A bank fails when it is unable to meet its obligations to its depositors. Banks use depositors' funds to make loans and to purchase other assets, but some of a bank's borrowers may find themselves unable to repay their loans, or the bank's assets may decline in value for some other reason. In these circumstances the bank could find itself unable to pay off its deposits.
A peculiar feature of banking is that a bank's financial health depends on the confidence of depositors in the value of its assets. If depositors come to believe many of the bank's assets have declined in value, each has an incentive to withdraw his or her funds and place them in another bank. A bank faced with the wholesale loss of deposits is likely to close its doors, however, even if the asset side of its balance sheet is fundamentally sound. The reason is that many bank assets are illiquid and cannot be sold quickly to meet deposit obligations without substantial loss to the bank. If an atmosphere of financial panic develops, therefore, bank failure may not be limited to banks that have mismanaged their assets. It is in the interest of each depositor to withdraw his or her money from a bank if all other depositors are doing the same, even when the bank's assets are sound.
Bank failures obviously inflict serious financial harm on individual depositors who lose their money. But beyond these individual losses, bank failure can harm the economy's macroeconomic stability. One bank's problems may easily spread to sounder banks if they are suspected of having lent to the bank that is in trouble. Such a general loss of confidence in banks undermines the payments system on which the economy runs. And a rash of bank failures can bring a drastic reduction in the banking system's ability to finance investment and consumer-durable expenditure, thus reducing aggregate demand and throwing the economy into a slump. There is evidence that the string of U.S. bank closings in the early 1930s helped start and worsen the Great Depression.3
3For an evaluation, see Ben S. Bernanke, "Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression," American Economic Review 73 (June (983), pp. 257-276,
Because the potential consequences of a banking collapse are so harmful, governments attempt to prevent bank failures through extensive regulation of their domestic banking systems. Well-managed banks themselves take precautions against failure even in the absence of regulation, but because the costs of failure extend far beyond the bank's owners, some banks might be led by their own self-interest to shoulder a level of risk greater than what is socially optimal. In addition, even banks with cautious investment strategies may fail if rumors of financial trouble begin circulating. Many of the precautionary bank regulation measures taken by governments today are a direct result of their countries' experiences during the Great Depression.
In the United States an extensive "safety net" has been set up to reduce the risk of bank failure; other industrialized countries have taken similar precautions. The main U.S. safeguards are:
1. Deposit insurance. The Federal Deposit Insurance Corporation (FDIC) insures bank depositors against losses up to $100,000. Banks are required to make contributions to the FDIC to cover the cost of this insurance. FDIC insurance discourages "runs" on banks because small depositors, knowing their losses will be made good by the government, no longer have an incentive to withdraw their money just because others are doing so. Since 1989, the FDIC has also provided insurance for deposits with savings and loan (S&L) associations.4
2. Reserve requirements. Reserve requirements are central to monetary policy as a main channel through which the central bank influences the relation between the monetary base and monetary aggregates. At the same time, reserve requirements force the bank to hold a portion of its assets in a liquid form easily mobilized to meet sudden deposit outflows.
3. Capital requirements and asset restrictions. The difference between a bank's assets and its liabilities, equal to the bank's net worth, is also called its bank capital. Bank capital is the equity that the bank's shareholders acquire when they buy the bank's stock, and since it equals the portion of the bank's assets that is not owed to depositors it gives the bank an extra margin of safety in case some of its other assets go bad. U.S. bank regulators set minimum required levels of bank capital to reduce the system's vulnerability to failure. Other rules prevent banks from holding assets that are "too risky," such as common stocks, whose prices tend to be volatile. Banks also face rules against lending too large a fraction of their assets to a single private customer or to a single foreign government borrower.
4. Bank examination. The Fed, the FDIC, and the Office of the Comptroller of the Currency all have the right to examine a bank's books to ensure compliance with bank capital standards and other regulations. Banks may be forced to sell assets that the examiner deems too risky or to adjust their balance sheets by writing off loans the examiner thinks will not be repaid.
4 Holders of deposits over $100,000 still have an incentive to run if they scent trouble, of course. When rumors began circulating in May 1984 that the Continental Illinois National Bank had made a large number of bad loans, the bank began rapidly to lose its large, uninsured deposits. As part of its rescue effort, the FDIC extended its insurance coverage to all of Continental Illinois's deposits, regardless of size. This and later episodes have convinced people that the FDIC is following a "too-big-to-fail" policy of fully protecting all depositors at the largest banks. Officially, however, FDIC insurance still applies automatically only up to the $100,000 limit.
5. Lender of last resort facilities. U.S. banks can borrow from the Fed's discount window. While discounting is a tool of monetary management, the Fed can also use discounting to prevent bank panics. Since the Fed has the ability to create currency, it can lend to banks facing massive deposit outflows as much as they need to satisfy their depositors' claims. When the Fed acts in this way, it is acting as a lender of last resort (LLR) to the bank. When depositors know the Fed is standing by as the LLR, they have more confidence in the bank's ability to withstand a panic and are therefore less likely to run if financial trouble looms. The administration of LLR facilities is complex, however. If banks think the central bank will always bail them out, they will take excessive risks. So the central bank must make access to its LLR services conditional on sound management. To decide when banks in trouble have not brought it on themselves through unwise risk taking, the LLR must be involved in the bank examination process.
The banking safeguards listed above are interdependent: Laxity in one area may cause other safeguards to backfire. Deposit insurance alone, for example, may encourage bankers to make risky loans because depositors no longer have any reason to withdraw their funds even from carelessly managed banks. The recent U.S. S&L crisis is a case in point. In the early 1980s, the U.S. deregulated the S&Ls. Before deregulation, S&Ls had largely been restricted to home mortgage lending; after, they were allowed to make much riskier loans, for example, loans on commercial real estate. At the same time this deregulation was occurring, bank examination was inadequate for the new situation and depositors, lulled by government-provided insurance, had no reason to be vigilant about the possibility that S&L managers might finance foolish ventures. The result was a wave of S&L failures that left taxpayers holding the bill for the insured deposits.
The U.S. commercial bank safety net worked reasonably well until the late 1980s, but as a result of deregulation, the 1990-1991 recession, and a sharp fall in commercial property values, bank closings rose dramatically and the FDIC insurance fund was depleted. Like the United States, other countries that deregulated domestic banking in the 1980s— including Japan, the Scandinavian countries, the United Kingdom, and Switzerland— faced serious problems a decade later. Many have overhauled their systems of banking safeguards as a result.
Banking regulations of the type used in the United States and other countries become even less effective in an international environment where banks can shift their business among different regulatory jurisdictions. A good way of seeing why an international banking system is harder to regulate than a national one is to look at how the effectiveness of the U.S. safeguards just described is reduced as a result of offshore banking activities.
1. Deposit insurance is essentially absent in international banking. National deposit insurance systems may protect domestic and foreign depositors alike, but the amount of insurance available is invariably too small to cover the size of deposit usual in international banking. In particular, interbank deposits are unprotected.
2. The absence of reserve requirements has been a major factor in the growth of Eurocurrency trading. While Eurobanks derive a competitive advantage from escaping the required reserve tax, there is a social cost in terms of the reduced stability of the banking system. No country can solve the problem single-handedly by imposing reserve requirements on its own banks' overseas branches. Concerted international action is blocked, however, by the political and technical difficulty of agreeing on an internationally uniform set of regulations and by the reluctance of some countries to drive banking business away by tightening regulations.
3. and 4. Bank examination to enforce capital requirements and asset restrictions becomes more difficult in an international setting. National bank regulators usually monitor the balance sheets of domestic banks and their foreign branches on a consolidated basis. But they are less strict in keeping track of banks' foreign subsidiaries and affiliates, which are more tenuously tied to the parent bank but whose financial fortunes may affect the parent's solvency. Banks have often been able to take advantage of this laxity by shifting risky business that home regulators might question to regulatory jurisdictions where fewer questions are asked. Further, it is often unclear which group of regulators has responsibility for monitoring a given bank's assets. Suppose the London subsidiary of an Italian bank deals primarily in Eurodollars. Should the subsidiary's assets be the concern of British, Italian, or American regulators?
5. There is uncertainty over which central bank, if any, is responsible for providing LLR assistance in international banking. The problem is similar to the one that arises in allocating responsibility for bank supervision. Let's return to the example of the London subsidiary of an Italian bank. Should the Fed bear responsibility for saving the subsidiary from a sudden drain of dollar deposits? Should the Bank of England step in? Or should the Banca d'ltalia bear the ultimate responsibility? When central banks provide LLR assistance they increase their domestic money supplies and may compromise domestic macroeconomic objectives. In an international setting, a central bank may also be providing resources to a bank located abroad whose behavior it is not equipped to monitor. Central banks are therefore reluctant to extend the coverage of their LLR responsibilities. The problems surrounding the 1982 failure of Italy's Banco Ambrosiano, discussed in the box on page 651, illustrate how international banking can lead to gaps in LLR coverage.
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