Financial distress and bank failures in Ghanaian banking system (PT 2)

…lessons from the dissolution of UT Bank and Capital Bank

2 (i) Financial Distress

Financial distress is the situation when a bank cannot meet or face difficulty to repay off its financial obligations to the creditors. The chances of causing financial distress increases when fixed costs are high, assets are illiquid, or revenues that are too sensitive to economic recessions. Bank financial distress can be described as a situation where the bank experiences a cash flow constraint, for one reason or another.  This constraint or cash flow shortfall can be of a temporary nature, provided that bank management has the capability and ability to take timely corrective action.

An example of corrective action is to negotiate an increased or bridging funding facility without it necessarily having a negative impact on its longer- term gearing.  Financial distress can be sub-divided into four intervals: deterioration of performance; failure; insolvency and default. Whereas failure affect the profitability of the bank, insolvency, and default are rooted in its liquidity. Theoretically, the outcome of each interval can be positive, implying that the bank breaks the downward trend, or negative indicating the continuing deterioration of the bank value and a movement downwards from one sub-interval of the spiral to another.  The bank’s inability to honor its immediate debt obligation, implying commercial insolvency, can ultimately result in the bank becoming factually insolvent where its total liabilities exceed its total assets.

(2ii) Bank Failure

Bank financial failure or factual insolvency results in the company’s affairs being wound up, whereby its assets are sold in execution and the net proceeds, if any, distributed amongst creditors.  Those creditors who have submitted claims against the insolvent estate could receive a liquidation dividend, partly or in full repayment of their claims.  This, however, is dependent on the ranking amongst the creditors – a secured creditor has a higher ranking than a preferential creditor, who in turn is ranked higher than an unsecured or concurrent creditor. The process where a company experiences financial distress over the short term and progresses over time into a situation of imminent failure is best demonstrated on a financial distress continuum.

 (2iii) Financial Distress Continuum

On a distress continuum (Cybinski 2001), financial distress can be of a temporary nature at the one end, or over time become more of a permanent nature at the other end.  Temporary financial distress could potentially be the result of several factors.  On the one hand, for example, delayed payment by a major debtor or the temporary suspension of an off -take agreement.  On the other hand, the company may have concluded a major new contract and experience temporary cash flow constraints due to the mismatching of working capital components during the project start-up phase.  Long term financial distress may inevitably lead to the company failing and its affairs being wound up.    On the distress continuum, early detection of financial distress is crucial as it could potentially increase the likelihood of returning the company to financial health.  The chances of returning the company to financial health diminish over time if inappropriate or no action is taken to remedy the distress situation.

3) Theories on causes of financial distress and bank failures

This section analyses and reviews the theories on some of the factors behind bank distress and failures. It is very useful for all stakeholders including regulators, government, academics, and researchers in the banking sector to know what causes a bank distress in order to prevent the failure.  Banking failures are particularly harmful for the economy and detrimental for the health of financial sector. Its fiscal burden is only a redistribution of resources within the economy. But the real cost of banking failure is dead weight loss and the consequent diversion in macroeconomic policy forced by the failure. The issue acquires another significance in the context of banking, as it can potentially inflict reputation damage to the nascent industry.

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The literature on financial distresses and bank failures identify that banking structure is inherently unstable and therefore, itself contributes to the occurrence of crisis (Diamond & Dybvig,1983; Bryant,1980). Being a deposit taking institution, the liabilities of a bank, at a given point in time, are fixed and a fixed interest is promised on them, whereas its assets are in the form of loans earning variable interest and subject to credit risk. This also leads to interest rate risk. Similarly, its demand deposits by nature are of shorter maturity while its loans are for longer duration. Therefore, there always exist a risk of maturity mismatch.

These features of the assets and liabilities render the banking sector prone to crisis in the wake of any shock, or decreased confidence of the depositors.  The literature on financial distress and bank failure can be attributed to both exogenous and endogenous factors, and endogenous factors include managerial ineptitude, insider abuses and malpractices, meddlesome interference by principal shareholders, weak internal control systems undercapitalization and so on. The exogenous factors include macroeconomic instability, regulatory weaknesses and policy induced shocks.

There is a vast of literature comprising of competing theories on macro and micro level causes of financial distress and bank failure. Caprio and Klingebiel (1996) point out that micro economic factors can be divided between (i) what is internal to the bank and (ii) what is external to the bank, which includes the banking environment, regulatory factors and behavior of bank customers. Lower (1997) provided a list of both internal and external factors. Lower (1997) suggest that internal factors include poor business model and strategy, poor credit risk assessment, concentrated lending and excessive risk taking, connected or related lending, entering into new business lines, internal control failures and other operational failures.

Lower (1997) also provided a list of external factors to the bank such as inadequate supervision and weak enforcement, regulatory forbearance, inadequate infrastructure, financial deregulation policies, weak accounting standard practices and poor disclosures and inefficient external audit practices. Macro-economic factors include persistent budget deficits, high inflation and high interest rates, currency depreciation and deterioration of terms of trade.

The issue especially concerns board of directors, senior management and regulators are also be considered as micro factors that could affect the distress and bank failure.  This is because most directors and senior management are sanctioned and punished in some jurisdictions while in the other jurisdictions such as Ghana both directors and senior managers go scot free. For regulators are blamed whenever there are bank distresses and failures. It is therefore for all stakeholders to understand the theoretical underpinning for the causes of bank distress and failure in order to help them to prevent crisis. Furthermore, the economic and social costs of bank failure could be high especially in the absence of robust deposit protection or insurance scheme. The social costs of a bank failure could be bigger than the economic costs incurred by the failed bank. The consumers could lose confidence in the entire financial system. There is a vast literature comprising of competing theories on macro and micro level causes of bank distress and failures.

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One notable cause that has contributed to the spate of financial distress and bank failures globally has been the issue of bad loans. According to Michael et al (2006) opined that asset quality is a critical determinant of sound functioning of the banking system. Risk assets can turn into non-performing loans when borrowers default on their repayment of both the interest and principal on maturity date. Asset quality impairment is caused by several reasons. According to Misra and Dahl (2010), unusual business cycle is a primary reason for most banks’ non-performing assets.

Kent and Davcy (2000) argued that the potential for banks to experience substantial losses on their loan portfolio increases towards the peak of the expansionary phase of the cycle. However, towards, the top of the cycle, banks appear to be relatively health, when the quality of non-performing loans are satisfactory and profits are high, reflecting the fact that even the riskiest of borrowers tend to benefit from buoyant economic conditions. While the risk inherent in bank lending portfolio peaks at the top of business cycle, this tends to be realized during contraction phase of the business cycle.

As the banks’ non-performing loan increases, profit declines and substantial losses to capital may negatively affect the capital adequacy. De Bock and Demyanets (2012) averred that the herds of behavior of bank managers can lead to a deterioration of credit standards during economic booms, as credit mistakes are judged more leniently. Gopalakrishnan (2005) submits that the causes of non -performing loans can be classified into political, economic, social and technological reasons. He observed that the neglect of proper credit appraisal, lack of monitoring and follow-up, poor credit administration, recessional pressures in the economy, change of government’s monetary and fiscal policies, and diversion of funds are some of the major causes of non-performing loans which could ultimately cause financial distress and bank failures.

Reddy (2002), however, notes that the problem of non-performing loans are not mainly because of lack of strict prudential norms, but due to legal impediments and time- consuming nature of assets disposal process, postponement of the problem by the banks to show higher returns on assets and manipulation by debtors using political influence. A study by Aggarwal and Mittal (2012) noted that improper selection of borrowers’ activities, weak credit appraisal system, industrial problems inefficient management, slackness in the credit management and monitoring, lack of proper follow up are major reasons for high non-performing loans. Non-performing loans affect the operational efficiency which impacts negatively profitability, liquidity and solvency positions of the banks. Non-performing assets generate a vicious cycle of effect on the sustainability and growth of the banking system and if not managed properly could lead to both financial distress and ultimately bank failures.

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