{"id":1647,"date":"2013-11-05T06:06:39","date_gmt":"2013-11-05T06:06:39","guid":{"rendered":"http:\/\/www.rationalargumentator.com\/index\/?p=1647"},"modified":"2014-02-09T00:12:28","modified_gmt":"2014-02-09T00:12:28","slug":"banks-going-bankrupt","status":"publish","type":"post","link":"https:\/\/www.rationalargumentator.com\/index\/blog\/2013\/11\/banks-going-bankrupt\/","title":{"rendered":"Why Do Banks Keep Going Bankrupt? – Article by Kirby R. Cundiff"},"content":{"rendered":"
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\"The<\/div>\n<\/div>\n
Kirby R. Cundiff
\n<\/big><\/big><\/strong><\/span><\/div>\n
November 4, 2013<\/big><\/span><\/div>\n
Recommend this page<\/a>.<\/strong><\/div>\n
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The banking industry is unstable. Banks are regularly going bankrupt. Crises in the banking industry have occurred in three distinct time periods during the twentieth century\u2014during the Great Depression of the 1930s, during the Savings and Loan crisis of the 1980s and 1990s, and during the Great Recession from 2007 to present.<\/p>\n

Why the banking industry is so vulnerable to bankruptcies and what can be done to correct this problem?<\/p>\n

Debt to assets, or leverage, ratios vary significantly from industry to industry<\/a>. They are typically under ten percent in most high tech industries and go up to forty percent for public utilities. Average debt ratios in the banking and financial services industry are in the fifty to seventy percent range, however, and many banks have much higher leverage ratios.<\/p>\n

Firms attempt to minimize their total financing costs or Working Average Cost of Capital (WACC). The component costs of capital (cost of debt and cost of equity) are determined by investors\u2019 perceptions of the risk and return possibilities associated with buying debt or equity in a given company or individual.<\/p>\n

A credit card loan has a higher interest rate than a home loan because the credit card loan is riskier\u2014i.e. there are no assets to seize if the money is not paid back. Similarly, a high-risk company normally pays a higher interest rate on its debt than a lower-risk company and increasing leverage is normally associated with increasing risk. Due to deposit insurance, however, this isn’t the case with banks.<\/p>\n

Moral Hazard<\/strong><\/p>\n

The Federal Deposit Insurance Corporation (FDIC) insures deposits up to $250,000 in the United States. Most of the European countries (including Cyprus) have similar organizations that insure deposits up to 100,000 EUR. (See Deposit Insurance<\/a>.)<\/p>\n

Since depositors believe that their bank accounts are insured by governments, they do not generally know or care how much risk banks incur when they invest their depositors’ money. This creates a moral hazard problem with very little oversight by depositors of a bank\u2019s management of their assets. Bank managers can take a lot of risk and, if they make profits, they keep the money. If they lose money, the taxpayers pay for the losses. In theory, this moral hazard problem is mitigated by subordinated debt, investors with deposits over the deposit insurance limit, and banking regulations. But these approaches are clearly not working.<\/p>\n

In a series of agreements called the Basel Accords, the Basel Committee on Bank Supervision (BCBS) provides certain recommendations on banking regulations in regards to capital risk, market risk and operational risk. The purpose of these accords is to ensure financial institutions have enough capital to meet their obligations<\/a>. The Tier I and Tier II capital controls of the Basel Agreements are supposed to prevent banks from taking too much risk with depositors\u2019 assets. Tier 1 capital consists largely of shareholders’ equity. Tier 2 capital comprises undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated debt.<\/p>\n

The capital ratios are:<\/p>\n