Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Closing Troubled Banks: How the Process Works

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

Closing Troubled Banks: How the Process Works

Article excerpt

Business failure typically occurs when a financially weak firm can no longer pay its creditors. Failure generally involves a series of steps. First, the firm suffers losses. Second, when the firm's creditors learn of the losses, they increase their estimate of the firm's probability of default. To compensate themselves for this increased risk, creditors demand higher interest rates or require debt repayment. Third, the firm finds itself unable to raise or generate additional funds to meet those demands and defaults. Creditors then either force the firm into bankruptcy, in which case a bankruptcy court decides how to best allocate the firm's assets to meet its debts, or the firm privately arranges with creditors for a payout of firm assets. In either case, the assets can be redeployed in more valuable uses. While business failure is often exceptionally disruptive for the firm's managers and employees, it is beneficial for society since it ensures that business resources are not devoted to ineffectual enterprises.

But what about banks? How does their failure ensue? A high proportion of bank liabilities are government-insured deposits. Deposit insurance primarily exists to prevent inappropriate bank runs that may occur when many of a bank's depositors seek to withdraw funds even though the bank is healthy. While it solves one problem-inappropriate runs-deposit insurance can create another. Insured depositors have no incentive to demand higher interest rates or debt repayment when their bank is troubled. While uninsured bank creditors will likely demand repayment, the bank can often raise funds to meet these demands by gathering new insured deposits at little extra cost. As a result, the market-driven process of failure and subsequent reallocation of assets is short-circuited for banks, and its societal benefits are muted.

Because market forces are unlikely to bring about the timely closure of troubled banks, the government agencies that charter and supervise banks are typically left to decide when a bank is no longer viable and should be closed. Mistakes by the agencies can create significant inefficiencies. For example, during the 1980s many insured depository institutions remained open long after they became insolvent. As a result, financial resources were tied up in inefficient operations for extended periods. Legislators recognized the problem and in 1991 enacted the Federal Deposit Insurance Corporation Improvement Act (FDICIA). The Act required bank supervisors to step in and close depository institutions more quickly and reformed the process by which the Federal Deposit Insurance Corporation disposed of failed depositories. All of which raise the crucial question: How do these agencies decide when to step in under rules established by the FDICIA? Further, how do the agencies proceed following intervention? This article seeks to answer these questions.

Supervision of healthy banks is intended to ensure that the government safety net does not provide incentives for banks to undertake inefficient risks. Supervision of banks includes propagating and enforcing restrictions on risky activities, setting deposit insurance premia and insurance coverage levels, and establishing minimum capital requirements as well as examining banks to ensure that capital requirements are met. The supervisory treatment of failing banks, however, is likewise important if the safety net is to be prevented from inducing excessively risky behaviors.

This article provides an overview of the process by which troubled banks are closed. It not only points out the beneficial changes to the FDICIA's closure process, but also indicates some areas of remaining weakness. One example involves the opportunities for uninsured depositors to escape losses by withdrawing their deposits immediately prior to bank failure. The FDICIA addresses one avenue of escape by restricting Federal Reserve discount window lending to troubled banks. As will be shown, even if the Act prevented all such lending, many uninsured depositors would be likely to escape losses nevertheless. …

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