## Getting It Wrong The Failure Of Franklin National Bank

In the mid-1970s, Franklin National Bank—one of the largest banks in the United States—went bankrupt. The bank's management had made several errors, but we will focus on the most serious one.

Using the Theory: Getting It Wrong and Getting It Right

First, a little background. A bank is very much like any other business firm: It produces output (in this case a service, making loans) using a variety of inputs (land, labor, capital, and raw materials). The price of the bank's output is the interest rate it charges to borrowers. For example, with a 5 percent interest rate, the price of each dollar in loans is 5 cents per year.

Unfortunately for banks, they must also pay for the money they lend out. The largest source of funds is customer deposits, for which the bank must pay interest. If a bank wants to lend out more than its customers have deposited, it can obtain funds from a second source, the federal funds market, where banks lend money to one another. To borrow money in this market, the bank will usually have to pay a higher interest rate than it pays on customer deposits.

In mid-1974, John Sadlik, Franklin's chief financial officer, asked his staff to compute the average cost to the bank of a dollar in loanable funds. At the time, Franklin's funds came from three sources, each with its own associated interest cost:

Source Interest Cost

Checking Accounts 2.25 percent Savings Accounts 4 percent Borrowed Funds 9-11 percent

What do these numbers tell us? First, each dollar deposited in a Franklin checking account cost the bank 2.25 cents per year,8 while each dollar in a savings account cost Franklin 4 cents. Also, Franklin—like other banks at the time—had to pay between 9 and 11 cents on each dollar borrowed in the federal funds market. When Franklin's accountants were asked to figure out the average cost of a dollar in loans, they divided the total cost of funds by the number of dollars lent out. The number they came up with was 7 cents.

This average cost of 7 cents per dollar is an interesting number, but, as we know, it should have no relevance to a profit-maximizing firm's decisions. And this is where Franklin went wrong. At the time, all banks—including Franklin—were charging interest rates of 9 to 9.5 percent to their best customers. But Sadlik decided that since money was costing an average of 7 cents per dollar, the bank could make a tidy profit by lending money at 8 percent—earning 8 cents per dollar. Accordingly, he ordered his loan officers to approve any loan that could be made to a reputable borrower at 8 percent interest. Needless to say, with other banks continuing to charge 9 percent or more, Franklin National Bank became a very popular place from which to borrow money.

But where did Franklin get the additional funds it was lending out? That was a problem for the managers in another department at Franklin, who were responsible for obtaining funds. It was not easy to attract additional checking and savings account deposits, since, in the 1970s, the interest rate banks could pay was regulated by the government. That left only one alternative: the federal funds market. And this is exactly where Franklin went to obtain the funds pouring out of its lending department. Of course, these funds were borrowed not at 7 percent, the average cost of funds, but at 9 to 11 percent, the cost of borrowing in the federal funds market.

8 This cost was not actually a direct interest payment to depositors, since in the 1970s banks generally did not pay interest on checking accounts. But banks did provide free services such as check clearing, monthly statements, free coffee, and even gifts to their checking account depositors, and the cost of these freebies was computed to be 2.25 cents per dollar of deposits.

To understand Franklin's error, let's look again at the average cost figure it was using. This figure included an irrelevant cost: the cost of funds obtained from customer deposits. This cost was irrelevant to the bank's lending decisions, since additional loans would not come from these deposits, but rather from the more expensive federal funds market. Further, this average figure was doomed to rise as Franklin expanded its loans. How do we know this? The marginal cost of an additional dollar of loans—9 to 11 cents per dollar—was greater than the average cost—7 cents. As you know, whenever the marginal is greater than the average, it pulls the average up. Thus, Franklin was basing its decisions on an average cost figure that not only included irrelevant sunk costs but was bound to increase as its lending expanded.

More directly, we can see Franklin's error through the lens of the marginal approach. The marginal revenue of each additional dollar lent out at 8 percent was 8 cents, while the marginal cost of each additional dollar—since it came from the federal funds market—was 9 to 11 cents. MC was greater than MR, so Franklin was actually losing money each time its loan officers approved another loan! Not surprisingly, these loans—which never should have been made— caused Franklin's profits to decrease, and within a year the bank had lost hundreds of millions of dollars. This, together with other management errors, caused the bank to fail.9

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