Why banks fail?

There is no single and straight answer to this question. The causes of failure are multiple and complex. We shall try to analyse some of them and see if we can arrive at a rational outcome.

The modern banking system runs on a principle called "fractional reserve banking". This principle permits banks to lend money after keeping in reserve a fraction of the deposit to provide for withdrawal.

Each loaned amount is credited to the borrower's account. Thus, a new demand deposit is created to the extent of each loan. These new deposits are known as "derivative deposits". This is how banks can create new money.

To understand the vastness of this issue, let us consider some examples of bank failure at home and abroad:

In Bangladesh, banks are not allowed to fail. For cultural and political or perhaps because of public sentiment, banks are provided with central bank funding and support to thrive as going concern for an indefinite period.

In 1974, Herstatt Bank, a privately owned bank in the German city of Cologne, collapsed because of over-trading in the foreign currency markets. The bank indulged in cross-border foreign currency trading in multiple time zones.

The well-established bank went burst due to failure to settle payment obligations on a timely basis. Before this incident, the banking community was not aware that there was a risk called settlement risk. To mitigate the risk, real-time gross settlement (RTGS) came into being.

Bearing Bank, a London-based bank, collapsed due to reckless trading of its Singapore-based trader, Nick Lesson. He took huge exposure in derivatives, a speculative capital market product. There was no supervisory control over this rogue trader in his 30s. An investment bank with over 200 years of great legacy went bankrupt in the hands of a flamboyant trader.

Lehman Brothers, the second-largest US investment bank, failed in 2007 for its betting on a US sub-prime mortgage derivative called "collateral debt obligation".

It got overexposed to one single derivative product, ran out of cash and had no collateral to borrow from the Federal Reserve System or from the overnight money market. This was a classic example of greed and impulsiveness.

The recent failure of Silicon Valley Bank was generated by market risk. The bank invested heavily in treasury bonds. It neglected to consider the emerging market risk arising from the interest hike by the US Federal Reserve. At one point in time, it had no cash to pay customer withdrawals.

Banks can create money by fractional reserve banking. It can provide temporary liquidity to its cash flow by borrowing from the overnight money market. It can borrow from the central banks. These tools provide opportunities for banks to hide the underlying stress and at times to take foolish risks.

Again, the banking budget is time-bound. All efforts are set out for the current year's result. In other words, the profit motive keeps bankers bogged down in the numbers and the timeframe, oblivious of their true values.

Conservatism is the essential attribute of bankers. Conservatism in the banking context is the urge to conserve the depositor's interest ahead of profit motives.

Banking truly is a business in which one makes a modest and definite income. Flamboyance and recklessness to earn big profits have no place in the banking realm.

The author is an independent director of Bank Asia Limited. He can be reached at dhc707@gmail.com