Banking Issues 1980Understanding Global Developments

Coverage:
US Banking Crisis 1980-1994
Role of deposit Insurance
Glass Steagall Act Separation of
commercial banking and investment
banking
Too Big To Fail
CAMELS rating
Japanese Banking Crisis
Basel Committee
Banking Crisis of 2008

The Banking Crises of the

1980s and Early 1990s : Implications
The distinguishing feature of the history of US banking in
the 1980s was the extraordinary upsurge in the number
of bank failures.
Between 1980 and 1994 more than 1,600 banks insured
by the Federal Deposit Insurance Corporation (FDIC) were
closed or received FDIC financial assistance.far more
than in any other period since the advent of federal
deposit insurance in the 1930s (see Figure 1.1).
The magnitude of bank failures during the 1980s put
severe, though temporary, strains on the FDIC insurance
fund; raised basic questions about the effectiveness of
the bank regulatory and deposit insurance systems; and
led to far-reaching legislative and regulatory actions.

Reasons for large scale bank failures

The rise in the number of bank failures in the 1980s had no
single cause or short list of causes. Rather, it resulted from a
concurrence of various forces working together to produce a
decade of banking crises.
First, broad national forces- economic, financial, legislative,
and regulatory- established the preconditions for the
increased number of bank failures.
Second, a series of severe regional and sectoral recessions
hit banks in a number of banking markets and led to a
majority of the failures.
Third, some of the banks in these markets assumed
excessive risks and were insufficiently restrained by
supervisory authorities, with the result that they failed in
disproportionate numbers.

Reasons for large scale bank failures

The incidence of failure was particularly high in states characterized by
severe economic downturns related to the collapse in energy prices (Alaska,
Louisiana, Oklahoma, Texas, and Wyoming);
real estate related downturns (California, the Northeast, and the Southwest);
the agricultural recession of the early 1980s (Iowa, Kansas, Nebraska,
Oklahoma, and Texas);
an influx of banks chartered in the 1980s (California and Texas) and the parallel
phenomenon of mutual-to-stock conversions (Massachusetts);
prohibitions against branching that limited banks. ability to diversify their loan
portfolios geographically and to fund growth through core deposits (Colorado,
Illinois, Kansas, Texas, and Wyoming);
the failure of a single large bank (Illinois) or of a small number of relatively large
banks (New York and Pennsylvania).
In some states bank failures were affected by more than one of these factors.
For example, the particularly high incidence of failures in Texas reflected the
rapid rise and subsequent collapse in oil prices, the commercial real estate
boom and bust, the effects of the agricultural recession, the large number of
new banks chartered in the state during the 1980s, and state prohibitions
against branching.

Regional and sectoral economic recessions

There were four major regional and sectoral economic recessions that
were associated with widespread bank failures during the 1980- 94 period.
The first accompanied the downturn in farm prices in the early and middle
1980s after years of rapid increases during the late 1970s . The downturn
in prices led to reductions in net farm income and farm real estate values
and a rise in the number of failures of banks with heavy concentrations of
agricultural loans.
The second recession occurred in Texas and other energy producing
southwestern states, where gross state product dropped after oil prices
turned down in 1981 and again in 1985. The 1981 oil price reduction was
followed by a regional boom and bust in commercial real estate activity.
The third recession was in the northeastern states, which experienced
negative growth in gross state product in 1990-91.
The final episode was a recession in California, as growth in gross state
product turned negative in 1991- 92.
Of the 1,617 bank failure and assistance cases from 1980 to 1994, 78
percent were located in the regions suffering these economic downturns.

Common elements leading to bank failures

Although all four of the recessions associated with
bank failures were partly shaped by their own distinct
circumstances, certain common elements were
present:
1. Each followed a period of rapid expansion; in most
cases, cyclical forces were accentuated by external
factors.
2. In all four recessions, speculative activity was
evident. Expert. opinion often gave support to overly
optimistic expectations.
3. In all four cases there were wide swings in real
estate activity, and these contributed to the severity
of the regional recessions.
4. Commercial real estate markets in particular
deserve attention because boom and bust activity in

Fraud and Financial Misconduct

The precise role of fraud and financial misconduct as a
cause of bank failures is difficult to assess. The
consensus of a number of studies is that fraud and
financial misconduct (1)were present in a large proportion of bank and thrift
failures in the 1980.94 period,
(2)contributed significantly to some of these failures, and
(3) were able to take root because of the same
managerial deficiencies and inadequate internal controls
that contributed to the financial problems of many failed
and problem institutions (apparently internal weaknesses
left some institutions vulnerable not only to adverse
economic developments but also to abuse and fraud).
The studies also agree that the dollar impact of such
activity is extremely difficult to estimate.

The Federal Deposit Insurance Corporation (FDIC) preserves and promotes

public confidence in the U.S. financial system by insuring deposits in banks
and thrift institutions for at least $250,000; by identifying, monitoring and
addressing risks to the deposit insurance funds; and by limiting the effect
on the economy and the financial system when a bank or thrift institution
fails.
An independent agency of the federal government, the FDIC was created in
1933 in response to the thousands of bank failures that occurred in the
1920s and early 1930s.
The FDIC receives no Congressional appropriations it is funded by
premiums that banks and thrift institutions pay for deposit insurance
coverage and from earnings on investments in U.S. Treasury securities. The
FDIC insures approximately $9 trillion of deposits in U.S. banks and thrifts
deposits in virtually every bank and thrift in the country.
The standard insurance amount is $250,000 per depositor, per insured
bank, for each account ownership category. The FDIC is managed by a five-

Role of Deposit Insurance

Deposit insurance has often been described as involving a trade-off between stability
and moral hazard.
On the one hand, by protecting depositors against loss, deposit insurance virtually
eliminates the risk of bank runs and disruptive breakdowns in bank lending.
On the other hand, by assuming the risk of losses that would otherwise be borne by
depositors, deposit insurance eliminates any incentive for insured depositors to monitor
bank risk and permits bank managements to take increased risks.
Because of deposit insurance, banks are able to raise funds for risky projects at costs
that are not commensurate with the risk of the projects, a situation that may lead to the
misallocation of resources and to failures.
Moral hazard is a particularly serious concern if the bank is insolvent or close to
insolvency, in which case the owners have strong incentives to make risky investments
because profits accrue to the owners, whereas losses fall on the insurer. (On the other
hand, risk taking may be restricted if the bank has sufficient franchise value, defined as
the present value of future income expected to be earned by the bank as a going
concern.)
In principle, the insuring agency can protect itself by requiring deductibles (equity
positions) so that owners have their own funds at risk and by charging premiums
commensurate with the risk assumed by the various banks. However, because it is
difficult to identify indicators that give accurate advance warning of future distress,
moral-hazard problems are inherent in deposit insurance, as in other types of insurance.

Role of Deposit Insurance

Deposit insurance suffers from the additional problem that it insures
against losses that are not independent but are interrelated through the
effects of cyclical economic activity and the possibility of contagious bank
runs.
During the 1980s, the balance in this trade-off was generally tipped in
favor of stability.
In this respect, regulatory policy was eminently successful; despite an
unprecedented number of bank and thrift failures, there was no evidence
of serious runs or credit-flow disruption at federally insured institutions.
Stability was achieved, it should be noted, at substantial cost to surviving
institutions and to their customers (assuming the institutions passed on at
least part of the burden of increased assessments). In the case of thrift
institution failures, some of the costs were borne by taxpayers as well.
The estimated total cost of FDIC failed-bank resolutions in 1980-94 is
$36.3 billion. The estimated cost of the savings and loan debacle is $160.1
billion, of which an estimated $132.1 billion was borne by the US
taxpayers.

Depository banks
Prior to the Great Depression, U.S. consumer bank deposits were
not guaranteed by the government, increasing the risk of a bank
run, in which a large number of depositors withdraw their deposits
at the same time.
Since banks lend most of the deposits and only retain a fraction in
the proverbial vault, a bank run can render the bank insolvent.
During the Depression, hundreds of banks became insolvent and
depositors lost their money.
As a result, the U.S. enacted the 1933 Banking Act, sometimes
called the Glass-Steagall Act, which created the Federal Deposit
Insurance Corporation (FDIC) to insure deposits up to a limit
($250,000 in 2013).
In exchange for the deposit insurance provided by the federal
government, depository banks are highly regulated and expected
to invest excess customer deposits in lower-risk assets.

Glass Steagall Act 1933: Senator

Carter Glass, a former Treasury
secretary and the founder of the US
Federal Reserve System was the
primary force behind the GSA. Henry
Bascom Steagall was a member of the
House
of
Representatives
and
chairman of the House Banking and
Currency Committee. Steagall agreed
to support the Act with Glass after an
amendment was added permitting
bank deposit insurance (this was
the first time it was allowed).

Senator Carter Glass

January 4, 1858 May 28,
1946

In November of 1999 Congress repealed

the GSA with the establishment of the
Gramm-Leach-Bliley Act, which
eliminated the GSA restrictions against
affiliations between commercial and
investment banks.
Henry B. Steagall

Glass-Steagall Act
The Glass-Steagall Act, also known as the Banking Act of
1933, was passed by Congress in 1933 and prohibits
commercial banks from engaging in the investment business. It
was enacted as an emergency response to the failure of nearly
5,000 banks during the Great Depression.
At the time, "improper banking activity," or what was considered
overzealous commercial bank involvement in stock market
investment, was deemed the main culprit of the financial crash.
According to that reasoning, commercial banks took on too
much risk with depositors' money. Additional and sometimes
non-related explanations for the Great Depression evolved over
the years, and many questioned whether the GSA hindered the
establishment of financial services firms that can equally
compete against each other. GSA was repealed in 1999.

Glass-Steagall Act
The GSA, however, was considered harsh by most in the financial
community, and it was reported that even Glass himself moved to
repeal the GSA shortly after it was passed, claiming it was an
overreaction to the crisis.
The limitations of the GSA on the banking sector sparked a debate
over how much restriction is healthy for the industry.
Many argued that allowing banks to diversify in moderation offers the
banking industry the potential to reduce risk, so the restrictions of the
GSA could have actually had an adverse effect, making the banking
industry riskier rather than safer.
Consequently, to the delight of many in the banking industry (not
everyone, however, was happy), in November of 1999 Congress
repealed the GSA with the establishment of the Gramm-Leach-Bliley
Act, which eliminated the GSA restrictions against affiliations between
commercial and investment banks. Furthermore, the Gramm-LeachBliley Act allows banking institutions to provide a broader range of
services including underwriting and other dealing activities.

Banking
Commercial banking
Banking that covers services such as
(i) cash management (money transfers, payroll services, bank
reconcilement),
(ii) credit services (asset-based financing, lines of credits,
commercial loans or commercial real estate loans),
(iii) deposit services (checking or savings account services) and
(iv) foreign exchange;
Investment banking
Banking that covers an array of services from asset
securitization, coverage of mergers, acquisitions and corporate
restructuring to securities underwriting, equity private placements
and placements of debt securities with institutional investors.

Did Glass-Steagall Cause The 2008

Financial Crisis?
Some Democratic candidates have blamed the 1999
scaling back of the Glass-Steagall Act for the
financial collapse. That's arguably only partially true.
Former Maryland Gov. Martin O'Malley suggested
several times that consolidation in the banking
business was a big factor in the 2008 financial crash
and that the U.S. economy remains vulnerable
because of it:
"[T]he big banks I mean, once we repealed GlassSteagall back in the late 1999s, the big banks, the six
of them, went from controlling, what, the equivalent of
15 percent of our GDP to now 65 percent of our GDP."

Warren, McCain introduce bill to

bring back Glass-Steagall
Sens. Elizabeth Warren (D-Mass.) and John McCain (R-Ariz.) are
reintroducing legislation to revive the Glass-Steagall Act, which
would force big banks to split their investment and commercial
banking practices.
Glass-Steagall was first passed in 1933 but repealed during the
Clinton administration, leading many progressives to argue that it
contributed to the 2008 financial collapse.
Warren and McCain, along with their cosponsors, Sens. Angus King
(I-Maine) and Maria Cantwell (D-Wash.), said in a statement that the
legislation would make big banks that are "too big to fail" smaller
and safer and minimize the likelihood of a government bailout.
The bill, which they first introduced in the last Congress, proposes
to separate traditional banking with checking and savings accounts
from financial institutions that offer services such as investment
banking, which are riskier.

Three traditional means of controlling

moral hazard
There are three traditional means of controlling moral hazard: (1)
examination and supervision; (2) regulatory capital requirements and
risk-based deposit insurance premiums; and (3) uninsured depositor
and creditor discipline.
In varying degrees and at various times, all three of these means
were operating imperfectly in the 1980s.
Although for some time regulators had been using capital standards to
assess the condition of banks, uniform minimum capital requirements
covering all banks were not adopted until 1985, and risk-based capital
requirements not until 1990. Most bank failures were resolved through
purchase-and-assumption transactions or open-bank assistance
agreements that protected uninsured depositors and non-deposit
creditors and therefore fostered the belief that all deposits of large
banks were 100 percent insured.
This belief severely limited the discipline that depositors might
otherwise have exerted on the behavior of banks.

Investment banks and the shadow

banking system
In contrast to depository banks, investment banks generally obtain funds from
sophisticated investors and often make complex, risky investments with the
funds, speculating either for their own account or on behalf of their investors.
They also are "market makers" in that they serve as intermediaries between two
investors that wish to take opposite sides of a financial transaction. The GlassSteagall Act separated investment and depository banking until its repeal in
1999. Prior to 2008, the government did not explicitly guarantee the investor
funds, so investment banks were not subject to the same regulations as
depository banks and were allowed to take considerably more risk.
Investment banks, along with other innovations in banking and finance referred
to as the shadow banking system, grew to rival the depository system by 2007.
They became subject to the equivalent of a bank run in 2007 and 2008, in which
investors (rather than depositors) withdrew sources of financing from the shadow
system. This run became known as the subprime mortgage crisis.
During 2008, the five largest U.S. investment banks either failed (Lehman
Brothers), were bought out by other banks at fire-sale prices (Bear Stearns and
Merrill Lynch) or were at risk of failure and obtained depository banking charters
to obtain additional Federal Reserve support (Goldman Sachs and Morgan
Stanley). In addition, the government provided bailout funds via the Troubled
Asset Relief Program in 2008.

Too Big To
Fail ( TBTF)

Until 1950, the FDIC had basically had two options in dealing with failed
and failing banks: close the institution and pay off the insured depositors,
or arrange for the banks acquisition.
After 1950, a third option was available if the FDIC Board of Directors
deemed a bank essential to its community: keep a failing bank open
through direct infusion of funds.
The statute limited the "assistance" option to cases where "continued
operation of the bank is essential to provide adequate banking service."
Regulators shunned this third option for many years, fearing that if
regionally or nationally important banks were thought generally immune
to liquidation, markets in their shares would be distorted. Thus, the
assistance option was never employed during the period 1950-1969, and

Too Big To Fail

( TBTF)

The Federal Deposit Insurance

Corporation Improvement Act was
passed in 1991, giving the FDIC the
responsibility to rescue an insolvent
bank by the least costly method.
The Act had the implicit goal of
eliminating the widespread belief
among depositors that a loss of
depositors and bondholders will be
prevented for large banks. However,
the Act included an exception in
cases of systemic risk, subject to
the approval of two-thirds of the
FDIC Board of Directors, the Federal
Reserve Board of Governors, and
the Treasury Secretary.

Too Big To Fail ( TBTF)

U.S. banks, on average, have grown increasingly larger over time, while the
total number of banks has declined. As the chart ( next slide) shows, the
average inflation-adjusted total assets of U.S. commercial banks rose from
$167 million in 1984 to $893 million in 2011, while the number of banks fell
by more than 50 percent.2 (The number of banks reached its post-World War
II peak in 1984.) Moreover, the share of total banking system assets held by
the very largest banks has continued to rise. For example, in 2001, the five
largest commercial banks held 30 percent of total U.S. banking system
assets, topped by Bank of America, which had $552 billion of assets.
By contrast, in 2011, the five largest banks held 48 percent of total system
assets. Four banks had total assets in excess of $1 trillion, and the largest
commercial bankJPMorgan Chase Bankhad $1.8 trillion of assets, equal
to 14 percent of the total assets of all U.S. commercial banks.
Proponents of limiting the size of banks argue that large banksand the
government policies that have implicitly backstopped these bankspose
serious risks to the financial system and potentially catastrophic
consequences for the broader economy. On the surface, the latest financial
crisis and recession seemed to bear this out, as four of the nations 10
largest depository institutions Bank of America, Citibank, Wachovia Bank
and Washington Mutual Bankeither failed or received government
assistance to stay afloat, while only about 6 percent of smaller banks failed.

Systemic Risk and Too Big To Fail

The financial crisis revealed how closely connected many of the worlds
largest financial institutions are through a web of short-term loans, credit
guarantees and other financial contracts.
These connections pose systemic risk in that the failure of one large,
complex financial institution could bring down others and threaten the
broader financial system. Indeed, as the latest financial crisis developed,
doubts about the ability of individual financial firms to repay their loans
or meet other contractual obligations caused a widespread pullback in
lending as banks and other financial firms sought to protect themselves
by moving their funds into safe assets, such as U.S. Treasury securities
and cash reserves.
The bankruptcy of Lehman Brothers, a medium-sized investment bank, in
September 2008 reinforced these fears; the banks collapse intensified
the rush for safe, liquid assets while increasing pressures on money
market mutual funds, the commercial paper market and other segments
of the financial system that depend on a continuous flow of credit.

Too Big To Fail ( TBTF)

The potential for the collapse of a large bank to
impose significant losses on other firms or seriously
impede the functioning of the financial system, and
the consequent risks to the broader economy, have
made governments generally unwilling to let large
banks fail.
As a result, governments have often treated large
banks as too big to fail (TBTF) and have committed
public funds to ensure payment of a large banks
debts when it would otherwise default. Although
treating large banks as TBTF mitigates systemic
risk, TBTF has a dark side, known as moral hazard.

Too Big To Fail ( TBTF)

Moral hazard is the tendency for insurance to encourage
risk-taking and, thereby, make an insurance payout more
likely. For example, a government guarantee that
protects a banks creditors from loss enables the bank to
borrow on more favorable terms and operate with greater
leverageand, thereby, have a greater chance of failing
than it would without the government backstop.
Federal deposit insurance is one example of a guarantee
that can encourage greater risk-taking. However,
coverage limits, risk based insurance premiums,
minimum
capital
requirements
and
government
supervision all discourage or prevent excessive risktaking.

Too Big To Fail ( TBTF)

Treating a bank as TBTF extends unlimited protection to
all of the banks creditors, not just depositors, which
gives the bank a funding advantage and more incentive
to take on risk than other banks have.
The Dodd-Frank Act of 2010 imposes new rules and
oversight over banks and other financial firms in an
effort to control risk-taking. It also aims to end TBTF by
creating a new process for resolving failures of large
financial firms in a way that subjects the creditors of
such firms to losses. However, critics contend that the
only definitive way to end TBTF and the associated
moral hazard problem is to enforce strict limits on the
size of individual financial institutions.

Size Limits Might Be Costly

Although size limits could, in principle, end TBTF, some research suggests
that they could also raise the cost of providing banking services by
preventing banks from exploiting economies of scale.
Bankers often point to scale economies to justify bank acquisitions and
mergers, though policymakers have expressed doubts. Most research
published before 2000 found that banks exhaust scale economies at
roughly $300-$500 million of assets.
However, some newer studies have detected potential scale economies
for banks with $1 trillion of assets or more.
As in many industries, recent advances in information processing and
communications technologies have revolutionized banking. For example,
small and medium-size banks traditionally enjoyed an advantage in
lending to small businesses and other borrowers where close proximity
and personal relationships were important for evaluating credit risks and
monitoring borrowers. However, new information-processing technologies
have reduced the costs of acquiring quantifiable information about
potential borrowers and eroded some of the benefits of close proximity
and personal relationships for small-business lending and, thereby, have
tilted the pendulum more in favor of large banks.

Size Limits Might Be Costly

The same technological changes have likely increased
the fixed costs of providing banking services, costs
that larger banks can spread over more customers.
Furthermore, recent changes in regulation, such as a
loosening of branching restrictions, and the fixed
costs of complying with new consumer protection and
other regulations have also likely given larger banks a
cost advantage over their smaller competitors. Thus,
technological advances and changes in regulation
might explain why some newer studies find evidence
of economies of scale for large banks when older
studies did not.

Flipside of TBTF
In October 2009, Sheila Bair at that time the Chairperson of the FDIC,
commented
Too big to fail' has become worse. It's become explicit when it was
implicit before. It creates competitive disparities between large and small
institutions, because everybody knows small institutions can fail. So it's
more expensive for them to raise capital and secure funding.
Research has shown that banking organizations are willing to pay an
added premium for mergers that will put them over the asset sizes that
are commonly viewed as the thresholds for being too big to fail.
The editors of Bloomberg View estimated there was an $83 billion annual
subsidy to the 10 largest United States banks, reflecting a funding
advantage of 0.8 percentage points due to implicit government support,
meaning the profits of such banks are largely a taxpayer-backed illusion.
Further development on this issue will be discussed after discussion of
economic recession of 2008.

Continental Illinois
The failure of Continental Illinois.a
bank with $45 billion in assets in 1981
and one of the ten largest in the
US-.was the large-bank transaction
that set the terms for the ensuing
too-big-to-fail debate. The $4.5
billion rescue package devised by the
regulators in May 1984 was prompted
by a high-speed electronic bank run
that followed a period of deteriorating
performance.
Problems
in
Continentals loan portfolio had been
highlighted in July 1982, when Penn
Square Bank failed; Continental Illinois
had had a heavy concentration of loan
participations with Penn Square. The
rescue package included the promise
to protect uninsured depositors fully,
and it brought to an end the FDICs
modified payoff program, in which
only a portion of the amount owed to
uninsured depositors was paid; that
portion was based on the estimated
recovery
value
of
the
failed
institutions assets.

Continental Illinois
The reversal in FDIC policy reflected concerns that other large banks
might be subject to bank runs and that Continentals correspondent
banks would suffer losses if the FDIC resolved the bank through a
deposit payoff or otherwise failed to protect uninsured deposits.
These transactions in the early 1980s involving mutual savings
banks, money-center banks, and Continental Illinois generally set
the pattern for the treatment of large banks throughout the rest of
the decade. In large-bank resolutions in the Southwest and
Northeast as well as in other regions, the FDIC used purchase-andassumption transactions, bridge banks, and open-bank assistance
agreements that provided full protection for uninsured depositors.
These methods eliminated the need for uninsured depositors to
monitor the performance of large banks and raised questions of
fairness, since numerous small-bank failures were resolved through
deposit payoffs, in which uninsured depositors suffered losses.

System weakness
The treatment of some large-bank failures has also been criticized on
the ground that regulators were not assertive or prompt enough in
curbing the risky behavior that led to the failures. It is clear that
some years before its failure in May 1984, Continental Illinois had
embarked on a rapid-growth strategy built on decentralized loan
management that was unconstrained by an adequate system of
internal controls and was heavily reliant on volatile funds.
It is also clear that supervisory restraints were insufficient to modify
the banks behavior.
A House subcommittee report in 1985 criticized a lack of .decisive
action. on the part of the OCC and also found fault with the Federal
Reserves supervision of the parent holding company. Some of the
regulators who participated in the Continental Illinois transaction
have indicated that while the bank was profitable, regulators were
reluctant to take early action in opposition to the banks board of
directors.

CAMEL Rating
Camels rating is a supervisory rating system originally developed in the U.S. to classify a
bank's overall condition. It's applied to every bank and credit union in the U.S. and is also
implemented outside the U.S. by various banking supervisory regulators.
The ratings are assigned based on a ratio analysis of the financial statements, combined
with on-site examinations made by a designated supervisory regulator. In the U.S. these
supervisory regulators include the Federal Reserve, the Office of the Comptroller of the
Currency, the National Credit Union Administration, the Farm Credit Administration, and the
Federal Deposit Insurance Corporation.
Ratings are not released to the public but only to the top management to prevent a
possible bank run on an institution which receives a CAMELS rating downgrade. Institutions
with deteriorating situations and declining CAMELS ratings are subject to ever increasing
supervisory scrutiny.
The components of a bank's condition that are assessed:
(C)apital adequacy
(A)ssets
(M)anagement Capability
(E)arnings
(L)iquidity (also called asset liability management)
(S)ensitivity (sensitivity to market risk, especially interest rate risk)
Ratings are given from 1 (best) to 5 (worst) in each of the above categories.

Effectiveness of CAMEL ratings

When examination ratings were up-to-date, they
generally identified most of the banks that
required increased supervisory attention well
before the banks actually failed. As shown in
figure 1.9, of the more than 1,600 banks that
failed in 1980.94, 36 percent had CAMEL 1 and 2
ratings two years before failure; 25 percent had
ratings of 3, 31 percent had ratings of 4, and 8
percent had ratings of 5. But these data refer to
examination ratings available two years before
failure, whereas some of the examinations had
actually been conducted considerably more than
two years before failure.

Japanese banking crisis

Extracts of IMF Paper

Japanese Banking Crisis

Financial deregulation started in Japan during the late 1970s for a variety of reasons,
including large issues of government bonds and the pressure from the US to open Japanese
financial markets. The salient feature of Japanese deregulation was gradualism and the
maintenance of the segmentation approach to the financial industry. An example of the
gradualism is the process of the deregulation of interest rate control on time deposits. The
deregulation started in 1985, but was completed nine years later. The segmentation
approach has implied that different types of financial services have been provided by
different types of financial institutions with fairly strict barriers between segments of the
financial industry. Thus, long-term banking and short-term banking have been separated.
Trust banking services have been provided by trust banks with only a few exceptions. Smaller
banks have been encouraged to lend to small businesses. Needless to say, banking and
securities businesses have been strictly separated.
This policy of segmentation, when coupled with liberalisation in other fields such as
development of the securities markets, has created serious difficulties for some banks. For
example, long-term credit and trust banks were created as financial institutions specialising
in loans to large firms. Under deregulation, these banks increasingly lost large borrowers to
the bond and equity markets, and expanded real-estate-related loans. With segmentation,
they were not able to move aggressively into investment banking.
Similarly, smaller banks and Jusen increased commercial real estate loans because large city
banks, which were also losing large borrowers, aggressively sought customers among smaller
firms and individuals.

Read Case study : Japanese Banking

Crisis

The Bubble Economy

The Bubble Economy

Collapse of the bubble

Jusen companies

Bank of Japan : Discount

Rate %

Collapse of the Bubble : Nation-wide urban

Residential Land Price Index

Jusen companies

Nikkei 225

Jusen companies

One of those lessons comes from the experience with jusen. Jusen
companies were mortgage lending institutions created by Japanese
banks in the early 1970s with strong encouragement from the Ministry
of Finance (MOF) that saw growing importance of financing housing for
increased urban population. Increased competition in the financial
industry following the deregulation in the late 1980s drove jusen
companies to shift away from mortgage financing (where they often had
to compete with their parent banks) to more risky loans to real estate
developers. The banks often introduced very high-risk projects that
they were reluctant to finance to the jusen for finders fees. In this
sense, the jusen then resembles the bank affiliated SIVs (structured
investment vehicles) of the U.S. banks that invest in securitized subprime loans.
Large exposure to the real estate sector made the jusen the first
casualty of the collapse of land prices. In 1991, the MOF put together a
rescue attempt that included loan forgiveness and interest concessions
by founder banks to help the jusen, their borrowers, and agricultural
coops, which were their important lenders. The financial situation of the
jusen, however, did not improve, and the MOF put together the second
rescue plan in 1993. Both of these plans were based on the assumption
that land prices in Japan would recover soon. The MOF hoped the
financial assistance would allow jusen to survive the temporary shock

Jusen companies
The jusen case shows how the Japanese government
regulators tried to help troubled financial institutions
and their borrowers to cope with what they saw as a
temporary setback in land prices, and how such a
regulatory forbearance failed. The MOF rescue
attempts may have stopped the fire sales of properties
for a while, but it seems to have just lengthened the
falling phase of land prices. Of course, it is hard to tell,
but earlier liquidation of the jusen and sales of the
properties would have lowered the land prices even
more, and that may have attracted new investors who
saw the prices have fallen sufficiently.

Basel Committee
The Basel Committee on Banking Supervision has its
origins in the financial market turmoil that followed the
breakdown of the Bretton Woods system of managed
exchange rates in 1973. After the collapse of Bretton
Woods, many banks incurred large foreign currency losses.
On 26 June 1974, West Germany's Federal Banking
Supervisory Office withdrew Bankhaus Herstatt's banking
licence after finding that the bank's foreign exchange
exposures amounted to three times its capital. Banks
outside Germany took heavy losses on their unsettled
trades with Herstatt, adding an international dimension to
the turmoil. In October the same year, the Franklin National
Bank of New York also closed its doors after incurring large
foreign exchange losses.

Herstatt Bank Failure

On 26 June 1974 a number of banks had released Deutschmarks (the
German currency) to the Herstatt Bank in exchange for dollar payments
deliverable in New York. Due to differences in the time zones, there was
a lag in the dollar payment to the counterparty banks; during this lag
period, before the dollar payments could be effected in New York, the
Herstatt Bank was liquidated by German regulators.
This incident prompted the G-10 nations to form the Basel Committee
on Banking Supervision in late 1974, under the auspices of the Bank for
International Settlement (BIS) located in Basel, Switzerland.
After starting life as a G10 body, the Committee expanded its
membership in 2009 and again in 2014 and now includes 28
jurisdictions. The Committee now also reports to an oversight body, the
Group of Central Bank Governors and Heads of Supervision (GHOS),
which comprises central bank governors and (non-central bank) heads
of supervision from member countries.

Institutions represented on the Basel

Committee on Banking Supervision

Basel I: the Basel Capital Accord

With the foundations for supervision of internationally active banks laid,

capital adequacy soon became the main focus of the Committee's activities.
In the early 1980s, the onset of the Latin American debt crisis heightened the
Committee's concerns that the capital ratios of the main international banks
were deteriorating at a time of growing international risks. Backed by the G10
Governors, Committee members resolved to halt the erosion of capital
standards in their banking systems and to work towards greater convergence
in the measurement of capital adequacy. This resulted in a broad consensus
on a weighted approach to the measurement of risk, both on and off banks'
balance sheets.
There was strong recognition within the Committee of the overriding need for
a multinational accord to strengthen the stability of the international banking
system and to remove a source of competitive inequality arising from
differences in national capital requirements. Following comments on a
consultative paper published in December 1987, a capital measurement
system commonly referred to as the Basel Capital Accord was approved by
the G10 Governors and released to banks in July 1988.
The 1988 Accord called for a minimum capital ratio of capital to risk-weighted
assets of 8% to be implemented by the end of 1992. Ultimately, this
framework was introduced not only in member countries but also in virtually
all other countries with active international banks. In September 1993, the
Committee issued a statement confirming that G10 countries' banks with
material international banking business were meeting the minimum

Basel I: the Basel Capital Accord

The Accord was always intended to evolve over time. it was amended in
November 1991. The 1991 amendment gave greater precision to the definition
of general provisions or general loan-loss reserves that could be included in the
capital adequacy calculation. In April 1995, the Committee issued an
amendment to take effect at end-1995, to recognise the effects of bilateral
netting of banks' credit exposures in derivative products and to expand the
matrix of add-on factors. In April 1996, another document was issued
explaining how Committee members intended to recognise the effects of
multilateral netting.
The Committee also refined the framework to address risks other than credit
risk, which was the focus of the 1988 Accord. In January 1996, following two
consultative processes, the Committee issued the so-called Market Risk
Amendment to the Capital Accord (or Market Risk Amendment), to take effect
at the end of 1997. This was designed to incorporate within the Accord a capital
requirement for the market risks arising from banks' exposures to foreign
exchange, traded debt securities, equities, commodities and options. An
important aspect of the Market Risk Amendment was that banks were, for the
first time, allowed to use internal models (value-at-risk models) as a basis for
measuring their market risk capital requirements, subject to strict quantitative
and qualitative standards. Much of the preparatory work for the market risk
package was undertaken jointly with securities regulators.

Basel II: the New Capital Framework

In June 1999, the Committee issued a proposal for a new capital
adequacy framework to replace the 1988 Accord. This led to the
release of the Revised Capital Framework in June 2004. Generally
known as "Basel II", the revised framework comprised three
pillars, namely:
minimum capital requirements, which sought to develop and
expand the standardised rules set out in the 1988 Accord;
supervisory review of an institution's capital adequacy and
internal assessment process; and
effective use of disclosure as a lever to strengthen market
discipline and encourage sound banking practices.
The new framework was designed to improve the way regulatory
capital requirements reflect underlying risks and to better address
the financial innovation that had occurred in recent years. The
changes aimed at rewarding and encouraging continued
improvements in risk measurement and control.

Banking Crisis
In 2008 the world economy faced its most dangerous crisis
since the Great Depression of the 1930s.
The contagion, which began in 2007 when sky-high home
prices in the United States finally turned decisively
downward, spread quickly, first to the entire U.S. financial
sector and then to financial markets overseas.
The casualties in the United States included a) the entire
investment banking industry, b) the biggest insurance
company, c) the two enterprises chartered by the
government to facilitate mortgage lending, d) the largest
mortgage lender, e) the largest savings and loan, and f) two
of the largest commercial banks. The carnage was not
limited to the financial sector, however, as companies that
normally rely on credit suffered heavily.

Financial Crisis Time Line

Feb. 7,2007 : HSBC announces losses
linked to U.S. subprime mortgages.
June 2007 : Two Bear Stearns-run hedge
funds with large holdings of subprime
mortgages run into large losses and are
forced to dump assets. The trouble
spreads to major Wall Street firms such as
Merrill Lynch, JPMorgan Chase, Citigroup
and Goldman Sachs which had loaned the
firms money.

Financial Crisis Time Line

Aug. 2007: French bank BNP Paribas freezes withdrawals in
three investment funds.
Sept. 2007 : Crisis-hit UK bank Northern Rock admits
financial difficulties as it asks Bank of England for assistance.
Share prices fall as customers queue up to withdraw their
money. It was nationalized in Feb 13 2008
Oct. 1 2007 : Swiss bank UBS announces losses liked to U.S.
subprime mortgages.
Oct. 5 2007 : Investment bank Merrill Lynch reports losses of
$ 5.5 billion.
Oct. 15 2007: Cititgroup announces $6.5 billion third quarter
losses.
Oct. 24 2007: Merrill Lynch announces losses to be over $8
billion.

Financial Crisis
Approximately 6% of all mortgage loans in United
States were in default. Historically, defaults were
less than one-third of that, i.e., from 0.25% to 2%.
A huge portion of the increased mortgage loan
defaults are what are referred to as sub-prime
loans. Most of the sub-prime loans have been
made to borrowers with poor credit ratings, no
down payment on the home financed, and/or no
verification of income or assets (Alt-As). Close to
25% of sub-prime and Alt-As loans were in
default.

Financial Crisis
New York Times article explained, In a move that could help
increase homeownership rates among minorities and low
income consumers, the Fannie Mae Corp. is easing the credit
requirements on loans that it will purchase from banks and
other lenders.
Why would banks make such risky loans? Some experts
viewed that the Clinton administration pressured the banks to
help poor people become homeowners, a noble liberal idea.
Reportedly the Clinton Justice Department threatened banks
with lawsuits and fines ($10,000 per application) for redlining
(discrimination) if they did not make these loans. Also ACORN
(Obamas community service organization) was instrumental
in providing borrowers and pressuring the banks to make
these loans.

Financial Crisis
To allow Fannie Mae to make more loans, President
Clinton also reduced Fannie Maes reserve requirement
to 2.5%. That means it could purchase and/or
guarantee $97.50 in mortgages for every $2.50 it had
in equity to cover possible bad debts.
Principally Senate Democrats demanded that Fannie
Mae & Freddie Mac (FM&FM) buy more of these risky
loans to help the poor. Since the mortgages purchased
and guaranteed by FM&FM are backed by the U.S.
government, the loans were re-sold primarily to
investment banks which in turn bundled most of them,
taking a hefty fee, and sold the mortgages to investors
all over the world as virtually risk free.

Financial Crisis
As long as the Federal Reserve kept
interest rates artificially low, monthly
mortgage payments were low and housing
prices went up. Many home owners got
home equity loans to pay their first
mortgages and credit card debt.
Home prices peaked in the winter of 200506 and the house of cards started to
crumble. People could no longer increase
their mortgage debt to pay previous debts.

Financial Crisis Time Line

Jan 2008 : Swiss bank UBS announces fourth quarter losses at $14
billion.
Jan. 11 2008 : Bank of America pays $4 billion for Countryside
Financial.
Jan. 15 2008 : Citigroup reports $18.1 billion loss in fourth quarter.
Jan. 17 2008 : Merrill Lynch reports $11.5 billion loss in fourth
quarter. Washington Mutual posts losses.
Feb. 13 2008 : UK bank Northern Rock is nationalized.
March 2008 : UK hedge fund Peloton Partners and U.S. fund
Carlyle Capital fail.
March 16 2008 : Bear Stearns, the U.S.'s fifth largest investment
bank, collapses and is taken over by JP Morgan.
April 1 2008: German Deutsche Bank credit losses of $3.9 billion
in first quarter.

Financial Crisis Time Line

April 13 2008 : U.S. bank Wachovia Corp. reports big loss for
quarter.
May 12 2008 : HSBC writes off $3.2 billion in the first quarter
linked to exposure to the U.S. subprime market.
July 22 2008 : WaMu reports $3.3 billion loss for second quarter.
Aug. 31 2008 : German Commerzbank AG takes over Dresdner
Kleinwort investment bank.
Sept 7 2008 : Fannie Mae and Freddie Mac effectively nationalized
by the U.S. Treasury which places them into "conservatorship."
Sept. 9 2008 : Lehman Brothers shares plummet to lowest level
on Wall Street in more than a decade.
Sept 14 2008 : Lehman Brothers files for bankruptcy. Stock
markets plummet; Central banks inject billions of dollars into money
markets. Bank of America agrees to buy Merrill Lynch.

Financial Crisis Time Line

Credit crisis looms over 'world's
factory'
Oil falls below $78 on recession
worries
President Bush announces $250B
bailout.

Financial Crisis Time Line

Sept. 16 2008: AIG Corp, the world's
biggest insurer, bailed out by the U.S.
Federal Reserve. Morgan Stanley and
Wachovia enter merger talks.
Sept. 17 2008: Halifax Bank of Scotland
(HBOS) to merge with UK bank Lloyds TSB
in an emergency rescue plan.
Sept. 18 2008 : Federal Bank and other
central banks inject billions into global
markets to help ease the crunch.

Financial Crisis Time Line

Oct 1 2008 : US Senate passes amended $700
billion bail-out plan.
Oct 3 2008 :- US Congress passes $700 billion bailout, President Bush signs it into law.- Swiss bank
UBS to cut 2000 jobs.- Dutch government
nationalizes banking and insurance activities of
Fortis.
Oct 8,2008
- UK Treasury announces 500 billion bank rescue
package.- U.S., UK, China, Canada, Sweden,
Switzerland and ECB cut interest rates.- IMF forecasts
"Major global downturn".

Financial Crisis Time Line

Oct 10 2008: Black Friday- G7 finance
ministers meet in Washington and issue a
five-point plan.- Nikkei falls almost 10%,
biggest drop in 20 years.- FTSE falls more than
10%, closes at 8.85%; worst daily fall since
1987.- Oil prices fall to $80 a barrel.- Dow
crashes nearly 700 points before regaining
some lost ground.- Icelandic bank Kaupthing is
nationalized.
And there were record fall in stock markets
across the world.

Bail out and Reforms

Between 2009 and 2011, the governments of the 20 leading
industrialized and emerging economies (the G-20) agreed at
several summit meetings that fundamental reforms were
needed.
They were determined that banks should never again be in a
position to blackmail entire countries, because they were too
big and too closely intertwined with the rest of the financial
world to be allowed to fail.
That was the consensus reached by world leaders, from
German Chancellor Angela Merkel to US President Barack
Obama.
The G-20 resolutions were followed by many attempts to
tame what former German President Horst Khler once called
the "monster" of the financial markets.

Bail out and Reforms

Banks owe much of their comeback to ongoing support
from governments and central banks. Instead of having
to launch bailout operations worth billions, they have
simply turned to a policy of slowly feeding the financial
industry with cheap money.
In the euro zone, many banks would have trouble
refinancing themselves without the help of the European
Central Bank (ECB).
a number of institutions are not sufficiently profitable to
survive on their own in the long term. The euro-zone
countries, fearing the potentially uncontrollable
consequences of liquidating ailing financial groups, have
helped create so-called zombie banks.

Bail out and Reforms

European banks are still burdened with massive bad loans
left over from the financial crisis -- amounting to 136
billion ($180 billion) at Germany's Commerzbank alone.
Analysts with the Royal Bank of Scotland estimate that the
banks need to shed about 3.2 trillion in assets in the next
three to five years, while at the same time generating 47
billion in fresh capital to be considered stable. If one of
these shaky financial giants were to fall, it would likely
spell the end of the banking sector's tentative recovery.
Although the domino effect of a large bank failure would
occur more slowly than five years ago, the consequences
would still be so serious that a government would bail out
an institution like Commerzbank again.

Global Banking Trend aftermath the

Economic Crisis
Initiatives of the G20, the Basel III global banking
standards and the Dodd-Frank Wall Street Reform and
Consumer Protection Act (the Dodd-Frank Act) in the US
have begun to bring some aspects of the new rules into
focus.
Title I of Dodd-Frank creates a new systemic risk oversight
body, the Financial Stability Oversight Council, to identify,
monitor and address potential threats to U.S. financial
stability.
While regulators have focused mostly on the systemic risk
posed by some of the largest and most interconnected
institutions, banks are concerned with their ability to
compete and the resulting regulatory impact on returns.

TARP
Troubled Asset Relief Program ( TARP) is a government program created for
the establishment and management of a Treasury fund in an attempt to
curb the ongoing financial crisis of 2007-2008.
The TARP gives the U.S. Treasury purchasing power of $700 billion to buy
up mortgage backed securities (MBS) from institutions across the country, in
an attempt to create liquidity and un-seize the money markets.
The fund was created by a bill that was made law on October 3, 2008 with
the passage of H.R. 1424 enacting the Emergency Economic Stabilization
Act of 2008. The Treasury would be given $250 billion immediately, and the
President must certify additional funds as they are needed. The additional
funds will be distributed as $100 billion, and then as the final $350 billion is
given, Congress had the right to not approve the additional amounts.
In October of 2008, revisions to the program were announced by Treasury
Secretary Paulson and President Bush; allowing for the first $250 billion to
be used to buy equity stakes in nine major U.S. banks, and many smaller
banks. This program demands that companies involved lose some tax
benefits, and in many cases incur limits on executive compensation.

Towards Basel III

Even before Lehman Brothers collapsed in September 2008, the need for a
fundamental strengthening of the Basel II framework had become
apparent. The banking sector had entered the financial crisis with too
much leverage and inadequate liquidity buffers. These defects were
accompanied by poor governance and risk management, as well as
inappropriate incentive structures. The dangerous combination of these
factors was demonstrated by the mispricing of credit and liquidity risk,
and excess credit growth.
Responding to these risk factors, the Basel Committee issued Principles for
sound liquidity risk management and supervision in the same month that
Lehman Brothers failed. In July 2009, the Committee issued a further
package of documents to strengthen the Basel II capital framework,
notably with regard to the treatment of certain complex securitisation
positions, off-balance sheet vehicles and trading book exposures. These
enhancements were part of a broader effort to strengthen the regulation
and supervision of internationally active banks, in the light of weaknesses
revealed by the financial market crisis.

Towards Basel III

It also extended the framework with several innovations, namely:
an additional layer of common equity - the capital conservation buffer - that,
when breached, restricts payouts of earnings to help protect the minimum
common equity requirement;
a countercyclical capital buffer, which places restrictions on participation by
banks in system-wide credit booms with the aim of reducing their losses in
credit busts;
a leverage ratio - a minimum amount of loss-absorbing capital relative to all of
a bank's assets and off-balance sheet exposures regardless of risk weighting
(defined as the "capital measure" (the numerator) divided by the "exposure
measure" (the denominator) expressed as a percentage);
liquidity requirements - a minimum liquidity ratio, the liquidity coverage ratio
(LCR), intended to provide enough cash to cover funding needs over a 30-day
period of stress; and a longer-term ratio, the net stable funding ratio (NSFR),
intended to address maturity mismatches over the entire balance sheet; and
additional proposals for systemically important banks, including requirements
for supplementary capital, augmented contingent capital and strengthened
arrangements for cross-border supervision and resolution.

Discussion in Session 2

TARP
Stress testing
Banking Stability
Detailed discussion on Banking
functions
Understanding financial statements
of banks
Banking ratios