Why Strong Banks Fail

Introduction

The purpose of this paper is to identify the reasons why strong banks might fail. Banks play an important role in society. As financial intermediaries, they collect funds from savers and depositors and allocate these funds to businesses and entrepreneurs, thereby fulfilling their main intermediary function of channeling funds from surplus units to the deficit units (Hellwig, 1991; Thakor & Boot, 2008; Bord & Santos, 2012). Banks allocate funds to economic agents to carry out investment and production activities towards economic growth.

But for banks to perform their function effectively, regulators want banks to be stable and strong (Einarsson & Marquis, 2001; Gorton & Winton, 2003). A term used to describe this is ‘bank stability’. A bank is considered to be stable or strong when the bank has adequate capital, sufficient liquidity, high cost efficiency, high profitability, good management quality and low nonperforming loans, which together ensures that the bank is capable of withstanding unexpected losses and external shocks (Brauers et al, 2014; Köhler, 2015; Ozili, 2018). A bank is also considered to be ‘strong’ if its liquidity ratio, asset quality ratio, efficiency ratio and profitability ratio are within regulatory limits or when the ratios meet and exceed regulatory thresholds, thereby providing additional stability buffers. Banks that meet these criteria are considered to be ‘strong,’ hence, the term ‘strong banks.’

History is replete with many strong and powerful banks that suddenly collapsed. Examples are Northern Rock in the United Kingdom and Bear Stearns in the United States. Many strong banks, that were once reputable and dominated the banking industry, have lost pre-eminence and have either become a shadow of their former selves or have collapsed and disappeared. Bank failure is a major concern for regulators and market participants because of the possible contagion across the banking sector and the subsequent collapse of the financial system (Luu, Doan, & Anh, 2021; Allen & Gale, 2000).

The fact that strong banks can suddenly fail is proof that there is an incomplete understanding of the causes of bank failure. Of course, some would argue that the choices, commitments, and actions of the executive management of strong banks are responsible for the failure of strong banks. While these factors may play a role in the failure of a strong bank, there are deeper causes of bank failure that need to be unmasked. Therefore, this paper identifies some of the reasons why strong banks might fail. An understanding of why strong banks might fail is crucial because it helps in developing prudential regulatory frameworks that enhance the stability and health of the banking sector. The insights gained from such understanding can help existing strong banks to avoid actions that could lead to bank failure in the future. Furthermore, the literature has examined the failure of weak banks (Braun & Deeg, 2020; Tamirisa & Igan, 2008; Tsagkarakis, Doumpos, & Pasiouras, 2021; De Grauwe & Ji, 2013). But there has been very little discussion about the failure of a strong bank. This study focus on strong banks and identifies some factors that could trigger the failure of a strong bank.

This study contributes to the bank stability literature (see, Köhler, 2015; Ozili, 2018; Nier, 2005; Ozili, 2020; Chava & Purnanandam, 2011; Englund, 1999; Cabane & Lodge, 2022; Lskavyan, 2020). It adds to existing studies that examine how certain events have triggered the failure of banks – both weak banks and strong banks. The study extends the literature by turning the focus to strong banks and identifying the factors that could trigger the failure of a strong bank. This paper also contributes to the banking crisis literature. The literature show that strong banks are more likely to survive a banking crisis due to their strong prudential ratios. However, some bank failures may be unrelated to changes in banks’ prudential ratios and I identify some factors that could trigger the failure of a strong bank.