Why Do Banks Fail and What to Do About It

Table of Contents

1. Frontmatter

2. Chapter 1. The Role of Banking

   Nordine Abidi, Bruno Buchetti, Samuele Crosetti, Ixart Miquel-Flores

   The chapter delves into the pivotal role of banks in the financial system, focusing on their function as intermediaries that connect borrowers and savers. It discusses the inherent risks in banking, such as insolvency and illiquidity, and explores the regulatory measures implemented post-2008 Global Financial Crisis to safeguard the financial system. The chapter also highlights the key functions of banks, including liquidity provision, asset transformation, risk management, and information processing. Additionally, it examines the role of banks in monetary policy transmission and the challenges posed by technological advancements and the entry of BigTechs into the financial sector.

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3. Chapter 2. Risk Management and Banking Failures

   Nordine Abidi, Bruno Buchetti, Samuele Crosetti, Ixart Miquel-Flores

   The chapter begins by defining bank failure and its regulatory implications. It then outlines the conditions that can lead to a bank being declared failing or likely to fail, including breaches of authorisation requirements, asset-liability mismatches, and the need for extraordinary public financial support. The role of the regulator in responding to bank failures is discussed, highlighting the assessment process and potential resolution actions such as mergers, investor bailouts, and liquidation. The chapter also explores the theoretical underpinnings of bank regulation, emphasising the need to balance prevention of failures with allowing market forces to operate. Traditional risks like credit, interest rate, and liquidity risks are covered, along with emerging challenges such as climate change and cybersecurity. The impact of the 2008 financial crisis and the 2023 collapse of Silicon Valley Bank are used as case studies to illustrate the evolving landscape of banking risks. The chapter concludes with a discussion on the future of banking regulation, stressing the importance of robust risk management practices and the need for regulatory frameworks that can adapt to new challenges.

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4. Chapter 3. The Role of the Accounting Information in Banking Failures

   Nordine Abidi, Bruno Buchetti, Samuele Crosetti, Ixart Miquel-Flores

   This chapter delves into the pivotal role of accounting information in banking failures, tracing back to historical events like the Great Depression and the Great Financial Crisis. It examines how stakeholders can scrutinize bank behavior and the complexities of financial statements. The text distinguishes between commercial and investment banks, revealing tactics such as the overstatement of assets and underreporting of liabilities. Notable cases like Monte dei Paschi di Siena and Lehman Brothers illustrate the severe consequences of these manipulations. Additionally, the chapter explores creative accounting strategies like the ‘Lehman 105 Repo Scandal’ and the use of Special Purpose Entities. It also discusses quarter-end borrowing tactics, accrual accounting risks, and income smoothing, providing a comprehensive analysis of the motivations and impacts of financial misrepresentation in the banking sector.

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5. Chapter 4. Corporate Governance and Banking Failures

   Nordine Abidi, Bruno Buchetti, Samuele Crosetti, Ixart Miquel-Flores

   This chapter delves into the critical role of corporate governance in preventing banking crises, highlighting the significance of robust risk oversight and the dangers of unchecked directorial ambition. It draws upon the theoretical framework of Buchetti and Santoni (2022a) to elucidate the unique agency costs within the banking sector, where the interests of shareholders, depositors, and directors often diverge. Using case studies like Wells Fargo and Washington Mutual, the chapter illustrates how these agency problems can lead to large-scale banking disasters. It concludes by offering a roadmap for enhancing corporate governance, aiming to prevent such missteps and foster a more resilient banking landscape.

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6. Chapter 5. Banking Resolution and Its Key Concepts and Tools

   Nordine Abidi, Bruno Buchetti, Samuele Crosetti, Ixart Miquel-Flores

   The chapter delves into the intricacies of banking resolution, focusing on the critical functions banks perform and the tools available to manage their failures. It emphasizes the importance of preserving critical functions while avoiding public bailouts, and discusses the unique challenges posed by large banks. The text also explores the concept of resolvability, outlining the criteria and preparations necessary for banks to be effectively resolved in a crisis. Additionally, it highlights the role of resolution authorities in planning and executing resolution strategies, and the importance of protecting taxpayers and maintaining financial stability.

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7. Backmatter