Current Legal Issues Affecting Central Banks, Volume V

Chapter 9 Bank Failure Case Histories

Robert Effros
Published Date:
May 1998
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9A. A Central Bank’s Perspective


Over the past dozen years, the United States experienced more bank closings than during any other period since the Great Depression of the 1930s. These closings resulted from a variety of causes, including poor loan or investment policies at individual banks; loss of confidence in particular groups of banks; and, more broadly, downturns in regional economies affecting banks in such regions. This latter problem occurred in a number of regions in the United States during the 1980s, including the farm belt, the southwest, and the northeast. Indeed, one might conclude that when the economy suffers, banks suffer.

The purpose of this chapter is not, however, to discuss the causes of bank closings but rather to discuss the central bank’s role in these closings, particularly its role as a lender of last resort. In this regard, it is necessary to view central banking functions in the context of the applicable supervisory regime for banking institutions. In the United States, the central bank generally does not charter banks. This point is important because ordinarily in the United States it is the chartering authority that is responsible for closing and, accordingly, determining when to close banks. In addition, the U.S. central bank does not insure or liquidate banks. Thus, it does not have direct control over the manner in which a closed bank is “resolved,” that is, whether it is recapitalized or liquidated. Finally, while the U.S. central bank supervises bank holding companies, it supervises only a limited number of banks and, therefore, must rely on information from other supervisors in making certain judgments.

Nevertheless, the central banks’ role as lender of last resort is critical in many troubled bank situations. The classic lender-of-last-resort role is to provide liquidity to solvent banks when they are unable to meet their liquidity needs from other sources. One of the primary reasons that a bank may be unable to meet its liquidity needs from other sources is that the bank has lost the confidence of its funding sources—depositors or the financial markets, or both—who are then unwilling to continue to extend credit to the bank. This loss of confidence may or may not result from the actual condition of the bank. If the bank is solvent, lending will serve as a bridge until the bank can regain market confidence. However, if the bank is insolvent, while the lending may serve certain policy purposes, it may also result in the preferring of those creditors that flee the bank early over other creditors.

A critical element in the formulation of the lender-of-last-resort role is whether the bank needing liquidity assistance is a viable entity. This issue takes on added significance in the United States where the deposit insurance system is ultimately underwritten by the taxpayers. Just as lending to a troubled bank can prefer some creditors over others by allowing the former to withdraw the full amount of their investment while effectively reducing the pool of assets available to the latter in the event of an insolvency, lending can either increase or decrease the costs of resolving a bank to the deposit insurance fund.

The potential for central bank lending to a troubled banking institution to increase the costs of resolving the bank to other-than-favored creditors and to a deposit insurance fund depends on the structure of the central bank lending and on the deposit insurance arrangements. For example, in the United States the deposit insurance fund is obligated to pay insured deposits (up to the statutory maximum) if a bank fails. The fund then steps into the shoes of the depositors that it has paid and has an unsecured claim against the estate of the failed bank. To the extent that the central bank lends to the bank on a fully secured basis before the failure (which the Federal Reserve does), as deposits and other funds flee the bank the central bank replaces unsecured credit with secured credit. The secured credit takes precedence over the claims of the unsecured creditors, including the insurer, and thereby reduces the assets available to meet their claims. This process can result in increasing losses to unsecured creditors and increasing the costs of resolving a troubled bank to the insurer over the costs that would have been incurred if no central bank credit had been provided. Moreover, the specter of this result may encourage creditors to flee troubled institutions ever more quickly.

On the other hand, lending can reduce the costs to the fund, or other creditors, where the central bank lending serves as a bridge to keep a viable bank operating until it can return to market sources of funds or to keep it operating while the insurer arranges for a purchase of the bank in a transaction that is less costly to the insurance fund than if it simply liquidates the bank. Lending in these situations may also have unquantifiable benefits by maintaining confidence in a local, regional, or national banking system, thereby staving off liquidity pressures on other banking institutions.

At this point, it should be noted that the value of assets for which there is not necessarily an active trading market, such as commercial loans, is directly related to the time available to liquidate the assets. In other words, if liquidity pressures force a bank to liquidate its assets quickly, the bank may have to perform that liquidation at “fire sale” prices, there by converting a previously solvent bank into an insolvent bank.

Early in this decade, a retrospective analysis of the potential for Federal Reserve lending to increase or decrease costs to the deposit insurance funds in the United States led to legislation designed to reduce the potential costs to the deposit insurer of resolving troubled banks. First, legislation was enacted that requires the insurer to resolve institutions on a least-cost basis.1 In order to minimize the effect of Federal Reserve lending on the cost of resolution, the legislation also discourages the Federal Reserve from lending to banking institutions that are not viable.2 The legislation effectively requires the central bank to make up any losses to the deposit insurer for lending beyond certain predetermined time limits designed to allow for prompt resolution decisions.3 This legislation also included a waiver of the least-cost requirements where there is broad agreement that a least-cost resolution could lead to systemic problems.4 Subsequent legislation created a preference for deposits over other bank liabilities, thereby potentially improving the recovery of the insurance fund but, at the same time, potentially reducing the recovery of other nondeposit creditors.5

With this background, two examples of bank “failures” are now examined:

(i) Continental Illinois National Bank (Continental), where the bank was rescued on a basis that was probably not “least cost,” out of concerns for systemic consequences, and (ii) the Ohio thrift crisis, a series of failures that might be characterized as systemic, at least in a particular geographical area.

Continental was a large midwestern bank that had significant exposure to the energy industry. It might have been characterized as a wholesale bank, at least on the funding side, where it relied heavily on money market sources of funds rather than on retail deposits. In the early 1980s, it ran into significant loan quality problems in part due to its dealings with Penn Square, an Oklahoma bank that failed due to energy-related loans. Nevertheless, Continental continued to operate normally until early May of 1984, when a rumor circulated that Continental was going to discuss the insolvency of its holding company with supervisors at the Federal Reserve Bank of Chicago. An official at Continental quickly issued a denial of this rumor. This rumor, and the denial, caused concern among Continental’s money market suppliers of funds, particularly foreign suppliers, who either cut off funds or shortened the maturities of their funding and demanded higher rates. The Federal Reserve made up Continental’s funding shortfalls with central bank credit that rapidly grew to billions of dollars.

By mid-May, Continental’s problems had become pronounced. At that time, the Federal Deposit Insurance Corporation (FDIC) provided Continental with $2 billion in funding in the form of subordinated notes, and the FDIC, the Federal Reserve, and the Office of the Comptroller of the Currency (OCC), the bank’s chartering authority, issued a statement that all depositors and other general creditors of the bank would be fully protected. At the same time, a group of major U.S. banks agreed to provide over $5 billion in unsecured credit to the bank. Unfortunately, these steps were not adequate to restore confidence in the bank. Funding continued to erode, and Federal Reserve credit to the bank increased.

In late July of 1984, the FDIC, the Federal Reserve, and the OCC announced a more comprehensive plan to resolve Continental’s difficulties. This plan included the infusion of an additional $1 billion in capital, the purchase of $4.5 billion in problem loans from the bank by the FDIC, and the installation of a new management team. The capital was infused through the bank’s parent holding company, and the loan purchase was effected in part by the FDIC, which assumed $3.5 billion in loans from the Federal Reserve Bank of Chicago. The announcement of this plan effectively stemmed the erosion of Continental’s funding, and its implementation ultimately allowed the bank to remain in business.

Why was Continental “rescued” rather than liquidated? The short answer is because of concerns about systemic risk. Exactly what these concerns were, however, is a matter of some debate. One of Continental’s lines of business was correspondent banking for smaller banks. These banks held substantial balances in their accounts at Continental. One fear was that the failure of Continental would trigger the insolvency of these banks because of the losses that they would incur on their deposits with Continental. Another view is that the failure of Continental would have triggered a loss in confidence in the U.S. banking system internationally, thereby making it more difficult for U.S. banks to obtain funding abroad. In any event, the rescue of Continental through open bank assistance saved everyone from learning whether either of these consequences would have come to pass.

The second case is the Ohio thrift crisis. In early 1985, the state of Ohio had about 70 state-chartered savings institutions that were insured by a “private” deposit insurance fund, the Ohio Deposit Guarantee Fund (ODGF). The fund had assets of about $130 million. One of the savings banks insured by ODGF was Home State Savings Bank, an institution based in the city of Cincinnati, with assets of approximately $600-$700 million. Home State was heavily engaged in U.S. government securities transactions with a Florida government securities dealer, E.S.M. Government Securities. E.S.M. was engaged in extensive fraud and failed abruptly. Press reports that Home State might suffer a large loss due to the failure triggered a run on Home State and it was closed within the week. At that point, it appeared as though the losses at Home State were sufficiently large to trigger the insolvency of the ODGF.

During the next week, public confidence in other ODGF institutions began to deteriorate, and by the end of that week depositor runs forced the state of Ohio to suspend the operations of all of the ODGF-insured institutions. Interestingly, these runs, which appeared to be triggered by loss of confidence in the insurer, did not extend to wholly uninsured thrifts.

Although the run at Home State was largely funded by loans from ODGF, by the time it was closed the Federal Reserve Bank of Cleveland had put in place arrangements to fund further withdrawals if that had proved necessary. During the runs on the remaining ODGF-insured institutions, the Federal Reserve Bank of Cleveland provided loans and shipments of currency to help meet depositor demands. In both cases, the issue of the solvency of these institutions loomed large. While the losses at Home State made it highly likely that Home State was insolvent, the lack of ready access to good supervisory information on the other ODGF institutions made the condition of these institutions far from clear. Ultimately, this lack of information, including lack of information on the quality of collateral that was available to secure Federal Reserve lending, raised serious questions as to the propriety and ability of the Federal Reserve to fund further withdrawals and was a critical factor in determining to close the remaining ODGF-insured institutions.

Subsequent examination of many of the ODGF-insured institutions disclosed that they were viable, and they were able to reopen with federal insurance to help ensure public confidence. Other ODGF-insured institutions were effectively insolvent, and their depositors were made whole only after the state of Ohio elected to protect them.

The Ohio experience is a classic example of the way that failure of a single banking institution leads to runs on other institutions and, in some cases, the failures of those institutions. It also highlights the limitations inherent in the classic lender-of-last-resort function if good supervisory information is not available. In these cases, it simply was not possible to determine whether or not some individual institutions were viable. Thus, in the Ohio situation, uncertainties about the condition of many of the ODGF-insured institutions made it impossible for the Federal Reserve to determine whether prospective lending by it could be supported by adequate collateral and, even if it could be so supported, whether lending to individual institutions would have been solely for liquidity purposes, or whether it would have merely funded the flight of depositors from a failing institution, thereby effectively creating preferences for those fleeing depositors. Uncertainty as to the availability of Federal Reserve credit led in part to the decision to close the ODGF institutions. Although for the healthy institutions this closing was only temporary, such closing resulted in an interruption in depositors’ access to their funds. Interruptions in access to funds can, depending on the circumstances, be almost as serious as a loss of funds. For example, some savings may be for medical purposes. In any event, it is this type of problem that the role of the lender of last resort is designed to avoid.

In sum, in dealing with troubled banks a central bank’s powers as lender of last resort can be a two-edged sword, depending on the condition and ultimate resolution of the borrowing institution. In appropriate circumstances, it can serve as a vital source of funds to borrowing institutions, maintaining their operations, protecting their creditors, and thereby guarding against systemic problems. At the same time, used inappropriately these same powers can result in preferring creditors and potentially encouraging their early flight from troubled banking institutions.

9B. Bank Failures in Nordic Countries


For some years, the Nordic countries suffered from a severe banking crisis. The problems were most severe in Finland, Norway, and Sweden; Denmark and Iceland also experienced problems, although on a much smaller scale. As a result of the crisis, the authorities in Finland, Norway, and Sweden had to take drastic actions to support problem banks. In all three countries, the governments had to use large amounts of taxpayers’ money to rescue insolvent banks in order to safeguard the stability of the banking system and to protect depositors’ money. In Norway and Finland also, the central banks were directly involved in providing funding to support ailing banks.

Even though Finland, Norway, and Sweden are neighbors, are closely related to one another, have similar cultures, and have a well-organized system of bank supervisor cooperation, they have chosen different ways to rehabilitate their banking systems. This is a clear signal that bank restructuring strategies should not be duplicated from one country to another. Each country is unique, and what works in one country might not work in another. However, that does not mean that each country has to start from scratch, because there are a number of basic principles regarding what to do and not to do, which are always applicable in any bank restructuring.

Since the crises seem to be over, they can be examined to elicit lessons regarding the complex process of bank rescue operations. The different models used are being thoroughly analyzed—in the IMF and else-where—and attempts are being made to assess which model has proved the most successful. Countries still facing banking problems are also closely reviewing the crises to see what they can learn about how to restructure their own banking systems.

The first country to face banking problems was Norway in 1987, while the bank crisis did not hit Finland and Sweden until 1991. One can only wonder to what extent the other countries realized that, if Norway had banking problems, it would only be a question of time until they too were likely to face at least some strains in their own banking systems. Thus, one would have thought that Finland and Sweden would immediately start to consider corrective measures in order to try to avoid a similar crisis or at least to try to minimize the effects of an imminent bank crisis. Unfortunately, they did not. In Sweden, for example, the general belief at that time seems to have been that a bank crisis such as that in Norway would never happen because of Sweden’s larger and more diversified economy. Consequently, despite a respite of four years, the authorities did little to prevent or minimize the effects of a developing bank crisis. However, the blame should certainly not rest solely on the authorities. The banks must also bear a large share of the blame because when they noticed the problems that their colleagues were facing in Norway they should have asked themselves if something similar could happen to them.

However, the attitude shown by the authorities—and the banks—is not uncommon. Many countries have shown a lack of recognition of problems at the early stages of their bank crises. Thus, preventive steps are often delayed until a crisis materializes. There should not, however, be any doubt that the earlier the authorities start to act, the less difficult and costly the rehabilitation process will be.

Cause of the Crisis

The causes of the banking problems in the different Nordic countries are similar. In all cases, the crisis was a result of a combination of factors. For example, the Norwegians have recognized that there were three main causes: dad banking, bad luck, and bad policies. Those causes well describe the causes of the crises in Finland and Sweden too.

The first cause was bad banking. Although the supervisory authority has a responsibility to supervise banks, the boards and managements of the banks themselves must ultimately be responsible for what happens in the banks that they are hired to run. They can never blame the supervisory authority or anyone else if problems arise. However, it is human nature to criticize the supervisory authority when problems do arise, but never to compliment it when things go well.

Financial markets in all of the Nordic countries were deregulated during the early and mid-1980s. The deregulation was followed by a period of intense competition for market shares in lending, and the rate of growth in lending became the most important indicator in determining a successful bank. Basic elements in prudent loan assessment were over-looked, credit assessment of new customers was inadequate, proper risk-management systems were not in place, and asset values were overestimated. Furthermore, the euphoria that characterized many financial markets throughout the world in the late 1980s led bank managers to be overly optimistic in establishing branches and subsidiaries both domestically and internationally. Most banking markets became over-crowded, and when the recession started in the early 1990s, there were too many banks and not enough business for all of them. Some banks had to disappear, either by voluntary or forced liquidation or by mergers.

Second, bad luck refers to the international recession that took place in the early 1990s, the length of which surpassed most expectations. In Sweden, the real estate market collapsed, and prices fell by about 50 percent in metropolitan areas in the course of two years. In Norway, the situation was exacerbated by a fall in oil prices and in Finland by the collapse in trade with the Baltic countries, Russia, and other countries of the former Soviet Union.

The third cause, bad policies, refers to the economic policies conducted in the Nordic countries during the latter half of the 1980s. Policies were generally lax, despite a booming economy. The deregulation of financial markets took place during an upturn in the economy, and because interest payments on loans were to a large extent deductible from income taxes, this stimulated an excess demand for credit. At the same time, there was generally a negative attitude toward providing more resources to the supervisory authorities, despite the financial market deregulation. To make matters worse, supervisors were unfamiliar with the new environment and, as in the past, focused more on banks’ compliance with laws than on how banks were monitoring and minimizing the risks that they were taking. It became increasingly common to challenge unpopular decisions by supervisors in court; this not only may have caused supervisors to be more reticent to take such decisions, but also may have slowed efforts to introduce stricter supervisory guidelines.

The bank crisis was most severe in Finland. Finnish banks’ loan losses in the period of 1989-94 averaged 2.2 percent of gross domestic product.1 The corresponding figure for Sweden was 2.1 percent and for Norway 1.7 percent.2 Worth noticing is that the figure for Denmark was 1.5 percent—only slightly lower than Norway’s.3 In Norway, the highest figure of 3.1 percent was recorded in 1991, while Sweden and Finland recorded their highest figures in 1992, 4.9 percent and 4.6 percent, respectively.4

Deposit Insurance

In Finland, a compulsory security fund system (deposit insurance) had been in place for some years.5 Voluntary security funds had also been set up for commercial banks, cooperative banks, and savings banks.6 The security funds were supposed to repay depositors if this could not be done out of a bank’s own resources because of bankruptcy. However, the accumulated resources in all three funds proved to be minimal in relation to potential compensation liabilities.

In Norway, the Savings Banks Guarantee Fund and the Commercial Banks Guarantee Fund had been set up some years prior to the crisis, and in the initial stage of the crisis banks were supported by these funds. By the beginning of 1991, however, the funds had been drained, and it became clear that they no longer had the financial capacity to constitute a credible safety net for Norwegian banks. By contrast, in Sweden no such funds existed.

Government Support

When the magnitude of the banking problems became clear—as well as the risks posed to the economy as a whole if a number of banks were allowed to fail—the Finnish and the Swedish governments each chose to issue a general guarantee that all banks would meet their obligations. No such guarantee, however, was issued by the Norwegian government.


In August 1992, the Finnish government issued a statement in which it asserted that the stability of the Finnish banking system would be assured under all circumstances.7 The commitment was reaffirmed in February 1993, when the Parliament unanimously approved a resolution stating that “Parliament requires the State to guarantee that Finnish banks are able to meet their commitments on time under all circumstances. Whenever necessary, Parliament shall grant sufficient appropriations and powers to be used by the Government for meeting such commitments.”8 According to Finnish sources, this resolution is exceptional in Finnish parliamentary history, because it states that the whole political system stands behind commitments made by Finnish banks.9


As the banking problems in Sweden worsened, the government became increasingly concerned that confidence in, and the stability of, the Swedish banking system as a whole could be jeopardized if there were a run on Swedish banks. At the same time, the banking problems were exacerbated by the sharp interest rate increases that took place in the wake of the currency crisis in the autumn of 1992, as interest rates were raised up to 500 percent in an unsuccessful attempt to defend the Swedish krona.10

In September 1992, after receiving support from the leading opposition party, the Swedish government announced that it would request a broad authorization by the Parliament to take measures to strengthen the payment system and safeguard the supply of credit.11 The bill, passed in December 1992, stated (i) the state guarantees that banks and certain other credit institutions will meet their obligations on a timely basis, (ii) the government had been authorized to decide about measures of support, (iii) measures should be based on commercial principles and arranged in a way that would minimize the long-term cost for the state and provide that support paid out could be recovered, (iv) the state would not endeavor to become an owner of banks, (v) all commitments of an institution were covered except its share capital and perpetual debentures, and (vi) the support would be temporary and would be terminated once it could be done without jeopardizing the rights of creditors.12


Special organizations were set up in all three countries to manage the support system for the bank restructuring and to decide on the measures to be taken. In principle, they all operated in a similar way.

In Finland, the Government Guarantee Fund was established in April 1992.13 The Fund was allowed to provide support to banks in various ways, such as acquisition of bank shares and provision of other types of equity capital, loans, and guarantees.14 Prior to the establishment of the Government Guarantee Fund, the Bank of Finland had supported one insolvent commercial bank.15

In Norway, two separate bank support authorities were set up. First, the Government Bank Insurance Fund was established in March 1991.16 Its mandate was to provide support loans to the existing banks’ guarantee funds to enable them, in turn, to supply risk capital to banks.17 However, the need for public support grew, leading to the creation of the Government Bank Investment Fund in November 1991.18 The two funds had different roles to play. State ownership as part of crisis management was the role of the Government Bank Insurance Fund, while state ownership as investor on a commercial basis was the responsibility of the Government Bank Investment Fund.

In Sweden, a decision was taken to set up a Bank Support Authority in December 1992, but the Authority did not begin its work until May 1993.19 Banks had already started to recover, and most of the restructuring was completed. Prior to the Authority beginning its work in April 1993, bank restructuring had been handled in the Ministry of Finance.20 An appeal Board for Bank Support Issues was also set up to act as the final instance for assessing support issues in cases where the state and an institution did not reach an agreement.21

Forms of Support

In Norway, the main support was provided by the two above-mentioned government funds, although the banks’ own security funds were able to provide a substantial amount of support. The Bank of Norway supported problem banks by granting low-interest loans, there-by helping to improve their results. In the course of the restructuring, the three largest Norwegian commercial banks were taken over and recapitalized by the state, and the old share capital was written off.22 The Norwegian Parliament decided that the state would remain owner of the two largest banks at least until after the election in 1997, while the third bank should be privatized.23 This implies that the Norwegian authorities, at least for the time being, consider it important that the state has control of the two largest banks.

In Finland, most of the support was given in four different forms. First, when the crisis started the Bank of Finland took control of one insolvent bank, recapitalized it, bought its largest risk exposures, and later sold it to the Government Guarantee Fund.24 Second, the government offered a general capital infusion to all banks, regardless of their solvency, using a formula based on their risk-weighted assets. The capital was offered in order to secure the support of bank credit to customers. Third, the Government Guarantee Fund bought shares and preferred capital in some banks to safeguard their solvency. Fourth, the state and the Government Guarantee Fund set up and capitalized asset management companies. Large volumes of bad assets in banks being restructured have been transferred to these companies.

In Sweden, all support was provided by the state through a combination of capital injections, guarantees, and loans. More than 98 percent of the total amount paid out was used to capitalize two banks, one of which was already owned by the state.25 Included in the amount is the capitalization of two new asset management companies set up to recover bad assets in these two banks. These asset management companies have played an important role in handling the Swedish bank crisis.

Public Cost of Bank Restructuring

The Norwegian banks have now recovered, and recent estimates indicate that the Norwegian government will fully recover the support it provided to banks during the crisis.26 It may even make a profit if all of the government’s bank shares are sold.27

In Sweden, banks have also recovered substantially. In 1992, the peak year of the crisis, the combined operating losses for the five largest bank groups was SKr 50 billion, while these banks in 1994 had a profit of SKr 12 billion.28 The government also proposed in a bill to Parliament to abolish the general state guarantee that all banks would meet their obligations as of July 1, 1996.29 Estimates also indicate that the government will recover most, if not all, of the support provided through the privatization of the state-owned bank and by successful loan recoveries in the two state-owned asset management companies.30

In Finland, however, banks are still facing problems, although the crisis seems to be over. As a group, they were expected to show a loss for 1995 but a small profit in 1996.31 The Finnish government is not likely to get back all its support. At present, the total cost for restructuring the banking system is estimated to be in the range of Fmk 40 to Fmk 50 billion.32


Although the Nordic countries have chosen different ways to solve the problems that they have experienced in their banking systems, there are also many similarities among the methods used. All three countries can be said to have successfully rehabilitated their banking systems in a few years. (In Norway, and probably also in Sweden, the governments are likely to get back all the funds invested in restructuring the banking systems.) The following general conclusions can be drawn from the handling of the Nordic bank crisis:

  • Once there are signals about an imminent bank crisis, the authorities need to take action immediately. Early intervention by the authorities is likely to be the most cost-effective way to rehabilitate a banking system.

  • There should be a political consensus on how the banking system is to be restructured.

  • The government is ultimately responsible for confidence in, and the stability of, the banking system. A deposit protection scheme cannot solve a systemic bank crisis.

  • The government should be responsible for the restructuring. This is probably best done by setting up a special government agency to decide on the measures to be taken, to act as owner of any banks taken over, and to administer the support. The supervisory authority or the central bank should not be directly involved in such an agency.

  • A step-by-step restructuring should be avoided, because such an approach tends to prolong the crisis; instead, forceful actions should immediately be taken.

  • In the Nordic countries, a large part of the support provided was in the form of capital injections. This has proved to be a good way to ensure that a maximum amount of public funds used will be paid back. To temporarily nationalize insolvent banks and, once they are rehabilitated, reprivatize them, gives the government—not the shareholders—the upside of the restructuring.

  • The transfer of bad assets to an asset management company can be a useful way to maximize loan recoveries and to minimize the government’s cost. The Nordic experience shows that such a company should be set up outside of the banks.

  • No Nordic country allowed a bank to operate unless it met Basle capital standards.33

  • No depositors have lost any money in the Nordic bank crisis. This clearly indicates how unwilling the governments were to let banks fail. However, shareholders have lost a substantial amount of money in all three countries.

9C. Bank Failures in Latin America



Bank failures, as isolated episodes or as part of more widespread processes leading to banking crises,1 have become a worldwide phenomenon in recent years. Bank failures have been a feature of the recent economic scene in industrial countries (for example, Japan and the Nordic countries) and in developing countries.

While in the case of industrial countries bank failures and crises have been costly, the damage that they caused seems to have been far greater for developing countries (including economies in transition). This has been particularly true for Latin American countries. Open systemic banking crises have occurred in the past several years in Argentina, Bolivia, Mexico, Paraguay, and Venezuela, while important cases of bank failures—without reaching systemic proportions—affected several other countries, notably Costa Rica, Ecuador, and Brazil. In contrast, countries like Chile, Colombia, and Uruguay remained unaffected even after the emergence of the Mexican crisis in December 1994.

As for the developing countries and, in particular, Latin American countries, the IMF has become increasingly aware of the threats that bank failures pose on macroeconomic stability. In turn, macroeconomic instability has been seen as one of the main factors explaining banking crises. The fragility of the banking sector in a number of Latin American countries has highlighted the serious problems that could arise for stabilization efforts or growth if insolvency undermines the soundness of the banking system. The answer to bank failures is to strengthen the efforts to identify and address problem banks, and to strengthen prudential regulation and banking supervision.

Causes of Bank Failures and Deposit Runs, and Responses from the Authorities

While recent interest in bank failures has been mostly concentrated on the Mexican crisis and its spillover effects, many lessons can be drawn from the earlier Venezuelan banking crisis that emerged in January 1994, when Banco Latino was closed and after a few days reopened under state management.

In general, the nature and causes of banking failures and crises differ among Latin American countries. However, there are some common factors that are important to underscore, such as uncertainty regarding the future direction of macroeconomic policies (particularly when the country is experiencing serious imbalances that affect, among other things, the normal functioning of its banking sector) and bank mismanagement (including irregularities and fraud that unfold in the framework of perceived weakness of prudential regulations and banking supervision). These two causes could be considered of an endogenous nature, mostly generated within the banking sector itself or resulting from the interaction between the real and the banking sectors. Another set of causes relates to unexpected exogenous shocks, such as an abrupt deterioration in the country’s terms of trade or developments taking place in other parts of the world. There are also other kinds of shocks that can be domestically generated, like an unexpected election result, the worsening of a leading economic indicator, or the decline in the net worth of a particular class of bank borrowers affected by a change in relative prices. These are domestic shocks, but still of an exogenous nature in the sense that they do not originate in any factor inherent to the functioning of the banking system.

A major feature of most episodes of bank failures is deposit runs; still, not all bank failures entail generalized deposit runs. Analysis of bank failures in Argentina, Mexico, and Venezuela provides examples of different depositors’ behavior and the nature of deposit runs.

The Venezuelan and Mexican banking crises can both be broadly characterized as being triggered by endogenous factors. Inconsistent macro-economic policies, combined (particularly in the Venezuelan case) with poor bank management; significant corruption and fraud; and lack of appropriate banking supervision led to a strong deterioration in the depositors’ perception of the viability of banks. While both the Venezuelan and the Mexican crises share a number of features, there were fundamental differences in depositors’ reactions in the two countries. In particular, Venezuela suffered significant deposit runs, while Mexico did not. In both countries, there existed the deeply rooted belief, based upon past historic experiences, that the state would eventually come to the rescue of ailing banks. Policies implicitly supported the confidence of depositors who expected to be protected, irrespective of the depth of the crisis.2

Even more interesting is a comparison between the Venezuelan and Argentine banking crises because both involve significant deposit runs. However, they differ in a substantive way in two respects, namely, the factors that triggered the run and the scope of the run. In the Venezuelan case, deposit runs started once the interbank market and the central bank took the decision to halt the financial support to Banco Latino, the second largest private bank. Shortly thereafter, a group of banks perceived by depositors as financially weak and risky started suffering deposit runs. The Venezuelan crisis is characterized by the fact that deposit runs were “targeted” at a group of banks that the market believed to be in poor financial condition. A process of deposit redistribution then took place from “ailing” to “healthy” banks so that runs were not generalized.3

In contrast, the Argentine banking crisis was clearly triggered by an external shock (the Mexican crisis) and affected all banks (even though with different intensity). Despite some financial problems that had started to unfold before the emergence of the Mexican crisis of December 1994, the Argentine banking sector was basically sound; it showed a reasonable level of solvency and liquidity. The sudden change in expectations about the underlying fundamentals of the Argentine banking system, caused by the Mexican crisis, led to a generalized deposit run that affected all banks and bank categories.4

The difference between deposit runs in Venezuela and Argentina is remarkable. In Venezuela, practically all banks were privately owned, and the crisis was endogenously generated when the market decided that the long-standing problems of some banks (compounded by significant macroeconomic imbalances) were no longer sustainable. In contrast, the Argentine banking system was affected by depositors’ fear about the fate of the entire banking system after the emergence of the Mexican crisis. In addition, the disturbing history of policies adopted by the government to resolve previous financial crises also generated negative expectations.

The immediate response of financial authorities to deposit runs and bank failures also differed importantly among Latin American countries. A distinction can be made between cosmetic solutions and the adoption of measures of a more permanent nature aimed at consolidating the condition of the banking system.

Nonsystemic Bank Failures

Costa Rica and Brazil provide cases where failures of large banks have not resulted in systemic banking crises. In Costa Rica, Banco Anglo Costarricense, a large state bank, was closed in December 1994 after incurring losses representing 2 percentage points of GDP. Some important economic events during 1995 dispelled the threat of a systemic crisis, although many problems still persist in the banking system.

In Brazil, the successful adoption of Plan Real in June 1994 brought about deep changes in the functioning of the banking system. Banks lost the profits that had resulted from the “float” in the context of high inflation, and many of them could not adapt to the new situation of low inflation. Many small banks and two large private banks failed during 1995, but the situation cannot be characterized as one of systemic crisis. Nevertheless, the authorities need to address some serious problems affecting the banking sector that, if unattended, could ultimately jeopardize the success achieved on the macroeconomic front.


Several lessons can be drawn from the recent bank failures and crises that have occurred in Latin America. In particular, the authorities need to introduce and maintain comprehensive strategies to address problem banks. In addition, they need to strengthen prudential regulation and banking supervision in order to protect the soundness of their banking systems and, indirectly, their countries’ macroeconomic stance.

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