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Financial Crises and Bank Regulation

Buy custom Financial Crises and Bank Regulation essay

The financial sector is one of the sectors that require more attention in their management and regulation, as it holds the economy and development of a nation at its confinement. The banking segment makes up the biggest part of financial sector and influences the economy, while being affected by the masses of people using the banking system to perform various financial transactions. With or without regulation of banks, banks find themselves in crises depending on the activities they are involved in. These activities include loaning, allowing large deposit withdrawals, floating of local currencies, general performance of the bank relative to the economy, and the deposit size of the bank with the central bank. Crises of banks can be managed or regulated depending on the margin of the particular crisis and the policies that apply to the banking sector (Ben and Blinder, 1992).

As the governor of the central bank, I am required to make a choice on the issue of bank X, the president of which explained to me that his bank, which happens to be, the biggest in the country, couldn’t meet deposit withdrawals. To assess the issue and the number of options that can be applied requires for investigation as to why large deposit withdrawals have been experienced. Withdrawals of deposits that extend to the margins of disturbing a bank include the seasonal withdrawals that affect the banks in terms of many people withdrawing money at the same time. However, banks that are troubled by bad economy will experience a run in the clients that rush to withdraw their deposits before the banks end up in closures. The former and the latter cases experienced are different in that the seasonal withdrawals through proper supervision can be managed whereas banks request for an expansion in their deposit vaults to deal with the matte (Bhattacharya, Sudipto and Gale, 1987). However, the latter case means that people are running out to withdraw their deposits before the bank can be liquidated.

To deal with the issue of Bank X, I have outlined a number of options that include increasing the number of deposits, proposing a merger with a potential bank, letting the bank up for acquisition by other active and financially stable players, providing liquidity, support, and liquidation of the bank. Decision on how the bank can operate with its clients depends on the variables of each option and the effects that are likely to be realized following the implementation of the options. This paper discusses the variables of each of the options and the reasons for considering the options as well as the effects expected from each option. Given only one decision has to be made out of the options, this paper will conclude with a recommendation of the most appropriate option to be adapted, as well as why it makes to be better than the rest of the options (Lowell, 1988).

Option 1: Deposit Expansion of Bank X

Dealing with banks that cannot meet withdrawal of deposits by clients depends on the reason as to why they are unable to do so. Fairly to many banks in terms of operation and their worth, it is likely to be found in such crises that they cannot meet the deposit withdrawals of their clients. The case at hand is presented by a leading bank countrywide; however, it is not certain that its size cannot result into interbank crisis or any other crisis that may be influenced by economic factors (Thomas and McDonald, 1998). As for this case, an assumption that the bank is experiencing seasonal difficulties would be taken into consideration. Seasonal withdrawals of deposits are expected by banks, but at times, depending on the economic status of the customers, banks may fail to predict the trends of the customers. During the difficult economic times, clients tend to apply for more loans, therefore, the bank credits their accounts while, on the other hand, the deposit reserves of the bank keep going down with subsequent withdrawals of deposits by customers (Charles and Kahn, 1991).

In addressing this crisis assumed a temporary phenomenon, the Central Bank would credit the accounts of Bank X through expansion of its deposit reserves. To do this, Bank X’s deposit reserves would be reviewed with the aim of finding out how much money is held in legal reserves and how much is in deposit reserves. With the demand for withdrawal and the estimate of time upon which it is expected to last, the central bank would credit the deposit reserves of Bank X to enable it deal with the withdrawals (Raymond, 1948). However, the Central Bank does not make many to fill up deposit reserves of banks, but will create a liability on itself by buying government securities from a dealer who, in turn, would have his/her payment from the securities credited for in the account at Bank X. Let’s say $100,000 of securities were bought by the Central Bank from the dealer, $100,000 deposited in its reserve, therefore, expanding the bank’s reserve with $100,000. On the side of the Central Bank, a debt of $100,000 stands as a liability while the fact that Bank X is liable to pay its bank falls as a credit, upon which the Central Bank has balanced its financial statements in that no amount would be required to live Central Bank to pay for securities payable at Bank X.

Reasons for Choosing Option 1

In respect to the original assumption that the crisis Bank X has found itself in was seasonal and brought forth because of a higher withdrawal turnout than predicted, the reason for choosing to expand Bank X’s deposits would be seasonal as well, so that Bank X could deal with the issues seasonally. When dealing with banks, regulation of their operations may not always follow the law as indicated in the constitution or other government dockets, as the banking industry is a dynamic one. “With regulation in ethical terms, a government undertaking, assessing the situations of banks, especially the large ones, is the work of the central bank” (Douglas, 1984). Trends and economic situations are not choices the government can make, neither would any solution coming from the government work without the assistance of the Central Bank. This is because legal reserves are maintained by the Central Bank and, thus, a bank in crisis would have to operate at a certain percentage of minimum reserve size which the central bank investigates to monitor the stability of the bank. On the other hand, the amount on the legal reserves means that bank can only be credited or can be supplied with money for the deposit reserves, depending on the percentage of the legal reserves relative to the maximum amount that the reserve can hold (Douglas and Dybvig, 1983).

Assuming that timely deposit withdrawals are responsible for the derailment of a banks operation in terms of meeting withdrawals of deposits, it therefore means that an expansion of the banks deposit reserves would depend on the margin of their legal reserves. If the legal reserves are of margin y, the deposit reserves would then be expanded 10 times and an equivalent of the legal reserve’s amount would be subtracted to give 10y-y (Stewart, 1984). The criterion for expanding the deposit reserves of Bank X complies with the Central Bank provisions, hence making this option a legal and policy respecting undertaking. If the government could intervene, its assumption would be different compared with mine, as the governor of the Central Bank, and could, therefore, result in action that goes against the policies of the Central Bank and the objectives of Bank X.

Expected Results of Option 1

Seasonal crises that a bank can find itself in are more economically oriented than management oriented, hence, the ease of prediction of how long these crises would last. Take, for example, Bank Y the client base of which exceeds 200,000 individuals and it has deposit reserves of $200,000,000 while, at the same time, there are 5,000 clients owing the bank $100,000,000 in result of loans to pay off their mortgages which resulted from fair deals with mortgage institutions. In result of this situation, assume that among the clients (195,000) who do not owe Bank Y anything each has deposit of $200 and each would like to withdraw $150 in order to celebrate Christmas or any other type of widely celebrated event or holiday. The total of the amount that these people would withdraw within that limited period would be (195,000 x 150 = 292,500,000); which in theory is more that the amount in Bank Y’s deposit reserves.

With the above statistics of Bank Y, it shows that the reason that the bank cannot afford to meet the customers’ withdrawals of their deposits in full is that some amount has been lent out as loans. In practice, the Bank is still safe as the 5,000 clients owing the bank $100,000,000 would definitely clear their debts over the periods agreed on their respective deals with the bank. Reapplication of this statistical approach to Bank X means that the results of crediting the account of Bank X with the amount supposed to pay the dealers of government securities would seasonally expand the deposit reserve of Bank X. This, in turn, would satisfy the need of the bank to serve its clients as the season passes and debtors pay off their loans. As the season ends up, the bank would have satisfied the withdrawal needs of the clients while, at the same, time its debtors will pay off their loans, therefore, being able to credit the government – securities dealer’s account (Douglas and Rajan, 2001). With the need to withdraw money from their deposit accounts, clients would reverse the trend, hence, enabling the bank to settle to its normal operability. Therefore, the expected result of option 1 is to enable Bank X to operate seasonally on loan as it waits for the seasonal trend to pass to regain its full potential.

Option 2: Liquidation of Bank X

Liquidation of a bank is the process of acquiring bank’s assets to pay off creditors. This move takes two procedures where a government committee can decide on the matter and a court ruling verifying the committee’s decision resulted and decision of the bank operators to liquidate the bank. Many banks sell shares to the public and are, therefore, owned by various people, upon which management skills and undertakings matter to all the parties involved (Mark, 1994). Bank crises originate from a number of issues, especially bad management or lack of insight in terms of lending and borrowing. As financial institutions, banks involve themselves in marketing, especially in their shares and IPOs of other organizations (Donald, 1998). When it comes to marketing and decision-making, a bank’s management assumes responsibility of the operations and the coordination of activities. However, bad management can be experienced as a result of corruption, therefore, jeopardizing the stability of the bank (Kenneth and Stein, 1998). To discuss option two that I would take as the governor of the Central Bank, an assumption that management of Bank X have engaged in ruthless activities would be taken into consideration.

Following the assumption of this option that the management of Bank X is involved with the crisis the bank is facing, liquidation of the bank would be more appropriate in order to pay off creditors and shareholders. With the bank unable to meet withdrawal of deposits, it means that clients have noticed the trends of Bank X and their efforts to withdraw their amounts are in order to salvage their investments and deposits before the bank would end up in a closure. The Central Bank does not have the power to close a bank, but can withdraw its support if the bank is involved in orthodox practices of banking. As the governor of the Central Bank, I would advise the president of Bank X to make a decision with the Board of Governors of his bank to liquidate the bank to pay off creditors and shareholders before the situation escalates out of proportion. Corruption in such cases could be a course, while being unable to conduct business fruitfully can be another reason Bank X ended up in crisis. Corruption is punishable by law while ruthless and risk taking by banks can lead to heavy fines that in addition to initial crisis can lead to further financial damages (Gary and Pennacchi, 1990).

Reasons for Choosing Option 2

Bank X is the largest in the country, and in normal circumstances it would be the first bank to get stimulus packages from the government in order to prevent the economy from falling into a crisis. However, as much of attention the government would be given to Bank X, there is a chance that the government would assess the performance grind of the bank before opting to take such an action. Being unable to meet deposit withdrawals means having insufficient amount of money in both legal and deposit reserves, which in theory does not happen for big banks, but in practice it can happen, considering the trends of the economy and clients in general. When a bank starts to operate on a loss basis or starts losing its clientele it means that he banks could be operating on debt from creditors (Gary and Pennacchi, 1992). If debts accumulate to an unsustainable level, whereby the interests of the debts are bigger than the debt itself, a bank or an organization results into bankruptcy, therefore, rendering itself unable to operate at normal levels. Bankruptcy in the case of banks takes several paths towards their resolutions as clients demand compensation of their deposits, shareholders demand for their investment, and the government may withdraw support for the bank if its trend has prevailed for some time.

The reason why I would advise the president of Bank X to liquidate the bank would be to salvage the situation before more parties can be affected by the bank’s performance. The likelihood of the bank to be sued by either shareholders or clients is high if the total of amounts the bank owes them, adds up to figures exceeding the worth of the bank’s assets. If the trends of unfavorable results of consecutive financial years prevail, the bank could accumulate more debt over the years it delays liquidation. The result of the delay is an accumulated debt and with clients withdrawing their deposits, the bank would not be able to lend money and expect interests from loans. This is because the money a bank loans out comes from the money clients deposit in the bank. Without deposits and continuous withdrawals, Bank X faces a danger of closure with lawsuits following in regards to the bank’s debts to creditors, as well legal suits from markets and shareholders (Bray, 1957).

Expected Result of Option 2

The economy of any nation depends on the activities of the financial sector upon which the variables of investment and savings are registered. Banks provide loans, assist in marketing, and predict the value of businesses regarding how national currencies fair against international currencies (Timothy, 1991). The economy of a nation can be estimated in terms of how much the currency of that particular nation fairs against the currencies of other economically growing or developed countries. The role of the bank is to regulate the fiscal affairs of organizations and business in terms of monitoring the amount of money in circulation relative to the economic condition of the nation (Robert, 1995).  Large banks can be equated with macroeconomic organizations, which do not affect the economy at a small scale but rather a large scale in terms of GDP (Sydney, 1998). With large banks involved in crises, the governments of the nations where these banks operate from do not take chances with closures or liquidations of such banks. Closing a multibillion financial institution would result in market collapse, as a good number of investors would lose their investment, adherent investors would not access loans, market turnovers would not be accounted for, and small banks that depend on the trends of the bigger banks would collapse due to pressure from increased margin of clients (Bengt and Tirole, 1998). 

The result of liquidating Bank X would be single faceted as the interests to be served with the liquidation would only be serving the banks and saving it from further financial crisis, as well as possible lawsuits. However, the importance of a big bank affects the economy of the nation at every possible side and saving itself from lawsuits and bankruptcy would course economic turmoil. In this case, liquidation of Bank X would only mean harm to the economic sector and derailment of marketing procedures. However, if the liquidation can be performed through acquisition of the bank by another potentially capable bank, the economic repercussions would be prevented (Bengt and Tirole, 2001).

Option 3: Acquisition of Bank X

Take, for example, two cannibal (capable of eating one of their own) animals of a moderate size and a third animal of their kind which is bigger than the former animals individually, but smaller compared with both as a unit (Robert, 1988). When the two cannibal animals face the danger of extinction if they do not get anything to eat and they cannot eat each other, because they will harm each other and both die; then the third animal would be the only possible way out of their situation. However, the animals cannot make to eat the third animal individually, because it is bigger and probably stronger than the two of them. For this matter, it would mean that the two animals would have to join efforts to overpower the stronger animal and save themselves.

The above situation translates to the case of Bank X that happens to be the largest bank in the country and in crisis. The inability of Bank X to meet deposit withdrawals shows that something is wrong with it in terms of economic collapse or management malfunction. However, a big bank like Bank X cannot afford to be closed while holding the majority of clients in a nation. Economically, such consideration as closing or liquidating such a bank would mean lack of insight, as clients and shareholders would cause a run on their respective banks thinking it is a nationwide phenomenon affecting banks. To rescue the situation, Bank X can be acquired, but being the largest bank in the nation is likely to have assets valued above those of other individual banks (Joel, James and Marcus, 1997). Assuming that Bank X has assets worth $50 billion and Bank Y has assets worth $45 billion, it means that an acquisition of Bank X by Bank Y would be impossible. However, considering Bank Z that comes below Bank Y with assets of $40 billion, it would be able for Banks Y and Z to acquire Bank X resulting into a merger and emergence of Bank YZ with assets worth $85 billion. For this case, the acquisition of Bank X can be achieved by the combined efforts of two or more banks entering into a merger, the combined asset value of which is larger than that of Bank X.

Reasons for Choosing Option 3

Currently Bank X is dealing with a crisis of not being able to meet deposit withdrawals, upon which a probability that clients do not think Bank X is in danger of closure or liquidation. For this matter, acquisition of Bank X would be resulted to ensure that clients do not panic and go for a run. With the economic interests of the nation prioritized, the existence of Bank X is vital, as it secures the economic patterns required by the market and other financial institutions. However, to deal with the issue of collapsing stability of Bank X, the bank would need a stimulus package from industry players that, in turn, would not cause alarm to clients. Alarm of any kind associated with the bank considering to merge, to be acquired, or to be liquidated would result to clients rushing to withdraw their deposits in order to avoid long processes of compensation (Anil and Jeremy, 1994, 2000).

The reason for choosing the option to enlist Bank X as a troubled bank is to find an acquirer with the potential to handle the client base of Bank X and seeking new opportunities of expanding operations. Since Bank X is the largest in the country, a mechanism to create a bigger bank or one valued above Bank X would be required to enable the acquisition. Through merging of potential banks, the acquisition of Bank X can be done without the need to raise alarm to the public. This move would put the market and the economy as a whole out of the great danger of damaging the patterns of GDP generation on the national grind (Anil, Jeremy and David, 1993). Considering the different types of acquisition, my option to resolve the problem Bank X is facing takes on a conditional acquisition, whereby the mechanism to enable a healthy acquisition would depend on asset valuation, whereby clients will not need to transfer deposits to a new bank running under a new name.

Expected Result of Option 3

If the option to enlist Bank X as a troubled bank bears fruits in terms of finding potential bidders, the acquisition would result in crisis resolution of Bank X. Without the ability to cater to the needs of its clients, Bank X would be unreliable to the clients as it seeks to serve public interests. Considering the number of clients served by Bank X as the largest bank in the country, a continued crisis would lead to the disappointment of customers, therefore, making most of them pull out from the bank. On the other hand, there are banks seeking to expand their operations and diversify their services; the two needs can be resolved as the clients of Bank X would require shifting or closing their accounts in case Bank X is unable to serve them, while another bank would require those clients for itself. With the acquisition, the largest bank in the country, Bank X, would cease to be, as a rather larger bank, depending on the conditions of the acquisition, will purchase it – a merger of two big banks with net assets larger than its own (Ruby and Opiela, 1998).

The result of the initial merger of Bank Y and Bank Z is to create a large bank that can handle the operations of Bank X, therefore, providing a platform that serves the interests of clients to withdraw their deposits, loan, and buy shares of the bank. With the credits of Bank X transferred to Bank YZ, the joint deposit and legal reserves of Bank XY would enable the clients of former Bank X to withdraw their deposits without causing panic or unrest to the management. with the dynamics of fund transfer from a client to the bank and vice versa, a large bank made from the merger of two banks and acquisition of a third one would maximize operations so that seasonal reserve fluctuations would not be experienced, and mixed management of one side would be vigilant with the other (Owen, 1997).

Recommendation and Conclusion

In the financial sector, many decisions have to be made regarding the internal operations of a bank, as well as its ethical and financial obligations. The government through the judiciary system ensures that public institutions are managed properly and abuse of office would result in jail terms and heavy fines. However, the financial sector is not run by the government, but rather the Central Bank that coordinates the goals and objectives of the economy through the banks (Frederic and Reinhold, 1985). With the task of the Central Bank being to monitor, assess, and store for banks, most banks would turn to the Central Bank for help in case they find themselves in crisis. For this reason, it is my obligation to expand the deposit reserves of Bank X, as acquisition by any other bank would require a process not quiet certain. This is because very few banks would be able to find similar objectives that would make them want to merge with others and be ready to take up on the liability of another troubled bank.

On the option of liquidation, a bank cannot be liquidated if it is the largest bank in the country for not being able to meet deposit withdrawals. The assumption that led to this option was bad management of the bank. In result, public funds and investments of shareholders would not be mismanaged in such a vital setting of the financial sector without the intervention of the government. Remedy to this type of crisis would require a government committee to review the undertakings of the bank and installing new management body to steer the bank the right way, acceptable to shareholders and satisfying to the clients (Larry, Ofek and Stulz 1996).

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