (see case study in Chapter 10).
Although state interference in CL partly explains why the bank got into such difficulties, it is one of the best examples where poor management, based on a strategy of growth at any expense, is the main reason for the bank ending up effectively insolvent.
Continental Illinois, a US bank, would have collapsed in 1984 had it not been for a government rescue. Its problems, too, can be traced back to managerial deficiencies. Managers were unaware one of the senior officers at Continental had a personal interest in Penn Square – he had arranged a personal loan of half a million dollars. There was no change in the internal credit review process, even though there had been repeated criticisms by the Comptroller of the Currency, one of several bank regulators in the United States. Furthermore, Continental’s internal audit reports on Penn Square never reached senior management. Finally, management’s strategy was growth by assets despite very narrow margins. Continental also relied on the wholesale (interbank) markets for most of its funding, partly explained by an Illinois rule which restricted a bank’s branches to one.
Barings was brought down by a ‘‘rogue trader’’, but the underlying problem was bad senior management. For example, head office allowed a trader in Singapore to run the front and back offices simultaneously even though a 1994 internal audit report had recommended Mr Leeson stop managing the back office. His simultaneous control of the two offices allowed him to hide losses in the ‘‘5-eights’’ account. Similar circumstances prevailed at Daiwa’s New York office. Managers at Barings failed to question how huge weekly profits could be made on arbitrage, which is a high volume, low margin business. Finally, senior management sanctioned a huge outflow of capital from Barings, London. For example, the bank transferred £569 million (its total capital was £540 million) to Barings Singapore in the first two months of 1995.
Senior management were also criticised in the Daiwa and AIB rogue trader cases. In 1993, two years before Iguchi’s confession, management assured US regulators that the back and front office activities at the New York office would be separated but failed to do so, leaving Iguchi as a trader with back office responsibilities. The Ludwig Report (commissioned by
43By forcing state owned banks to invest in these industries, the state continued to play an indirect role in the management of these firms, even if they were privatised.
44The rescue plans led to a formal complaint of unfair competition by other French and European banks. In response, the European Commission agreed to the rescue, conditional upon Credit´ Lyonnais being privatised by 2000.
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Square. There were suggestions of fraud in relation to the collapse of Johnson Matthey Bankers, but no one was ever prosecuted. However, it is rare to be able to identify fraud as the principal cause of bank failure – even BCCI had a low quality loan book. In the case of Barings, the Leeson fraud was only possible because of problems with senior management. In Japan (see Chapter 8), there were Mafia links to property firms which borrowed from banks and coops. Illegal activities have been proved in only a handful of cases, though they are thought to be widespread. In Heffernan (2003 – see Table 7.3), using an international database of bank failures, there is only one incident of fraud.
Securing a conviction can be problematic because of the fine line between fraud and bad management. The ‘‘looting’’ hypothesis (Akerlof and Romer, 1993 – see Chapter 1) illustrates this very point. According to Akerlof and Romer, many thrift managers bought risky debt (junk bonds) to profit from short-term high interest payments, when they knew default was likely in the longer term. The authorities had relaxed accounting rules in the early 1980s to encourage wider diversification, which meant managers could move into little known product areas. Finally, thrift managers took advantage of the system. In the USA, deposits of up to $100 000 (per bank) are insured – the thrifts knew they could attract customers by offering high deposit rates, thereby contributing to short-term profitability.
7.4.4. The Role of Regulators
Bank examiners, auditors and other regulators missed important signals and/or were guilty of ‘‘regulatory forbearance’’, that is, putting the interests of the regulated bank ahead of the taxpayer. In many cases of failure, subsequent investigation shows stated exposure limits were exceeded, with the knowledge of the regulator. Examples include Johnson Matthey Bankers, Banco Ambrosiano, most of the US thrifts and Barings.
Like all firms, banks pay for external private auditing of their accounts. In every western country banks are also subject to audits by regulators. For example, in the United States and Japan, banks are regularly examined by more than one independent regulator. In the UK, formal examination was introduced relatively recently;46 before then, the role of the private auditor assumes greater importance. However, Johnson Matthey Bankers, BCCI and Barings had been examined by private external auditors. Some firms are being sued by these banks’ liquidators for signing off a bank in good health when, in fact, it wasn’t. The official report47 into the collapse of Barings criticised Coopers and Lybrand, London for failing to detect the discrepancy between the large outflow of funds to Singapore and the claim that the Singapore office was responsible for three-quarters of the bank’s profits. Coopers London deny responsibility because the bank collapsed before they could conduct their 1994 audit, and it had questioned the documentation for a £50 million receivable. However, Leeson had been running fictitious accounts for two years. Furthermore, Coopers Singapore had audited the subsidiary in 1994 but did not raise any concerns.
46In the UK, formal examinations by the regulator are undertaken by the Financial Services Authority, created in 1998. The Bank of England did not carry out formal examinations but did monitor banks very closely. See Chapter 5 for more detail.
47The Board of Banking Supervision Report (Bank of England), July 1995.
