Why Banks Fail

IN 1970 when the Bank of Hawaii opened a branch on the Micronesian island of Yap, it had a problem: how to convince the people of Yap to deposit their money in the bank. “We had town meetings and began with the basics,” explained bank official Dominic B. Griffin III. “In subsistence economies, anything can be money. We had to explain why a pig wasn’t money, but that a signature on a piece of paper was.”

That problem underscores a basic point: Modern banking is based on trust. It is founded on the confidence that people—individuals as well as businesses—have in the banks with which they do business and in the agencies that back them up.

Yap already had a bank—the stone-money bank. For ages its culture had used huge stone wheels for currency. So large are they that no vault is needed to store and protect them. Instead, they are propped against walls and trees alongside a road outside of Colonia. Quarried in the islands of Belau, southwest of Yap, their value was determined by how difficult it was to obtain them and bring them to Yap by small boats. The stone money is never moved. Everyone is familiar with each piece and its history. Ownership (but not the actual stone) is transferred from family to family as land or goods are purchased.

Yap, then, literally had to be taken from the “stone age” to the age of modern electronic banking, to be introduced to checking and savings accounts, foreign exchange, savings bonds, telegraphic remittances. The people had to learn the value of printed scraps of paper and to put their trust in banks that would be handling money they could not see.

That situation exists worldwide today. No one really asks a bank to show him their money. In fact, most transactions take place electronically or by means of a check. People have faith that banks will produce the promised funds on demand or when term accounts become due. Yet banks actually carry in their vaults only the currency necessary for routine daily withdrawals. They know from experience just how much cash is needed at a particular time or season. Where, then, is all the rest of the money?

The Banking Business

Banks are businesses. Like other concerns, they are in business to make a profit. But unlike most others, their product is money. In essence, they borrow money from one source and lend it to another. By lending at a higher rate of interest than borrowed, they make money for themselves, their shareholders, and their depositors, as well as cover their expense of operation. But banks also create money. How do they do this?

Dennis Turner explains in his book When Your Bank Fails: “The Fed[eral Reserve System] requires banks to keep only a small percentage of their deposits on hand. While reserve requirements vary depending on the size of the bank and the type of deposit, they currently [1983] average 8%. If a depositor places $100 in his account, the bank may loan $92 of it. The borrower, whether he spends the money or deposits it in another bank account, will create $92 in new deposits. Of this deposit $84.64 may be loaned out, while $7.36 is kept in reserve. This pyramiding process continues, so that with an 8% reserve requirement, a $100 deposit may generate new money totalling $1,200.”

Banks usually lend up to the full limit permitted. But if a rumor spreads that the bank is in difficulty, depositors may lose their confidence in the bank and make a run on it. The bank will be unable to pay all the depositors on demand and could fail—unless rescued by the government or merged with a stronger bank. Even financially sound banks have gone under in this way.

Other Reasons for Failure

Often it is the loans themselves that bring a bank into difficulty, especially when made for long terms at low interest rates. Usually there is no problem when the economy remains stable and the rates the bank pays for money received from depositors or other sources is lower than the interest on loans. But when rates paid for money climb, as they did in recent times, the bank finds itself in the position of paying out more than it is taking in.

It is even worse when those who have taken out loans cannot pay them back. This is the situation right now with many farmers in the United States. Such default is causing many smaller regional banks to fail. “Exactly one-half of the banks on the 1985 failure list were designated as farm banks, that is, at least 25% of their loans were related to agriculture,” says the financial newspaper American Banker.

Outright fraud and embezzlement is another reason for bank failure. The age of electronic transfers has made possible stealing of funds that makes old-time bank holdups look tame by comparison. “The American economy suffers an annual loss of over 500 million dollars in this way,” states the Paris daily newspaper Le Figaro. “In Europe, the big banks are much more discreet about the figures, not wishing to reveal their problems. They nevertheless admit to greater losses from computer fraud than from holdups and common burglary. Computer fraud has become the scourge of our modern economy. . . . As soon as countermoves are discovered by computer experts, new loopholes come to light that are rapidly exploited by certain individuals to their own advantage.”

As in every business, mismanagement and poor business practices can also cause failure. In fact, mismanagement is said to play a crucial role in most bank failures. It could be that the bank directors made unsecured loans to their friends or relatives. Or perhaps they overextended themselves in more prosperous times. Or greed and an effort to make a killing and get rich quick fostered some reckless investments.

In some cases, fierce competition has led banks to take extraordinary risks. Some fall victim to their own overly aggressive lending policies. In a need to cover up when problems occur and to improve reserves and cash flow, some banks seek to entice depositors by offering unusually high rates of interest or even make further investments in risky ventures.

Governmental insuring of deposits—guaranteeing that, no matter what happens, depositors will be repaid—has also induced some banks to throw caution to the wind. But the future is unpredictable. Some who made investments in oil and other energy fields when such were booming and prices were high, for instance, went into bankruptcy when prices plunged or ventures failed. Or if money disinflates, it can wreak havoc for those who expected to pay back borrowed money in cheaper inflated dollars.