Bank failures

Most people tend to believe that the closure of a bank must be the result of challenges with liquidity or solvability. Unfortunately, sometimes banks fail due to a lack of transparency, they engage in illegal activities, or even worse, they are considered to be a prime concern for money laundering. The Federal Bank of the Middle East, FBME Bank, and Banca Privada d’Andorra recently had such a questionable experience.

Bank failure is an economical term used in legal practice to describe the situation of a bank or branch of an international bank that is unable to meet its obligations to its depositors or other creditors because it has become insolvent or too illiquid to meet its liabilities.

A bank usually fails economically when the market value of its assets declines to a value that is less than the market value of its liabilities. The insolvent bank either borrows from other solvent banks or sells its assets at a lower price than its market value to generate liquid money to pay its depositors on demand. The inability of the solvent banks to lend liquid money to the insolvent bank can create a bank panic (also known as a bank run) among the depositors as more depositors try to take out cash deposits from the bank. As such, the bank is unable to fulfill the demands of all of its depositors on time. Also, a bank may be taken over by the regulating government agency when equity of shareholders (i.e. capital ratios) are below the regulatory minimum. The result of this situation is that central banks place the bank under resolution or external management until the situation gets resolved.

The failure of a bank is generally considered to be of more importance than the failure of other types of business firms because of the interconnectedness and fragility of banking institutions. Research has shown that the market value of customers of the failed banks is adversely affected at the date of the failure announcements. It is often feared that the spill over effects of a failure of one bank can quickly spread throughout the economy and possibly result in the failure of other banks, whether or not those banks were solvent at the time as the marginal depositors try to take out cash deposits from these banks to avoid from suffering losses. Thereby, the spill over effect of bank panic or systemic risk has a multiplier effect on all banks and financial institutions leading to a greater effect of bank failure in the economy. As a result, banking institutions are typically subjected to rigorous regulation, and bank failures are of major public policy concern in countries across the world.

Why banks fail…

There are a few reasons why banks fail. Lately we see the systematic bank crisis, where  many banks in a country are in serious solvency or liquidity problems at the same time, either because there are all hit by the same outside shock or because failure in one bank or a group of banks spreads to other banks in the system. The more common reason for a bank failure is a mismatch between assets and liabilities resulting in substantial liquidity issues. A third unfortunate reason for a bank failure is when the rules and regulations set forth by the regulator are transgressed.

Especially when the central bank has to take action because of non financial reasons, there is uncertainty. The bank in dispute often cannot publicly declare their mistakes, especially when the allegations might result in criminal investigations and prosecution.

Bank run

In general, there is no advance notice given to the public when a bank fails. Under ideal circumstances, a bank failure can occur without customers losing access to their funds at any point. Sometimes the bank customers hear afterwards what happened because the regulators want to avoid a bank panic or a run on the bank.

A bank run or run on the bank is the phenomenon that the majority of the banks’ customers at the same time try to withdraw all their deposits and savings. This run on the bank leads to irrevocable and accute liquidity problems for the bank. A bank run therefore almost always results in a takeover, liquidation or even bankruptcy of the bank. A bank run happens both online as well as offline where customers try to get cash in hand and transfer funds money via internet banking facilities to another bank.

Since banks have short term and long term liquidity, there is always a risk for a bank failure after a bank run. Therefore also banks who do not engage in exotic investment strategies or fractional reserve lending can be put under resolution once the authorities fear a bank run.

Apples and oranges; too big to fail

Before the collapse of New York based investment bank and brokerage firm Bear Stearns collapsed the general opinion was that most banks are too big to fail. After Bear Stearns, another empire, Lehman Brothers failed and had to file for chapter 11 bankruptcy liquidation. These examples clearly show that in general banks are not too big to fail anymore.

When FBME Bank and Banca Privada d’Andorra were placed under resolution many customers and other stakeholders were indignant because the big banks like HSBC got away with paying a fine when they were accused of facilitating tax evasion or money laundering. The difference between these banks is the number of strategic business units. FBME Bank and Banca Privada d’Andorra were accused of being a prime concern of money laundering; their business model was focused towards a limited number of strategic business units. FBME Bank for instance only offered services to two seperate homogeneous groups of customers; offshore businesses and high net worth individuals and the local market in Tanzania. This limited diversification in activities makes the bank easy to close.

Regulation and central banks

The primary function of a central bank is to control the nation’s money supply, through active duties such as managing interest rates, setting the reserve requirement, and acting as a lender of last resort to the banking sector during times of bank insolvency or financial crisis. Central banks usually also have supervisory powers, intended to prevent bank runs and to reduce the risk that commercial banks and other financial institutions engage in reckless or fraudulent behaviour.

A central bank therefore is allowed to put a bank or foreign branche of a bank under resolution if the bank cannot comply with the rules and regulations set forth by the central bank. After a bank is placed under resolution banks management cannot make own decisions anymore and the central bank will try to re-open the bank after proper investigation, sell the bank to another financial institution, or request court to liquidate and close the bank. There are very specific guidelines and rules to follow when a bank has to close.

What if your bank fails…?

During recent years banks like Northern Rock (UK – 2007),  Laiki Bank (Cyprus – 2012) and Corporate Commercial Bank (Bulgaria – 2014) failed after a run on the bank started. There were various reasons, but in general it took weeks or months before the situation got stable again.

If your bank fails, first verify with the central bank in your country if the bank participates in the Deposit Guarantee Scheme. Ask the central bank for the procedures to apply for the guarantee and make sure you are first in line once the Deposit Guarantee Scheme is activated. When the funds on your account exceed the maximum limits for protection under the Deposit Guarantee Scheme, contact a legal representative with experience in Bank failures. Be sure you appoint the right legal advisor to avoid problems afterwards. Understand that the legal framework in most countries is in favor of depositors and just follow the rules for maximum compensation. And if you want to discuss your case during a free consult with one of our representatives, just leave your contact details on this page to receive a call back.