Discuss the reasons for bank failures in the U.S between 1995 and 2009 as well as regulatory responses to these failures.

| February 14, 2020

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Contents

Reasons for U.S bank failures. 2

Regulatory responses to U.S bank failures. 3

References. 5

Reasons for U.S bank failures

One of the main reasons why many U.S banks have been collapsing since 1995 is the weakening of the economy in the face of the balance of payment problems. The balance of payment problems brings about rising loan defaults. A bank is considered to have collapsed when it is not able to conduct its business for the following day.

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Deflation is another cause of failure of many banks in the U.S since 1995.  The reductions in inflation that were experienced in 1995 were somehow unexpected. They, therefore, induced debtor insolvency followed by bank failures with lags extending for up to eight years. For this reason, the supply of monetary services reduced as more and more banks became reluctant to lend money to individuals and corporate entities.

Thirdly, increasing loan losses on commercial real estate has also played a key role in failure by many U. S banks. The Federal Deposit Insurance Corporation (FDIC) anticipated that after the unfavorable turn of events in the real estate sector in 1995, bank failures were going to cost the U.S economy some $100 billion in the four years that were to follow. However, the FDIC started running out of funds. For this reason, it mandated U. S banks to start making advance payments for up to three years in advance.

In addition, failure by Washington Mutual in 2009 was the most significant in the history of the U.S banking sector. Its failure can be traced back to structural failures in the banking sector that started as far back as the mid-1990s (Brown & Dinç, 2009). The ongoing market turmoil has brought about massive capital erosion arising from excessive exposure to many collateralized mortgage obligations, industrial loans, and commercial real estate loans. All these factors brought about a severe drag on profitability as well as write-downs by banks.

According to statistics released by the FDIC in January 2010, bank failures have resulted in expenditures amounting to $28 billion in 2009 alone. Although there are signals that the economy is expected to grow significantly in 2009, the banking sector is bracing itself for failures because losses in the real estate portfolio may remain high especially for banks that are currently holding high amounts of high-risk industrial loans. Pelaez& Pelaez (2009) say that today, the rate at which lenders are failing is at its highest peak in 17 years, mainly due to losses being incurred through commercial and residential real estate loans.

Regulatory responses to U.S bank failures

            Many regulatory mechanisms have been adopted in the U.S in order to save more banks from giving in to economic instability and collapsing. These measures range from supervisory practices to banking regulation. The U.S. government has been taking a systematic approach to regulate the banking sector by reducing solvency risks that banks were exposed to since 1995 (Gup, 1998). The government has been on the frontline in encouraging banks to embrace practices that make it difficult for liquidity risks to cripple their operations. The main approach adopted in the achievement of this task has been through the sale of assets with the ability to generate value falls.

            Most fundamentally, U.S banking experts have in the last 15 years pushed for an increase in quality and quantity of bank capital as well as a significant increase in the federal reserve funds set aside for trading book capital (Sprague2000). Other related regulatory measures adopted since last year include the creation of countercyclical capital buffers and stabilization of gross leverage ratio. Current indications are that an increase in quantity of bank capital may result in a future banking system that has a higher capacity to absorb shocks. It is also expected to result in a lower return on equity rather than bring about increased risks that cause ripples in the entire banking industry.

            The recent debate on the best immediate regulatory responses to be adopted in the U.S banking system, according to Murphy (2004), has centered around deposit insurance, money market operations, bank insolvency regimes, procyclicality, boundaries of regulation and crisis management. Through deposit insurance, insured banking institutions can be easily closed down in the case of financial turmoil without clients having to suffer many hardships and without any unreasonable political fuss being created. In the absence of deposit insurance, the runs created by depositors can be politically embarrassing.

Through bank solvency regimes, U.S banking institutions have gained the capacity to meet some of the most pressing contractual payment obligations. Before a bank is declared bankrupt because liabilities run in excess of existing assets, bank solvency regimes can defer the dreaded audit for some time, thus offering financially-struggling banks one last opportunity to gamble for resurrection.

References

Brown, C. O.  & Dinç, I. S. 2009. Too Many to Fail? Evidence of Regulatory Forbearance When the Banking Sector Is Weak. Oxford: Oxford University Press.

Gup, B.E. 1998. Bank Failures in the Major Trading Countries of the World: Causes and Remedies, Westport: Greenwood Publishing Group.

Murphy, D. D. 2004. The Structure of Regulatory Competition: Corporations and Public Policies in a Global Economy. Oxford: Oxford University Press.

Pelaez, C. M. & Pelaez, C. A. 2009. Regulation of Banks and Finance: Theory and Policy after the Credit Crisis. New York: Palgrave Macmillan.

Sprague, I. H. 2000. Bailout: An Insider’s Account of Bank Failures and Rescues. Washington D.C: Beard Books.

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