Question

Over the years, some banks have failed woefully; with reference to Lehman Brothers and Merril Lynch 2008 financial crisis, briefly explain the reasons for bank failures.

Answer 1

Loans comprise much of the traditional banking sector as well as holding depositor funds. Before the later part of the 20th century, banks made loans mainly for individuals to buy homes and businesses so they could expand. Skills in credit analysis are important to this business line. In this regard, the majority of large banks have massive training programs dedicated to developing new lending officers, who are taught how to evaluate borrowers ' risks and protect the assets and productivity of the bank. As credit requirements are reduced, loan defaults eventually increase and generate financial problems to attract a more lucrative business.

Banks have balance sheets which carry huge asset amounts. Such assets are typically financed through a mix of short-term loans, shares, and equity. If a bank has trouble refinancing or repaying its debt the bank can fail. Funding problems are sometimes linked to general market conditions, but they arise more often because for some reason, investors lose confidence in the bank.

When the assets of a bank are disproportionate to the supporting liabilities, serious problems can arise. The simplest example of this is a floating liability that funds a fixed rate loan. As interest rates rise, the bank pays higher and higher interest on its debt while the borrower with a fixed rate pays the same amount. This misalignment will result in enormous loss. The consequences can be catastrophic when a large portion of a bank's portfolio is misaligned.

Proprietary trading. This newest bank company, and soon to be banned, created huge exposures for banks. Proprietary companies created big profits for the most part. But regulators conclude that the risk of large losses does more than outweigh the potential for profit. The company basically involved trading in unhedged options, large blocks of marketable securities, exotic instruments, and illiquid assets.