Bank Failure Case

Samaresh chhotray Case Studies on Bank Failure Bank failures, broadly defined, have occurred in virtually every country throughout history. In the 14th century the Bardi family of Florentine bankers was ruined by the failure of Edward III to meet outstanding loan obligations – the only time in history, to date, that an English government failed to honour its debts. Some failures seriously undermine the stability of the financial system (as happened, for example, in the UK in 1866 and the USA in 1933). Bankhaus Herstatt This West German bank collapsed in June 1974 because of losses from foreign exchange trading, which were originally estimated at £83 million but rose to £200 million. At the time it was unclear how the bank had managed to run up such losses. The bank’s failure is famous because it exposed a weakness in the system related to liquidity risk. Bankhaus Herstatt was due to settle the purchase of Deutsche marks (DMs, in exchange for dollars) on 26 June. On that day, the German correspondent banks, on instruction from the American banks, debited their German accounts and deposited the DMs in the Landes Central bank (which was acting as a clearing house). The American banks expected to be repaid in dollars, but Bankhaus Herstatt was closed at 4 p.m., German time. It was only 10 a.m. on the US east coast, causing these banks to lose out because they were caught in the middle of a transaction. The US payments system was put under severe strain. The risk associated with the failure to meet interbank payment obligations has since become known as Herstatt risk. In February 1984, the chairman of the bank was convicted of fraudulently concealing foreign exchange losses of DM 100 million in the bank’s 1973 accounts. Franklin National Bank In May 1974 Franklin National Bank (FNB), the 20th largest bank in the USA (deposits close to $3 billion), faced a crisis. The authorities had been aware of the problem since the beginning of May, when the Federal Reserve refused FNB’s request to take over another financial institution and instructed the bank to retrench its operations because it had expanded too quickly. A few days later, FNB announced it had suffered very large foreign exchange losses and could not pay its quarterly dividend. It transpired that in addition to these losses, the bank had made a large volume of unsound loans, as part of a rapid growth strategy. These revelations caused large depositors to withdraw their deposits and other banks refused to lend to the bank. FNB offset the deposit outflows Samaresh chhotray by borrowing $1.75 billion from the Federal Reserve. Small depositors, protected by the FDIC, did not withdraw their deposits, otherwise the run would have been more serious. In October 1974, its remains were taken over by a consortium of seven European banks, European American. FNB had been used by its biggest shareholder, Michele Sindona, to channel funds illegally around the world. In March 1985 he died from poisoning, a few days after being sentenced to life imprisonment in Italy for arranging the murder of an investigator of his banking empire. Banco Ambrosiano Banco Ambrosiano (BA) was a commercial bank based in Milan and quoted on the Milan Stock Exchange. It had a number of foreign subsidiaries and companies located overseas, in Luxembourg, Nassau, Nicaragua and Peru. The Luxembourg subsidiary was called Banco Ambrosiano Holdings (BAH). The parent, Banco Ambrosiano, owned 69% of BAH. BAH was active on the interbank market, taking eurocurrency deposits from international banks which were on-lent to other non-Italian companies in the BA group. The parent bank, BA, collapsed in June 1982, following a crisis of confidence among depositors after its Chairman, Roberto Calvi, was found hanging from Blackfriars Bridge in London, 10 days after he had disappeared from Milan. Losses amounted to £800 million, some of them linked to offshore investments involving the Vatican’s bank, the Institute for the Works of Religion. The Bank of Italy launched a lifeboat rescue operation; seven Italian banks provided around $325 million in funds to fill the gap left by the flight of deposits,and BA was declared bankrupt by a Milan court in late August 1982. A new bank, Nuovo Banco Ambrosiano (NBA), was created to take over the bank’s Italian operations. The Luxembourg subsidiary, BAH, also suffered from a loss of deposits, but the Bank of Italy refused to launch a similar lifeboat rescue operation, causing BAH to default on its loans and deposits. The main cause of the insolvency appears to have been fraud on a massive scale, though there were other factors whose contribution is unclear. The BA affair revealed a number of gaps in the supervision of international banks. The Bank of Italy authorities lacked the statutory power to supervise Italian banks. Nor was there a close relationship between senior management and the central bank, as in the UK at the time. It appears that Sig. Calvi’s abrupt departure may have been precipitated by a letter sent to him by the surveillance department of the Bank of Italy seeking explanations for the extensive overseas exposure, asking for it to be reduced and requesting that the contents of the letter Samaresh chhotray be shown to other directors of the bank. This activity suggests the regulatory authorities were aware of the problem. The Bank of Italy refused to protect depositors of the subsidiary in Luxembourg because BA was not held responsible for BAH debts; it owned 69% of the subsidiary. The Bank of Italy also pointed out that neither it nor the Luxembourg authorities could be responsible for loans made from one offshore centre (Luxembourg) to another (Panama) via a third, again in Latin America. In 1981, the Luxembourg Banking Commission revised some of its rules to relax bank secrecy and allow the items on the asset side of a bank’s balance sheet to be freely passed through the parent bank to the parent authority, though bank secrecy is still upheld for non-bank customers holding deposits at Luxembourg banks. The authorities in Luxembourg also obtained guarantees from the six Italian banks with branches in Luxembourg that they would be responsible for the debts of their branches. The 1975 Basel Concordat was revised in 1983 to cover gaps in the supervision of foreign branches and subsidiaries. In July 1994 the former Prime Minister of Italy, Bettino Craxi, was convicted of fraud in relation to the collapse of Banco Ambrosiano. Over 20 years later, questions relating to the death of Roberto Calvi continue. The first Coroner’s Inquest judged the death to be suicide, but the family has always protested this verdict, pointing to evidence such as bricks stuffed in the pockets of the deceased. A second inquest recorded an open verdict. The City of London police decided to investigate and in 2003, one woman was arrested on suspicion of perjury and conspiring to pervert the course of justice. In March 2004,11 four people went on trial in Rome for the murder of Roberto Calvi. One of them, a former Mafia boss, is already in prison. A member of the Mafia turned informer named the four accused. The prosecution claims the Mafia ordered his murder because Mr Calvi bungled attempts to launder bonds stolen by the Mafia and was blackmailing associates with links to Vatican and Italian society. A masonic lodge (P2) where Mr Calvi was a member also appears to be involved. Penn Square and Continental Illinois As will become apparent, the collapse of these two banks was connected. Penn Square Bank, located in Oklahoma City, had opened in 1960, as a one-office retail bank.12 On 5 July 1982, the bank collapsed, with $470.4 Samaresh chhotray million in deposits and $526.8 million in assets. It embarked on an aggressive lending policy to the oil and gas sector – its assets grew more than eightfold between 1977 and 1982. It sold the majority interest in these loans to other banks, but remained responsible for their servicing. From the outset, loan documentation was poor and loan decisions were based solely on the value of the collateral (oil and gas) rather than assessing the borrower’s ability to repay. From May 1977 onward, the Office of the Comptroller of Currency (OCC), the main regulatory authority, expressed concern about a host of problems: poorly trained staff, low capital, lack of liquidity, weak loans and increasing problems with the loan portfolio. The external auditors signed qualified opinion in 1977 and 1981. The way Penn Square’s failure was dealt with marked an apparent change in FDIC policy. Of the 38 banks that failed since 1980, only eight were actually closed with insured depositors paid off. The other 30 had been the subject of purchase and assumption transactions, whereby the deposits, insured and uninsured, were passed to the acquiring institution. Of the $470.4 million in deposits at Penn Square, only 44% were insured. The uninsured deposits were mainly funds from other banks. The FDIC paid off the insured depositors, and in August 1983 the Charter National Bank purchased the remaining deposits. At the time of its collapse, Continental Illinois National Bank (CI) was the seventh largest US bank and the largest correspondent bank, involving about 2300 banks.13 Though its problems were well known by regulators, they were caught out by the speed of the bank’s collapse. In the summer of 1984, a number of CI customers were having trouble repaying their loans because of the drop in oil prices. The decline in oil prices also undermined the value of the collateral securing these loans, much of it in real estate in centres of oil production.

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