Failed Financial Institution: Events, Causes, And Regulatory Response - Essay.

Events Leading to the Failure

Discuss about the Case study of a failed (or troubled) Financial Institution.

A financial institution refers to an entity or establishment with a responsibility of conducting financial or monetary transactions such as deposits, loans, investments and currency exchange (Gieve& Provost 2015, p. 61).  Research has shown that financial institutions play a very important and unique role in the economic process. A strong linkage has also been proved evident between financial sectors of the economy and the economic growth (Eichacker 2016, p. 21). The failure of financial institutions is a phenomenon that has seriously characterized the history of economic growth and development of many developed and developing nations. Other than the economic consequences of the financial crisis in an economy, the banking public has also suffered tremendous psychological, emotional, social and financial problems. The essay, therefore, will provide an analysis of case study of a failed financial institution in a bid to understand the events leading to the failure, the causes of the failure and the regulatory response to the failure.

A financial institution can be said to be struggling or experiencing a failure when it’s unable to meet the obligations of its depositors and creditors because of insolvency and inability to meet its liabilities. Economically, financial institutions are said to be in a state of failure if the market value of its assets falls to a value which is considerably lower than the market value of its liabilities (Darrat et al. 2016, p. 164). Just as the global economic and financial crisis of 2008, any financial crisis to any nation would have adverse effects if not addressed with the relevant regulatory and policy frameworks. The case study in this essay will examine the events and causes of failure financial institutions in the Republic of Iceland, which lead to the collapse of three banks as denoted by Dewing and Russell (2016, p. 165).

The events leading to the failure of the banks were all attributed to the financial crisis 2008 and the meltdown of the Iceland economy (Mcllroy 2008, p. 285). Dewing and Russell (2016) also assert that it took a period of five years since the privatization of the banking sector in Iceland in 2003 to its collapse in 2008. The fall or failure was considered and placed 3rd among the history of bankruptcies of banks in the US.  Later the government had to play a role in the regulation of the activities of the financial institutions. It is from the same domain, where the Special investigation Committee conducted a research to understand the causes of the failure of the banks despite government intervention in solving the already existing financial crisis.

Causes of Failure

The first cause of failure was the issues related to the growth of the banking industry and its credibility. Sigurthorsson (2012) denotes that over that period, the lending portfolio and balance sheets of the banks had grown immensely and to a level that could not be controlled. As a result of the growing portfolio, the management and the supervisors of the financial institution could not keep up with the rate of expansion of lending services which was growing rapidly. It was therefore not reasonable enough to keep such a high risk growth as it was incompatible with demands and long-term interests of growing banks. Also the financial, monitoring and evaluation bodies did not grow significantly as the partner’s rate of growth of its partners and as a result, they were not able to perform its task of regulation and control as required (Johnson 2012, p. 12).

These banks also suffered from increased margins of foreign debts, these were especially sought from the European debt securities market and others at the American debt securities market. The underlying reasons for this economic behavior were due to the existence of good credit rating and also the access to potential markets in Europe (Sigurhorson 2012, p. 148). Research has shown that these three banks had a magnitude of 14 billion in foreign securities market a debt which was more than the country’s GDP. The special investigation committee was of the opinion that, the decision to borrow from these foreign securities was done with too much haste and hence the reason for the failure. The market forces of demand and supply could have led to the reduction of the interest rates, because if the interest rates go up then access to borrowing becomes more difficult. Due to lack of management action on the increased foreign debt, by 2007, the banks were in a serious crisis of finding ways to finance the debt securities.

Thirdly, there was too much concentration of risks in the financial institutions centrally to the principle of diversification of risk which is very important in the operations of the financial institutions or banks. For example, the Bogor group and affiliated companies had securities in all the three banks. The financial institutions should not take too much risk because of one party such that the general performance of that bank is depended on the performance of the group. The behavior can end up proving to be very harmful to the depositors and other creditors of the bank in the event of a loss (Angeliech 2014, p. 5).

Regulatory Response

The financial institutions experienced a failure also because of the weak equity base. According to Suetin (2012), equity capital is a very important asset in the operations of the financial institutions and bears a great influence on the ability of the banks to finance its operations weak equity is characteristic of loans with collateral in own shares and forward contracts. Therefore,the study showed that financing of the owners’ equity from borrowing from the system itself threats the stability of the financial institutions. So these banks were using most of their equity in financing their debts, which destabilized the institution. The other reasonfor failure and collapse of the institutions were the incentive schemes. The SIC report showed that from 2004 to 2008 that the management and other staff of the banks had a link to their price stock which was way above and beyond what was considered acceptable for a good incentive scheme (Iceland.org, 2010).

Lastly, the financial institutions kept a higher record of foreign currency loans according to the Iceland's Meltdown Report (2011, p. 56). Research has shown that by doing so the banks were creating foreign exchange risks. There was also the problem of external audits. During the fiscal years 2004 to 2004 that were the annual accounts of the financial institution. The performance was endorsed without reservations by auditing firms by which the decision to use them was a choice of elected by the shareholders of the financial institution. A report by another audit showed that these financial statements did not reflect or give a true picture of their financial information status of the banks which then misguided the user of those financial statements both the internal and external users.

In response to the financial issues which led to the collapse of the three major banks in Australia, the government of Iceland formed a consultative group which was to discuss and find appropriate measures to revive the operations of the banks and the economy at large. The consultative group composed of the ministry of finance,prime ministers’office, ministry of business affairs, the central bank of Australia, and the FME. Through a series of discussions and engagements with different stakeholders and experts, the consultative group in February 2007, through the credit rating agency, had upgraded its policies on the long term credit of the three banks, this lead to the fall of the exchange rate of the Iceland Krona as well as the domestic prices (Iceland.org 2010).

Impact of Failure

It was the efforts of the consultative group, which also ensured that the government does not ignore the issues of the Iceland banks but communicates them to abroad economies for assistance. The initiative led to a special meeting by ambassadors on February 22nd, 2008, with the sole purpose of deliberating the financial sector under the economy of Iceland. And eventually, the problems associated with the equity of the banks and also the liquidity was addressed by the central bank of Iceland (CBI).

In a bid to remedy the financial crisis, Johnson (2012) denotes that the regulatory authorities, guided by the supervisory board of central bank of Iceland held a meeting on 23rd of May 2008.  It was found that 170 billion of the guarantees of the CBIs collateral loans were debt securities and the banks were suffering from foreign debt securities especially from the American debt securities market. These securities were issued for each other and in any case, they were to be submitted when the collateral loans were acquired. Through the intervention of the finance minister Mathieson, who presented a bill to parliament that would authorize the treasury of Iceland to acquire a foreign loan of UK 500 billion; the bill was then passed on the 29th of May 2008. Such initiative allowed for banks to borrow internally and eased the burden of foreign debt as the treasury through the central bank of Iceland was to control the lending activities of the bank (Darrat et al. 2014, p. 56).

There were some main weaknesses in corporate governance and supervisory in the financial crisis, this involved weaknesses of the risk management systems and lack of qualified board oversight as well as a robust risk management team (Sietin A, 2009). The corporate governance did not safeguard against risk taking which eventually led the financial institutions to foreign debt risk and concentrated risk instead of risk diversification.

Conclusion

Financial crisis needs to be addressed when they occur by laying down economic policies and strategies which will solve the problems effectively. The case study of Iceland financial crisis foreshadows the major events, causes and the social responsibility of the corporate governance in addressing any financial crisis globally, the initiatives may not necessarily be similar but there exist a causal effect relationship. A firm's understanding of the inherent risks is very important because for the Iceland banks the liquidity risks should have been taken into consideration in the first quarter of 2007, this would have prevented further outcomes in 2008. There is also need to understand and control over all the potential balance sheet growth and liquidity needs. A limited knowledge on these would have severe effects in case of a crisis. Lastly, there should be a coordinated approach to the management of the financial institutions in assessing the firm's wide risk exposures.

References

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