Why Banks Fail

IN 1970 when the Bank of Hawaii opened a branch on the Micronesian island of Yap, it had a problem: how to convince the people of Yap to deposit their money in the bank. “We had town meetings and began with the basics,” explained bank official Dominic B. Griffin III. “In subsistence economies, anything can be money. We had to explain why a pig wasn’t money, but that a signature on a piece of paper was.”

That problem underscores a basic point: Modern banking is based on trust. It is founded on the confidence that people​—individuals as well as businesses—​have in the banks with which they do business and in the agencies that back them up.

Yap already had a bank​—the stone-money bank. For ages its culture had used huge stone wheels for currency. So large are they that no vault is needed to store and protect them. Instead, they are propped against walls and trees alongside a road outside of Colonia. Quarried in the islands of Belau, southwest of Yap, their value was determined by how difficult it was to obtain them and bring them to Yap by small boats. The stone money is never moved. Everyone is familiar with each piece and its history. Ownership (but not the actual stone) is transferred from family to family as land or goods are purchased.

Yap, then, literally had to be taken from the “stone age” to the age of modern electronic banking, to be introduced to checking and savings accounts, foreign exchange, savings bonds, telegraphic remittances. The people had to learn the value of printed scraps of paper and to put their trust in banks that would be handling money they could not see.

That situation exists worldwide today. No one really asks a bank to show him their money. In fact, most transactions take place electronically or by means of a check. People have faith that banks will produce the promised funds on demand or when term accounts become due. Yet banks actually carry in their vaults only the currency necessary for routine daily withdrawals. They know from experience just how much cash is needed at a particular time or season. Where, then, is all the rest of the money?

The Banking Business

Banks are businesses. Like other concerns, they are in business to make a profit. But unlike most others, their product is money. In essence, they borrow money from one source and lend it to another. By lending at a higher rate of interest than borrowed, they make money for themselves, their shareholders, and their depositors, as well as cover their expense of operation. But banks also create money. How do they do this?

Dennis Turner explains in his book When Your Bank Fails: “The Fed[eral Reserve System] requires banks to keep only a small percentage of their deposits on hand. While reserve requirements vary depending on the size of the bank and the type of deposit, they currently [1983] average 8%. If a depositor places $100 in his account, the bank may loan $92 of it. The borrower, whether he spends the money or deposits it in another bank account, will create $92 in new deposits. Of this deposit $84.64 may be loaned out, while $7.36 is kept in reserve. This pyramiding process continues, so that with an 8% reserve requirement, a $100 deposit may generate new money totalling $1,200.”

Banks usually lend up to the full limit permitted. But if a rumor spreads that the bank is in difficulty, depositors may lose their confidence in the bank and make a run on it. The bank will be unable to pay all the depositors on demand and could fail​—unless rescued by the government or merged with a stronger bank. Even financially sound banks have gone under in this way.

Other Reasons for Failure

Often it is the loans themselves that bring a bank into difficulty, especially when made for long terms at low interest rates. Usually there is no problem when the economy remains stable and the rates the bank pays for money received from depositors or other sources is lower than the interest on loans. But when rates paid for money climb, as they did in recent times, the bank finds itself in the position of paying out more than it is taking in.

It is even worse when those who have taken out loans cannot pay them back. This is the situation right now with many farmers in the United States. Such default is causing many smaller regional banks to fail. “Exactly one-half of the banks on the 1985 failure list were designated as farm banks, that is, at least 25% of their loans were related to agriculture,” says the financial newspaper American Banker.

Outright fraud and embezzlement is another reason for bank failure. The age of electronic transfers has made possible stealing of funds that makes old-time bank holdups look tame by comparison. “The American economy suffers an annual loss of over 500 million dollars in this way,” states the Paris daily newspaper Le Figaro. “In Europe, the big banks are much more discreet about the figures, not wishing to reveal their problems. They nevertheless admit to greater losses from computer fraud than from holdups and common burglary. Computer fraud has become the scourge of our modern economy. . . . As soon as countermoves are discovered by computer experts, new loopholes come to light that are rapidly exploited by certain individuals to their own advantage.”

As in every business, mismanagement and poor business practices can also cause failure. In fact, mismanagement is said to play a crucial role in most bank failures. It could be that the bank directors made unsecured loans to their friends or relatives. Or perhaps they overextended themselves in more prosperous times. Or greed and an effort to make a killing and get rich quick fostered some reckless investments.

In some cases, fierce competition has led banks to take extraordinary risks. Some fall victim to their own overly aggressive lending policies. In a need to cover up when problems occur and to improve reserves and cash flow, some banks seek to entice depositors by offering unusually high rates of interest or even make further investments in risky ventures.

Governmental insuring of deposits​—guaranteeing that, no matter what happens, depositors will be repaid—​has also induced some banks to throw caution to the wind. But the future is unpredictable. Some who made investments in oil and other energy fields when such were booming and prices were high, for instance, went into bankruptcy when prices plunged or ventures failed. Or if money disinflates, it can wreak havoc for those who expected to pay back borrowed money in cheaper inflated dollars.

These problems that lead to bank failures are not limited to small banks. Some of the world’s largest financial institutions also find themselves in sore straits. Many have made millions, even billions, of dollars’ worth of loans to Third World countries that cannot now pay back the interest, much less the principal. The rash of bank failures in recent years has raised questions worldwide. Is our trust misplaced? Just how safe are the banks?

[Chart/​Picture on page 6]

U.S. Bank Failuresa

1977 - 6

1978 - 7

1979 - 10

1980 - 10

1981 - 10

1982 - 42

1983 - 48

1984 - 79

1985 - 120

[Footnotes]

[Picture on page 5]

The stone money of Yap can be seen outside this house

How Safe Are the Banks?

“In our opinion it is just a matter of time​—a relatively short time—​until there is a general worldwide run on the banks, with virtually all banks closing.”​—When Your Bank Fails, by Dennis Turner.

“The banking system is completely safe. We have in place the mechanisms to take care of any problems, large or small, that might arise.”​—William Isaac, former chairman of Federal Deposit Insurance Corporation, quoted in U.S.News & World Report.

FEW people store money under the mattress anymore. Aside from the danger of loss due to fire or theft, money thus stored is stagnant. It does not increase in amount and will most likely decrease in value because of inflation or devaluation of currency.

To increase one’s savings, money must be put to use. The means most widely accepted and used​—both for safekeeping and for profit—​is the banks. But how safe are they? As shown by the earlier quotations, there are widely divergent views.

Is There Reason for Alarm?

“The entire world banking system is very much interrelated,” points out David Rockefeller, retired chairman of Chase Manhattan Bank. “Necessarily, banks do a lot of business with one another, so there is tremendous interdependence.” As a result, no bank or nation really stands alone. So whenever a bank fails, there is concern that it may pull other banks down with it or reduce the confidence so essential to the banking industry. The possibility then exists that depositors elsewhere will rush to withdraw their funds and thereby cause the downfall of other banks in an uncontrolled domino effect.

Is there a chance that a bank collapse somewhere could pull down the international banking system? “The regulators in the U.S. and other countries are sure to take strong steps to prevent any major failure that appeared imminent,” says Rockefeller. “I think it is most unlikely that it will happen.”

So far, even though there have been some serious problems and failures around the globe in recent years, the governments have stepped in to bail out their troubled financial institutions. “The finance ministers and the bankers are more than ever haunted by the specter of 1929, and they will do everything they can to avoid a repetition of the financial catastrophe that happened fifty years ago​—with the more or less conscious hope of avoiding its seemingly inevitable result, world war,” explains the French weekly L’Express. Still, there is reason for concern.

The Debt Problem

Banks are inherently a risky business. They handle large amounts of money that is mostly not their own. Additionally, they create money and make loans far in excess of their net worth. While they may take adequate precautions, the banks know that some loans will turn bad. Therefore a certain amount is set aside as loan reserves to cover bad debts. But if an unusual number of loans turn sour, those reserves will not be sufficient to cover the large loan losses, or a run on the bank. “The more equity that’s at risk because of bad loans, the weaker the bank gets financially,” states New York magazine. “Bankruptcy (or failure) occurs when all the bank equity is used up.”

More and more banks today are finding themselves in just that position​—too many of their loans are turning sour, and there is insufficient capital to back them up. The reasons given are legion: the oil crisis, trade restrictions and deficits, downturns in the economy, unstable interest rates, capital flight, inflation, disinflation, recessions, overly aggressive lending policies, corporate bankruptcies, fierce competition, deregulation​—even ignorance and stupidity.

But there are ways to stay alive​—on paper. Rescheduling the loans, stretching the debt over a longer period, is one means used and reused. Another is to list the loans at full value, though there may be little hope of having the principal paid in full. An oft used tactic is to lend the borrowers more money so that they can make their interest payments.

All these methods are currently being used by banks in regard to Third World debt, considered by many to be the greatest threat to the stability of the international banking system. According to a World Bank survey, the external debt of over a hundred developing nations reached a combined total of some $950 billion at the end of 1985, an increase of 4.6 percent over the previous year. Although already too large, it is expected to reach $1.01 trillion by the end of 1986. Why? Because many of those nations simply cannot repay and are pressing for more time and money. Taking into account the enormity of their loans, the banks have complied. As one person puts it: “If I owe you a dollar, I am in your power; but if I owe you a million, you are in my power.”

Always looming ahead is the possibility that some deeply indebted nations, tiring of the hardships of austerity programs, may just decide not to pay at all. The banks cannot force sovereign states to pay. “For banks, the meaning of the global debt crisis is simple,” states Savvy magazine. “They earn most of their profits by making loans, and if countries cannot repay their huge loans, banks’ profits, capital bases, and stock prices could fall precipitously. . . . Significant Third World defaults could stretch the financial system to the breaking point, possibly resulting in the collapse of major banks.”

A default by just four nations​—Mexico, Brazil, Argentina, and Venezuela—​could bring about the collapse of the nine largest U.S. banks, experts warn. “That actual defaults have not taken place is remarkable,” states The New York Times Magazine. “One could, of course, attribute it to semantics. Just as wars are no longer ‘declared,’ no one is now declared ‘legally’ in default.”

“Is My Bank Safe?”

Can one tell if a bank is strong and solvent? “For most depositors it’s difficult or impossible to find out what shape a bank” is in, states the magazine Changing Times. Adds The New York Times: “Recent experience has shown that it is extremely difficult for outsiders to judge the soundness of a bank. Practically every large bank that collapsed in recent years, or nearly collapsed, had been highly touted by bank-stock analysts. . . . Even bank regulators and auditors were unable to detect serious troubles until it was far too late.”

Usually the most a customer does is examine the bank cosmetically: the types of services offered, the friendliness and speed with which he is served. In fact, where banks advertise, it is usually those things that they emphasize​—the friendly banker, the quick loan, special accounts or services, convenience. Sometimes gifts are offered to lure in new depositors. But little is said about the financial standing of the bank. Of course, a bank’s services are important. Also to be noted is the interest given and how it is compounded, as yields will vary. Of utmost importance to the depositor is the safety of his money.

Here, deposit insurance is the key. “Because of deposit insurance, unless there is an utter collapse of the banking system these are the problems of bankers and bank stockholders, not depositors,” says The Atlantic Monthly. “It is extremely unlikely that bank failures today could bring thirties-style losses of life’s savings to individuals.”

So it is good to check if accounts are insured and by whom. Government insurance, of course, is best. An example of this is the Federal Deposit Insurance Corporation in the United States. Some who were told that their accounts were insured later found that it was by a private agency with insufficient funds to repay all depositors when the bank failed. Check also the amount insured. If your account exceeds that limit, consider opening accounts in other banks so that all your money will be covered.

What Lies Ahead?

Individual bank failures are expected to continue and the number may even rise. Yet, what is of utmost importance to the banking system is that confidence in it be maintained. “A crisis would occur only if depositors interpreted these financial lurches as a reason to withdraw their money from the affected banks,” states Fortune magazine. Therefore, all-out efforts are being made to strengthen the system and keep that confidence strong.

Plans are also in motion to reduce the debt of Third World countries to manageable levels and aid them to meet their obligations. “In the final analysis, the enormous financial deficit will be absorbed by the taxpayers worldwide,” states Albin Chalandon, former French Minister of Industrial Planning.

How safe, then, are the banks? One bank official put it this way: “The banks are as safe as the governments that back them up.” While that may seem reassuring now, it gives thinking persons reason for pause. Why? Because the Bible foretells the complete destruction of all earthly governments and their replacement by the everlasting Kingdom of God. (Daniel 2:44) And it points to events of this 20th century as marking the conclusion of the present system of things.​—Matthew 24:3, 6, 7, 21, 22.

The Bible tells about people, at that time, throwing even their gold and silver into the streets as valueless to save them. (Ezekiel 7:19; Zephaniah 1:18) Since that will be true of these more precious substances, what trust can be placed in national currencies or in the financial institutions that depend on them? Gone will be the governments that back them up!

So Jesus aptly cautioned: “Stop storing up for yourselves treasures upon the earth, where moth and rust consume, and where thieves break in and steal. Rather, store up for yourselves treasures in heaven, where neither moth nor rust consumes, and where thieves do not break in and steal. For where your treasure is, there your heart will be also. . . . You cannot slave for God and for Riches.”​—Matthew 6:19-21, 24.

[Box on page 9]

The Banking Situation​—What Others Say

● “It is no overstatement to say that the governments of dozens of debt-ridden nations, the International Monetary Fund, the Federal Reserve Board, and hundreds of American and foreign banks together face the severest and broadest financial crisis since the 1930s.”​—New York magazine.

● “Present policies provide only a most precarious protection. The world’s financial safety is balanced on a knife-edge. The debt crisis threatens not only development in developing countries but also the stability of the banking system of industrial countries.”​—Report by a Commonwealth group of experts, The Guardian of London.

● “The immense debt owed to the banks of the United States by third-world nations is poised like a potential avalanche above the American banking system.”​—The New York Times Magazine.

● “The total global debt is so massive that it has laid the groundwork for a first-rate debt crisis in the international banking system.” “The supreme irony of the global debt crisis is that the banks are in so deep they can’t get out without bringing down the whole house of cards.”​—Savvy magazine.

● “The situation today is more critical and more dangerous than it was in the 1930s.”​—West German economist Kurt Richebächer, U.S.News & World Report.

[Chart on page 10]

Seventeen Heavily Indebted Developing Countries

Country Foreign Debt Percent Owed

($ in U.S. billions) Private Sourcesa

Argentina 50.8 86.8

Bolivia 4.0 39.3

Brazil 107.3 84.2

Chile 21.0 87.2

Colombia 11.3 57.5

Costa Rica 4.2 59.7

Ecuador 8.5 73.8

Ivory Coast 8.0 64.1

Jamaica 3.4 24.0

Mexico 99.0 89.1

Morocco 14.0 39.1

Nigeria 19.3 88.2

Peru 13.4 60.7

Philippines 24.8 67.8

Uruguay 3.6 82.1

Venezuela 33.6 99.5

Yugoslavia 19.6 64.0

Total 445.9 80.8

[Footnotes]

Source: World Debt Tables, 1985-86 edition, published by The World Bank, Washington, D.C.

[Picture on page 8]

If many big banks fail, a domino effect might cause the collapse of the whole banking system