Failure Northern Rock Case Study Analysis

The Failure of Northern Rock - A Multidimensional Case Study

edited by Morten Balling, Franco Bruni and David T. Llewellyn, Vienna, 2009

ISBN 978-3-902109-46-0
In August 2007 the United Kingdom experienced its first bank run in over 140 years. Although Northern Rock was not a particularly large bank (it was at the time ranked 7th in terms of assets) it was nevertheless a significant retail bank and a substantial mortgage lender. In fact, ten years earlier it had converted from a mutual building society whose activities were limited by regulation largely to retail deposits and mortgages. Graphic television news pictures showed very long queues outside the bank as depositors rushed to withdraw their deposits. There was always a fear that this could spark a systemic run on bank deposits. After failed attempts to secure a buyer in the private sector, the government nationalised the bank and, for the first time, in effect socialised the credit risk of the bank. It is now a fully state-owned bank.
Since then, another British bank (Bradford and Bingley – which was also a converted building society) has also been nationalised. Furthermore, the government has since taken substantial equity stakes in several other British banks as part of a general re-capitalisation programme. Of course, since Northern Rock failed the world has experienced what is arguably its most serious financial crisis ever and in the US much larger and more significant banks have failed. On the face of it, therefore, the Northern Rock crisis pales into insignificance within the global context. Nevertheless, the Northern Rock is particularly significant because it represents in a single case study virtually everything that can go wrong with a bank. As we argue in the first essay in this compendium, it was a multi-dimensional problem. For this, and other reasons, it will surely become a much-analysed case study in bank failure. It is also for this reason that the Editorial Board of SUERF decided to invite a selected group of eminent scholars to write short essays on what they judge to be some of the significant issues raised in the Northern Rock case study. We were anxious to ensure that the authors would not be exclusively from the United Kingdom and of the thirteen contributors, six are from outside the country including perspectives from the United States and Italy. All of the authors were given a completely free hand to select their own focus and no attempt has been made to coordinate or edit the contributions. The lessons to be learned are far from being exclusive to the United Kingdom. This is why the Editorial Board of SUERF has devoted this SUERF Study to this important episode in the history of bank failures.

The Northern Rock Crisis: a multi-dimensional Problem
David T. Llewellyn

The Northern Rock Crisis in the UK
David G Mayes and Geoffrey Wood

Fallout from the credit squeeze and Northern Rock crises: Incentives, transparency and implications for the role of Market discipline
Paul Hamalainen

Lessons from the Demise of the UK’s Northern Rock and the U.S.’s Countrywide and IndyMac
Robert A. Eisenbeis and George G. Kaufman

Northern Rock: Just the tip of the Iceberg
Marco Onado

Blurring the Boundaries in Financial Stability
Michael W. Taylor

Northern Rock and banking law reform in the UK
Rosa M Lastra

The Regulatory Response to the Financial Crisis
Charles A E Goodhart

Can central bank provision of market liquidity create a problem of moral hazard?
Alistair Milne

The Northern Rock affair: an analysis of the ‘teaser rate’ strategy
Tim Congdon

Additional Info
Keywords: Northern Rock, retail banking, mortgages, nationalisation, bank failure, United Kingdom, LPHI risk, lender of last resort, deposit insurance, market discipline, Countrywide, IndyMac, United States, deposit guarantees, supervisory failure, bank regulation, return on equity, business model, securitisation, financial regulation, financial stability, crisis management, banking law, insolvency, emergency liquidity assistance, cross-border bank insolvency, moral hazard, penalty rates, teaser rates, capital-asset ratios, Basel I, Basel II
JEL Codes: D14, D18, D4, E21, E5, E51, E53, E58, G18, G2, G21, G28, G32, G33, G34, G38, K2, L1, L5, L51
ISBN No.: 978-3-902109-46-0
Authors: Tim Congdon; Charles A.E. Goodhart; Robert A. Eisenbeis and George G. Kaufman; Paul Hamalainen; Rosa M. Lastra; David T. Llewellyn; David G. Mayes and Geoffrey Wood; Alistair Milne; Marco Onado; Michael Taylor
Editors: Morten Balling, Franco Bruni and David T. Llewellyn

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Study 2009/1

Table of Contents

Chapter 1
1.0 Introduction
1.1 Background information
1.2 Research problem
1.3 Purpose of the study
1.4 Chapter summary

Chapter 2
2.0 Aim and objectives of Research
2.1 Introduction
2.2 Research Questions
2.3 Structure of the dissertation
2.4 Chapter summary

Chapter 3
3.0 Literature Review
3.1 Introduction
3.2 Explaining bank crises
3.2 Weakening Economic Factors
3.3 Banks’ Regulations
3.3.1 Government Deposit Insurance Plan
3.3.2 Regulating the Deposits Interest Rates
3.3.3 Limiting Banks to Open Branches and Investments
3.3.4 Capital Requisite
3.3.5 Insufficient Reserve Requisite
3.3.6 Forbearance
3.3.7 Lender of Last Resort
3. 4. Mismanagement
3.4.1 Fraud
3.4.2 Bad Risk Management Practices
3.5 Deregulation of the Baking System
3.6 Political Interference
3.7 Market Competition
3.8 Banks failure and the macroeconomy
3.9 Summary

Chapter 4
4.0 Research Methodology
4.1 Introduction
4.2 Research method
4.3 Research strategy
4.3.1 Strengths and weakness of case studies
4. 3.2 Selecting the case study to use
4.4 Data collection methods
4.5 Sampling
4.6 Data analysis
4.7 Reliability and Validity
4.8 Chapter Summary

Chapter 5
5.0 Research Results
5.1 Introduction
5.2 Case study 1: Northern Rock bank Collapse
5.2.1 Introduction
5.2.2 Background
5.2.3 The start of problems
5.2.4 The Run on Northern Rock
5.2.5 The 2007 global financial crisis and Northern Rock
5.2.6 The end of Northern Rock
5.2.7 An overview of UK banking system
5.3.0 Case study 2: Lehman Brothers Collapse
5.3.1 Background
5.3.2 A brief history of Lehman Brothers
5.3.3 The entry into subprime mortgage market
5.3.4 Lehman’s biggest mistake
5.3.5 The collapse begins
5.3.6 Moving towards failure
5.3.7 Lehman Brothers becomes bankrupt
5.3.8 An overview the USA banking regulatory framework
5.4 Case study 3 USB Collapse
5.4.1 Background
5.4.3 Missed chance by UBS to recover
5.4.4 An overview of Swiss banking regulations
5.5 Chapter Summary

Chapter 6
6.0 Research Discussions
6.1 Poor risk management practices
6.2 Forbearance
6.3 Mismanagement
6.4 Chapter Summary

Chapter 7
7. 0 Conclusion

Chapter 8
8.0 Recommendation of the research
8.1 Suggestions for future research
8.1.1The effects of subprime mortgage market


Chapter 1

1.0 Introduction

The introduction chapter presents the background information of the study “why banks fail: A case study of Northern Rock, Lehman brothers, and Union Bank of Switzerland (UBS)?” This is then followed by the problem statement and purpose of this research.

1.1 Background information

Bank failures are common occurrences that happen in many countries across the world; certainly each country has witnessed one of its bank failure at one point or another (Basu, 2002). The cost that accompanies bank failure can be huge, and this destabilises the financial system of a country, which consequently impacts the country’s economic growth rate. Accordingly, the government or the central bank of the concerned country has to intervene by providing a rescue deal for the collapsing banks. However, such rescue deals are costly and difficult to provide particularly in this competitive business environment (Donaldson, 1993). Though, banks failure seem to occur more in those countries that have liberalised their financial markets and carried out deregulated, there are also common in countries where banks have dished out bad loans and undertaken a high percentage of non-performing loans, a common aspect in countries that were in the past highly regulated and depended on government subsidies to survive.

This brings us back to our question; why do banks fail? Owing to the experience learned from the Great Depression, many scholar such as Wigmore (1987), claimed that bank failures, mainly arose from the panic by depositors, which results in a run on the bank. According to Wigmore (1987) the cause of this panic may be due to speculative attack on the stock of the banks, or as noted by Diamond & Dyvbig, (1983); Donaldson (1993) illiquidity shocks, or according to Calomiris & Gorton (1991) due to shocks suffered by the banks’ asset value. From the above causes, one can note that the main cause of depositors’ panic is information asymmetry that exits between the banks and their depositors. The consequence of this is that the depositors are unable to know whether a particular bank is stable or unstable. However, the depositors can watch the effect of the shock on the bank’s portfolios, which lead in a run on that particular bank, resulting in bank failure (Bhattacharya & Thakor, 1993)

When a bank fails, stakeholders normally suffer negative consequences, besides the consequences suffered by the failed bank. At times the consequences are also suffered by the non-banking industries. As observed by Smith & Walter (1997) a bank failure results in loss of employment and livelihood, financial growth as well as other related public interests. Hooks (1994) contributing this subject underscores that bank failure greatly affects the economy in a negative way, and therefore it should be examined very critically.

Kaufman (1996) has also stressed the bank failure and the associated consequences. Accordingly, Kaufman (1996) states that banking failure creates losses to stakeholders through the interference that occurs to the settlement system; more so, it has a systemic impact on the whole economy. Similarly, Caprio & Klingebiel (1999) in their study of 114 cases of bank failure in 46 countries, they established that bank failure has negative impact on the economic development.

Northern Rock was the one of the biggest casualty of the global financial crisis that occurred between 2007 and 2009. During this period, the bank faced liquidity problems, and was forced to borrow from the Central Bank of England to resolve its liquidity issues. However, things did not change and depositors got afraid of the situation promoting them to withdraw their savings from the bank. This resulted in a bank run, and Northern Rock had to be nationalized in 2008 (Stucke, 2008). In an attempt to resolve the financial issues surrounding the bank, the bank was privatised in 2011 to Virgin Money.

Lehman Brothers became bankrupt on 15th September 2008. At that time the bank had an assert base worth 639 billion dollars and debts worth 619 billion dollars. As noted by, the bankruptcy of Leman was the biggest in history of bank failure, since its asset was much more than those of past bankrupt huge organisations such as WorldCom and Enron. Indeed, Lehman Brothers was the fourth-biggest American investment bank when it collapsed. At the same time, Lehman’s collapse as well marked the largest victim of the US financial crisis that affected global financial markets. According to (2009), this was an changing moment that highly worsened the 2008 financial crisis and resulted in a loss of about $10 billion trillion in terms of market capitalization from global financial market (, 2009).

UBS is the biggest Swiss bank with a global presence in more than 40 countries (Krystof et al., 2012). The bank has been in operation for more than hundred years. UBS offers usual banking services (e.g. saving and deposit services), investment banking as well as wealth management services. The bank as many Swiss banks, is known for its confidentiality and fidelity. When Union Bank of Switzerland and Swiss Bank Corporation merged in 1988, it became UBS (Krystof et al., 2012). This merger saw UBS outgrow the market considerable in profits and assets; a high proportion of its growth was from its investment division. As at 2006, UBS was one of the biggest banks globally with more than $2trillion worth of assets (Krystof et al., 2012). However, in 2007, UBS reported huge losses and faced similar financial crisis as Lehman brothers and Northern Rock. Matters worsen in 2008 when UBS posted a loss of more than 30billion Swiss Francs. This was the biggest corporate loss in the history of Switzerland. The Swiss government had to step in mid-2008 and bail out the bank (Krystof et al., 2012). . UBS loss shock the whole Swiss banking industry and affected the economy greatly is banking is the main global asset of Swiss (Krystof et al., 2012).

Various theories have been formulated by different scholars to explain the causes of bank failure. Hook (1994) citing Kindleberger (1989) states that bank failure are caused by rapid increase of bank credit. However, some like Calomiris & Gorton (1991) have argued that bank failure results from government involvement. According to Palubinskas & Stough (1999) bank failure is caused by several factors including, legislation, mismanagement, poor management and deposit insurance. a view shared by Hempel & Simonson (1999) who agree that mismanagement, governmental involvement and regulation interference contribute to bank failure. On his part Chu (1996) claims that free banking is one of the causes of bank failure.

1.2 Research problem

It is important for the researcher to identify and describe the research topic when writing a dissertation (Yin, 1994). This means that the researcher has to take enough time to describe the research problem. In addition, Yin (1994) recommends that the research topic has to be logical and structural so that it can address the questions regarding what, who, why, where and how. This allows the researcher to formulate the correct approach to use.

As stated before in the background information section, increase in bank failure has lead to many economists, bankers, regulatory bodies and even governments to take more great interest in this issue because it affects financial stability of a country. Chu (1996) notes that there is a general acknowledgement that banks are crucial element in economy and bank crises cost the entire economy thus, need for banking stability. Banks accepts deposits from their customers and also gives loans to these customers; this means that they are financial intermediaries. A part from that, banks also allows their customers to pay bills through their accounts making them central in the payment system. these functions and many more that are undertaken by the banks makes them to a play an important and critical role in monetary policy of a country and their failure begs us to ask of research question:why do banks fail, a case study of Northern Rock, Lehman brothers, and Union Bank of Switzerland (UBS)?

1.3 Purpose of the study

The main rationale of this study is to establish why bank fail with special attention to three banks; Northern Rock, Lehman brothers, and Union Bank of Switzerland (UBS). Banks as financial institution contribute a lot to the stability of a nation’s economy. However, in the recent past the numbers of banks that have collapsed have been on the increase. Thus, the need to re-examine the causes of bank failure, more so, the present research will provide additional understanding and knowledge to this subject.

1.4 Chapter summary

In summary, this chapter has provided the background information on causes of bank failure. In addition, the chapter has outlined the problem statement, purpose of the study. As noted in the earlier sections, bank failure results in considerable financial impact to the economy and negative impacts to other stakeholders. These huge costs from bank failures necessitate the need to examine causes of bank failure. Several theories have been formulated to explain the causes of bank failure; these theories will be tested against the case studies.

Chapter 2
2.0 Aim and objectives of Research

2.1 Introduction

This chapter takes up from chapter one and outlines the aims and objectives, research questions and also gives that the structure of the whole dissertation.

The research will be aimed at investigating the causes of bank failure. Further objectives of the proposed research are as follows:

The main aim of the present research is to examine why banks fail. Other objectives of the research are stated below:

- To examine the concepts of causes of bank failure in the past literature
- To study the causes that resulted in Northern Rock bank, Lehman brothers, and (UBS) Union Bank of Switzerland failure
- To investigate the impact of macro-economy (subprime crisis) on the case study banks (Northern Rock, Lehman brothers, and Union Bank of Switzerland UBS

2.2 Research Questions

As mentioned by Yin (1994) research questions are very crucial for examining research problem in the right direction of the study. Accordingly, this research presents the following research questions.

- What are the concepts outlined in the literature that causes bank failure
- How did Northern Rock, Lehman brothers and UBS (Union Bank of Switzerland) fail?
- What caused bank failure of Northern Rock, Lehman brothers, and (UBS) Union Bank of Switzerland?

2.3 Structure of the dissertation

The dissertation is arranged in 5 chapters as follows:

i. Chapter 1: Introduction: this chapter opens the with research paper by providing the background information of the dissertation, outlining the research problem, the rationale, and the aim and objectives of the study
ii. Chapter 2: Literature review: this reviews the past literature on history of bank failures and theories of bank failure
iii. Chapter 3: Methodology: this chapter describes the research methodology, instruments and techniques adopted by this dissertation to gather and analyze the data
iv. Chapter 4: Data analysis: Describes both qualitative and quantitative techniques to be used in presenting and interpretation of the data and explains the findings based on the case studies and the literature review
v. Chapter 5: Conclusions, Recommendations: This is the last chapter; it summarizes the findings the first four chapters as a conclusion, and provides recommendation based on the findings of the research.

2.4 Chapter summary

This short chapter has outlined the aims and objectives of the study, the research questions and the structure of the dissertation. As stated in the aims and objectives, this research aims at finding out why banks fail.

Chapter 3
3.0 Literature Review

3.1 Introduction

The following chapter will review the theories regarding why banks fail and past studies on why banks fail. It is important for the various stakeholders including customers, regulators and the management to understand the causes behind bank failures. Such an understanding will help the take stakeholders take an active role in preventing bank failure. Bank fail particularly concerns the management and the external regulators including the government. As noted by Hook (1994) when a bank fails, managers loss their jobs, the regulators shoulder the blame, and the government is expected to intervene. Similarly, other stakeholders should as well understand the causes of bank failure to be able to prevent it before it occurs. Certainly, when banks failure happens, all stakeholders suffer.

3.2 Explaining bank crises

How does bank failure occur? Though there are many ways in which banks fail, there is one common denominator of bank failure, the inability of banks to provide funds that depositors want. Boyd & De Nicolo (2005) explains that this will not create any problem supposing the rate at which the bank is growing in terms of deposits is more than the deposit interest rate. As noted by Wheelock & Wilson (2000) in such a situation, depositors are in essence transferring money to the banks, and the banks are able to maintain they liquidity even when they include all their loans.

Nonetheless, supposing the rate of growth of banks deposits is below that of the deposit interest rate, it follows that banks have to make a full transfer of funds to depositors. For this to happen, banks must transfer funds from their borrowers (debtors), or use their liquidity funds. According to Boyd & De Nicolo (2005) problems happen when the amounts required to be transferred is very high. This could be cause by high local interest rate, or due to low or negative deposit growth rate making it impossible for banks to get the demanded funds from their borrowers of their liquidity funds.

In theory, banks can get the demanded funds by merely requesting those with loans to pay back (Mannasoo & Mayes, 2009). But, in reality, this cannot happen because whatsoever the set maturity dates of the loans, borrowers would view an abrupt demand of credit as very disruptive. Supposing the market is going through a credit crunch, corporate borrowers can be able to pay their loans if the credit crunch does not last for long, by cutting down some of their activities. However, if the credit crunch is prolonged, the corporate borrowers may be forced to default on these loans (Boyd & De Nicolo, 2005). Some of the causes and concepts of banks’ failure are discussed in the following section.

3.2 Weakening Economic Factors

According to Hook (1994) weakening economic factors affecting the local market such as high interest rates and inflation contribute to bank failure. This view is supported by Eisenbeis (1986) who claims that macroeconomic factors, for example, abrupt negative changes in a country’s trade balance and instability in world interest rate worsen the banking environment leading to bank failure.Similarly, Gooldhart et al (1998) add their voice on this issue by restating that interest rate instability result in banking failure.

3.3 Banks’ Regulations

Eisenbeis (1986); O’Driscoll (1998) both agree that government regulations and interference contribute to bank failure. Contributing this viewpoint, Hempel and Simonson (1999) asserts that when a government gets involved in bailing out a bank from collapsing, customers and creditors seem to depend on the government to also safeguard their welfare. Hempel and Simonson (1999) ague that the involvement does not motivate other bodies, customers and creditors to successful check their welfare (interests) in the banks in a self-determining manner. Goodhart et al., (1998) highlight the various situations that could result in a bank collapse. Enactment of very many strict rules could result in banks overlooking these rules since the banks may view them as unnecessary. A number of risks that affect banks may be very complex to be tackled through laws and regulations. A strict and inflexible framework of rules and regulation could prevent banks from choosing the most efficient strategy of attaining regulatory objective set and this may de-motivate banks from seeking improvement of their operations (Goodhart et al., 1998)

Likewise, ineffective regulatory framework contributes to bank failure (Spollen, 1997). Hooks (1994) points out that the banking industry does not require government regulations since they do not bring any advantage.

3.3.1 Government Deposit Insurance Plan

According to Goodhart et al., (1998) where there is no any attempt to assist banks facing financial problems; such banks are likely to suffer depositors’ runs. Still, when a government offers full deposit insurance plans and other measures meant to rescue banks, it was observed that stakeholders get put off from checking the activities undertaken by the intermediaries. That responsibility of checking is left to the bank only. This explains why industry regulators safeguard the interest of stakeholders and the general public by advocating for less risk-seeking activities. Hooks (1994) point out when banks are given fixed-rate deposit insurance; it encourages them to invest in risky ventures.

Hook (1994) further notes that flat-rate fee deposit insurance also motivates banks to undertake risky ventures. Similarly, Palibinskas and Stough (1999) supports Hook (1994)’s arguments by stating that insurance plans leads to unpaid loans, owing to the fact that banks and customers do not suffer any loss when deposits are poorly invested or lost through corrupt ways. The same note White (1993) observed that in cases where the government offers a deposit insurance plan, cases of incompetent management and frauds are common even if regulations are tight.

3.3.2 Regulating the Deposits Interest Rates

It has been pointed out by Selgin (1996) that the objective of setting a ceiling on how high deposit interest rate can be charged by banks is to stop banks from taking large amounts of deposits by offering borrowers huge amounts of funds that bring big interest earning to these banks. According to Hooks (1994) a ceiling on deposit interest rates encourages banks to undertake risky businesses. More so, banks usually attempt to overlook the ceiling by provision of additional services to depositors, ultimately leading to increased transaction costs and reduced earnings. Accordingly, Selgin (1996) asserted that rather than reducing the possibilities of bank failures, setting ceiling on deposit interest rates decreases the capacity of banks to mobilise funds in cases where they become illiquid. Thus, Selgin (1996) argues that such a regulation of deposit interest rates works against banks, hence can contribute to bank distress.

3.3.3 Limiting Banks to Open Branches and Investments

Limiting banks to certain geographical areas creates a major threat to their operations (Selgin, 1996). More so, Selgin (1996) enumerates that these kind of restrictions have the following consequences on the banks; increases the exposure to various threats; increases systemic risks, while blocking market forces from circumventing failures. All these aspects increase the possibility of bank failure.

In related observations, Hooks (1994) reports that branching limitations could limit banks from expanding their investment ventures in various locations and regions. Hooks (1994) adds that this geographical limitation, together with restrictions on investments limits diversification efforts by banks. Contributing to this aspect, Goodhart et al., (1998) observes that lack of proper diversification in operations result in bank collapse. According to Hempel and Simonson (1999) when banks are restricted in terms of opening branches, their capacity to mobilize enough amounts of steady retail deposited is limited. This kind of a situation forces banks to depend heavily on unsteady funding sources that come from money market creditors. Hooks (1994) underline that banks may apply the freedom they have on flexible investment to concentrate on restricted higher-risk ventures.

According to Selgin (1996), though the objective of geographical restriction is to prevent banks from undue clustering and control competition, such an objective overlooks the benefits brought by bank branching as well as the significance of competition within the industry. Selgin (1996) (citing White, 1986) argues that branching restrictions increases the bank’s exposure to risks for both its liabilities and assets. Similarly, branching restriction regulations have encouraged banks to venture in risk-taking activities. Others regulations have as well restricted banks from venturing into various banking activities.

Thus, regulation on branching restriction contributes to bank failure, since banks’ capacity to avoid risk is restricted, and this compels banks to venture into risky activities (Selgin, 1996). Accordingly, Selgin, (1996) views this restriction on branching as very hard hitting.

3.3.4 Capital Requisite

According to Hooks (1994), the fewer amounts a bank has in terms of capital, the higher its chances to collapse. This viewpoint is supported by Goodhart et al., (1998) who state that when a bank’s capital reduces, it forces such a bank to get engaged in survival activities, which results in the bank undertaking risky activities. Thus, the probability of failure increases with the decrease of capital. Similarly, Palibinskas and Stough (1999) as well assert that one way of preventing bank failure is increasing the amount of capital banks should hold. This stipulation forces banks to increase the capital they hold, or merge with other banks or stop banking operations. As noted by Hooks (1994) capital is necessary since it cushions the banks from the losses they suffer. In situations where banks have insufficient capital, they normally hide this from stakeholders and the public fearing to reveal their illiquidity.

However, if the management and regulatory bodies do not successfully tackle capital reduction before it worsens, the concerned bank may go under. Goodhart et al., (1998) agrees with this observation by stating that sufficient capital lowers risk-taking ventures, whereas inadequate capital encourages banks to undertake activities meant to ensure their survival, even when such activities are very risky.

3.3.5 Insufficient Reserve Requisite

White (1999) explains that a reserve requirement entail a percentage of cash in terms of net deposits, which banks are required to keep. This measure ensures that banks operate in a prudential way and there is fiscal control on ventures undertaken by banks. In addition, a government requires banks to reserve some funds so as to enhance the real need for base money. Hooks (1994) contributes to this point by stating that bank failures occur because banks fail to maintain their deposits in accordance to reserve requirements.

3.3.6 Forbearance

As explained by Hempel and Simonson (1999) a number of regulatory bodies have regulations that allowing forbearance. However, this worsens bank crisis by allowing banks going through financial difficulties to continue with operating instead of liquating such banks. The objective of forbearance is to help banks recoup some profits. But, this negatively impacts the banks since they normally do not have enough capital to operate healthily, and as they continue their operations, they continue to loss the little capital they are left with.

3.3.7 Lender of Last Resort

Most countries use their central banks, which are lender of last resort to assist banks going through financial difficulties (Selgin, 1996); (White, 1999). However, when more banks face financial problems, the amount of money reserved to assist these banks reduced. The government then is left with limited options; it can either increase the amount in reserve or combine the banks going through financial difficulties. nonetheless, if banks know that they central bank will always to be there to assist when they are going through financial difficulties, they will be encouraged to get involved in risky activities that can result in their collapse.

3. 4. Mismanagement

Spiegel et al (1996) note that management determines the success of any business. Indeed, mismanagement is blamed for causing several banks failure in the 1980s and at the start of 1990s (Spiegel et al., 1996). According to Spiegel et al (1996) banking crisis usually arise from the lack of effective management and poor decisions taken by management. Thus, competency of the managers and focus are important in banking. White (1993) observes that mismanagement, particularly extreme risk taking by the management, is the leading cause of bank distress. White (1993) further points out that even though the management is blamed for mismanagement, it is hard to ascertain that the laxity of management is the sole reason for bank failure.

In a study carried out by Spollen (1997) he established various issues that causes businesses to collapse, which can be applied to the banking sector as well. They include:

- Failure of management to value and management a business
- Failure of management to conform to regulations. In most cases where a business collapses, the failure is blamed on absence of policies, and where policies are in place, they are either inadequate or are not followed
- Lack of enough staff, especially in middle management positions, which can lead to existing employees to be overworked, which may ultimately result in the failure of the business
- Failure of businesses to apply basic control processes
- Lack of involving internal audit in formulation of policies and procedures made by the board of directors
- failure of the board of directors to effectively deal with issues raised by audit (both internal and external)
- Over-dependence on a few staff members. In many cases businesses are swindled by workers employed in these businesses, in many cases those with long serving years who are trusted by the businesses (Spollen, 1997).

Heffernan (1996) supports Spollen (1997)’s observations by stating that there are practical cases such as the collapse of Barings Bank, which was blamed on fraud by employees. Goodhart et al (1996) contributes to this debate by stating that supposing employee compensation is related to performance, and yet his performance is below par, the manager may fabricate the performance because of being afraid of getting sacked. Such a move could finally contribute to bank failure for (example what happened to Barings Bank). According to Palubinskas & Stough (1999) asserts that a shortage of skilled and experienced bankers in various fields such as credit management, risk appraisal, evaluation of cash flow and financial management, contributes a lot to loan defaulting. Palubinskas & Stough (1999) further note that lack of competent professional results in a situation banks fail to effectively perform credit evaluation. At times bankers merely enforce and monitor credit manual, which is ineffective and difficult to update. This position is supported also by Goodhart (1998).


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