This classroom-ready tutorial reviews the sources of bank failures and the tools that regulators use to restructure failed banks

1. Slideshow for your Classroom from
Ed Dolan’s Econ Blog
A Tutorial on Bank Failure
and Bank Rescue
March 2013
Protest Against Rescue of Anglo Irish Bank
Photo source: Joe Higgins Euro Election Campaign via
http://commons.wikimedia.org/wiki/File:Protest_against_bailout_of_Anglo_Irish_Bank.jpg
Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are free
to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like
the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.

2. Big Banking Problems in Countries Large and Small
 Ireland, Iceland, and Cyprus are all small
countries that have had big banking
problems
 Big countries can have banking crises
too—US, UK, Russia and others
 Questions:
 What causes bank failures?
 What tools do regulators have for
rescuing failed banks?
 Who wins and who loses when banks
fail?
 Who wins and who loses when they are
rescued? Protest Against Rescue of Anglo Irish Bank
Photo source: Joe Higgins Euro Election Campaign via
http://commons.wikimedia.org/wiki/File:Protest_against_bailout_of_Anglo_Irish_Bank.jpg
March 2013 Ed Dolan’s Econ Blog

3. Stylized Balance Sheet of a Typical Bank
 A bank’s assets are all the things of
value that it owns, including reserves
of cash, loans, and securities
 Its liabilities are all of its obligations
to other parties, including . . .
 Deposits
 Borrowing in the form of short-term
interbank loans, bonds, etc.
 By definition, capital, which
represents shareholders’ stake in the Capital = Assets - Liabilities
bank, is equal to assets minus
liabilities
March 2013 Ed Dolan’s Econ Blog

4. Solvency and Insolvency
 A bank is solvent if its assets exceed
its liabilities, as is the case for this
balance sheet
 If the value of its assets decreases,
for example, because a borrower fails
to repay a loan in full or because a
change in market condition forces it
to sell securities for less than their
book value, its capital decreases
 When its capital falls to zero or
below, the bank becomes insolvent
March 2013 Ed Dolan’s Econ Blog

5. Insolvency: An example
 In this example, suppose a borrower
defaults on a $100 loan, reducing the
bank’s total assets by that amount
 The bank still owns $700 to
depositors and $200 to other
creditors from whom it has borrowed
 The loan loss brings the bank’s
capital to zero, and it becomes
insolvent
Items that change are shown in color
March 2013 Ed Dolan’s Econ Blog

6. Danger! Zombie Banks!
 Normally an insolvent bank must cease
operation
 If regulators allow an insolvent bank to
keep its doors open, it becomes a zombie
bank
 Risks of zombie banks:
 Because owners have nothing left to lose,
the bank may take huge risks to try to
restore solvency
 Insiders may be tempted to steal the
bank’s remaining assets and disappear
before regulators close the bank
 Even if managers act in good faith,
continued losses will raise the cost of any Banks can be Zombies, Too!
Photo source: Kenny Louie via
future rescue http://commons.wikimedia.org/wiki/File:Unleashed_%284925630503%29.jpg
March 2013 Ed Dolan’s Econ Blog

7. How Runs Can Contribute to Bank Failure
 A bank run occurs when many depositors
at once try to withdraw their funds because
they fear the bank will fail
 In order to meet the demands of
depositors, the bank may be forced to sell
loans, securities, or other assets at “fire-
sale prices” below the value they are listed
on the bank’s books
 The loss in the value of the banks assets
reduces its capital
 The fear of insolvency that caused the run
then becomes self-fulfilling Depositors Line Up During a Run on
Northern Rock Bank, 2007
Photo source: Lee Jordan via
http://commons.wikimedia.org/wiki/File:Birmingham_Northern_Rock_bank_run_2007.jpg
March 2013 Ed Dolan’s Econ Blog

8. Example: How a Bank Run can Lead to Insolvency
 Suppose a bank run leads to withdrawal of
$300 worth of deposits
 The bank covers the first $50 from its
reserves of cash
 To raise the balance, it sells securities, but
in this case, market conditions are
unfavorable so the bank has to sell all of its
remaining securities, which previously had
a book value of $350, to raise the
remaining $250 it needs to cover
withdrawals
 The end result: The bank’s liabilities have
fallen by $300 but its assets have fallen by Items that change are shown in color
$400, so the bank is now insolvent
March 2013 Ed Dolan’s Econ Blog

9. Liquidation
 Bank regulators may try to find another
bank to take over what is left of the failed
bank
 If they cannot do so, they will have to
liquidate the failed bank by selling its
remain assets to pay off depositors and
other creditors
 If the bank’s $600 of loans can be sold at
their book value, then all depositors and
other creditors can be paid in full
 Nothing is left for shareholders, who are
wiped out Items that change are shown in color
March 2013 Ed Dolan’s Econ Blog

10. Liquidation with a Haircut
 Sometimes sale of the bank’s assets does
not raise enough cash to pay off all
creditors
 Suppose selling the bank’s remaining loans
(original book value $600) raises only $500
in cash
 That is enough to pay depositors in full, but
only enough to pay other creditors half of
the $200 that the bank has borrowed
 In financial jargon, we say that creditors are
forced to take a haircut of 50 percent
 In a more extreme case, unsecured
creditors may be wiped out and even
depositors may be forced to take a haircut Items that change are shown in color
March 2013 Ed Dolan’s Econ Blog

11. Too Big to Fail
 Sometimes regulators decide not to
liquidate a bank because they think it is
too big to fail (TBTF)
 The reason may be economic . . .
 Failure of a big bank might start a panic
that damages the whole financial system
 Nonfinancial businesses might lose a key
source of credit
 . . . or political
 Cronyism or revolving-door appointments
between banks and government
 Bribery, campaign contributions, or other
forms of corrupt influence
 If the bank is TBTF, regulators may try to Picture source: Caitlin via
http://commons.wikimedia.org/wiki/File:Elephant_%281%29.jpg
restructure it to keep it in business
March 2013 Ed Dolan’s Econ Blog

12. Restructuring Tool 1: Emergency Loans to the Bank
 In some cases emergency government
loans may be enough to save the bank by
giving it time to sell assets at a better price
 If the loans are made at a below-market
interest rate, they may help restore
profitability
 Loans to a bank increase its assets and
liabilities by equal amounts, so they do not
directly increase its capital
 They are likely to work best for banks that Walter Bagehot, a 19th century financial
are weak but not completely insolvent writer, thought that the government
should act as a lender of last resort,
but only to banks that are solvent
Photo source: Popular Science Monthly via
http://commons.wikimedia.org/wiki/File:PSM_V12_D400_Walter_Bagehot.jpg
March 2013 Ed Dolan’s Econ Blog

13. Restructuring Tool 2: A Carve-Out of Bad Loans
 A second tool of bank restructuring is for
the government to swap good assets, like
government bonds, for bad assets, like
nonperforming loans
 This operation is called a carve-out
 If the terms of the carve out are favorable, it
will increase the bank’s capital
 The restructuring agency will suffer a loss
when it eventually sells the bad assets for
whatever price they will bring
March 2013 Ed Dolan’s Econ Blog

14. Restructuring Tool 3: A Capital Injection
 A third tool is for the government to
nationalize the bank, in whole or in part, by
exchanging good assets like government
bonds for equity in the bank in the form of
shares of stock
 This operation is called a capital injection
 Eventually the government can try to resell
its shares in the bank to private investors,
possibly at a loss, but if it is lucky, at a profit
March 2013 Ed Dolan’s Econ Blog

15. When a Restructuring Becomes a Bailout
 Sometimes a restructuring is done in such a
way that the original shareholders are
completely wiped out
 In other cases, the original shareholders of an
insolvent bank may retain full or part ownership
in the restructured bank, suffering only a partial
loss of their investment, or none at all
 In the latter case, we say that the restructuring
has become a bailout An astronaut undergoes emergency
bailout training
Photo source: NASA via
http://commons.wikimedia.org/wiki/File:Astronaut_Julie_Payette_during_emergency_bailout_training
.jpg
March 2013 Ed Dolan’s Econ Blog

16. Bailout vs. Bail-In
 If the unsecured creditors of a failed bank
avoid losses because of the restructuring, then
they, too, are bailed out
 Instead, regulators may insist that unsecured
creditors accept haircuts as a condition of the
restructuring plan
 The decrease in the creditors’ claims on the
bank helps to recapitalize it
 In this case, we say that the creditors are
bailed in instead of being bailed out
 In extreme cases, depositors may also be
bailed in with forced haircuts HMS Candytuft sinking after a U-boat
attack, Nov. 1917
Photo source: UK government via
http://commons.wikimedia.org/wiki/File:HMS_Candytuft_sinking_1917_IWM_SP_470.jpg
March 2013 Ed Dolan’s Econ Blog

17. The Bottom Line: Someone Must Always Bear the Costs
 It would be wrong to think that bank losses are
only “paper losses” that can be resolved with
some accounting trick
 Bank losses reflect real waste of resources, for
example, construction of unwanted homes that
are financed by bank loans during a housing
bubble
 Someone must always bear the cost
 If the government bails out bank owners,
creditors, and depositors, then taxpayers end up
paying for the bad investments
Unfinished housing development,
Dunfanaghy UK, 2009
Photo source: Ross via
http://commons.wikimedia.org/wiki/File:Unfinished_housing_development,_Dunfanaghy_-
_geograph.org.uk_-_1426980.jpg
March 2013 Ed Dolan’s Econ Blog

18. If you liked this slideshow, you may also want to see these:
• What is Basel III and Why Should we Regulate Bank Capital?
• More on Financial Regulation and Basel III: Regulating Bank
Liquidity
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