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1. Introduction

1.1 Background

The financial health of the bank industry has been a significant prerequisite for the global economic growth and stability. Consequently, the prediction of the bank conditions is a fundamental target for administrators. It is known to all that there was a bank failure in 2007-8 which involved with the global financial crisis. The main reason of the bank failure is the housing bubble in U.S.A. However, the housing bubble could have been foreseen. Concerns were raised in 1999 when Fannie Mae, responded to increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and pressure from stock holders to maintain its phenomenal growth in profits. (Holmes 1999). Unfortunately, people did not pay enough attention to such a warning until the failure has happened.

According to the global financial stability report (2003), the GDP of U.S.A only rose to 0.8% in 2001 while its GDP grew to 4% during 1997-2000. As a consequence, the Fed began to cut the interest rate in January 2001 and this period last for 3 years. The interest rate fell to 1% in June 2003 which is the lowest level in 45 years. Subsequently, the U.S.A entered the cycle of increasing interest rate due to the concerns of inflation. However, the low interest rate cycle has already lasted for 3 years.

Since the 1980s, the United States, Japan and the Nordic banking crisis has indicated that the incentive of banking crisis is a long period of loose monetary and large inflow of funds into real estate is the main cause of banking failure. Besides, the bank regulators relax to supervise the risk asset would increase the probability of bank failure.

For that reason, can we seek to assess some literatures which could have helped to predict the crisis in order to avoid this unnecessary crisis?

2. Prior literatures help us to forecast

2.1 The breakthrough of forecasting bank failure

It is common knowledge that loose monetary policy will normally lead to inflation which will lead to social instability so that the market price system will be disrupted. Normally, the government has to change the monetary policy in order to away from the inflation. However, U.S.A had remained at a relatively low CPI index level during the 2000-2003 when its asset price still stood at a high level. Because of this interesting phenomenon, U.S.A government implements the loose monetary policy in the long time. That is a prerequisite for the formation of banking failure.

2.2 Capital ratios forecast bank failure

Estrella (2000) has proved that failing banks begin to show signs of weakness in terms of its risk-weighted ratios, leverage ratios, gross revenue ratios before they failure. Specifically, risk-weighted ratios is an attempt to reflect heterogeneous return variances across assets and the gross revenue ratio reflects the asset risk to the extent that riskier assets have higher expected returns.

As is shown in the graph, the U.S.A bank industry created number of credit into the real estate. The proportion of loan related to housing and banking increased from 2000 about 40% to 2006 about 56%. Annual growth rate of housing- related loans at 15% or so (data from the Federal Reserve Board). The proportion of investing in housing bonds was increasing. Meanwhile, the shadow banking system (asset backed securitization) provided a great deal of real estate funds which did not calculate into the bank’s financial statements (Off-balance).

Just as we can judge from the graph, Estrella (2000) proved that the higher land loan ratio means the higher expected return meanwhile induce the higher risk index. Office of the Comptroller of the Currency (1988) has clearly shown that excessive credit-i.e. missing financial statements or income information about borrowers or poor collateral documentation is not a good indication for banks (found in 81% of the failed banks). According to the global financial stability report (2003), there were about 75% of sub loans and land loans belong to the ARM (Adjustable Rate Mortgage). This adjustable-rate mortgages will have an interest rate reset after it entry into force of the treaty in 3 or 4 years. That means the contract interest rates will be adjusted from the low initial interest rates to the market benchmark rate plus a risk premium. Because of this uncertain factor, the borrowers may suffer repayment pressure when the benchmark stands at a high level. The global financial stability report (2003) has pointed out this concern in the housing report.

2.3 Rising real estate price between 2000 and 2003 forecast bank failure.

If the high land loan is the core factor for us to forecast, then the rising house price between 2000 and 2003 is the incentive factor for the following banking failure. According to the global financial stability report (2003), the loose monetary policy and a great deal of bank loan induce the growth of U.S house price and this trend was even higher than that of previous 30 years in U.S.A.

In the background of rising real estate prices, if land loan borrowers cannot repay the debt, then they can re-apply for housing loan (Refinance), with a new loan to repay the old one. If real estate prices rise significantly, then the borrowers can get some cash (cash out) after they repay the previous debt. However, the weak point is also obvious when the real estate price is falling. If the real estate prices continued to decline, even if the borrowers re-apply for housing loan, cannot completely avoid the previous debt default. If the borrowers breach the contract due to the falling real estate price, the banks will suffer high risk in terms of its risk-weight ratios. Specially, commercial banks, investment banks and other financial institutions all use the leverage business model—aggregate asset size is much higher than the size of equity capital. According to the Gujarati (2009):

E=VA (1)

(E for financial institutions equity, A for aggregate asset of financial institutions, V for value at risk per dollar)

Financial institutions leverage is defined as:

L=A/E (2)

Sub (1) into (2):

L=1/V (3)

As we can see the equation, the financial leverage ratio is inversely proportion to total risk. The following graph show the VAR of four major banks in U.S.A between 2002 and 2003

Jan 02 Mar 02 Jun 02 Sep 02 Dec 02 Jan 03 Mar 03

VAR 1.00 0.89 1.05 1.29 1.38 1.49 1.58

Principally, there are two ways for financial institutions to reduce the leverage ratio. The first one is that these financial institutions sale their risky assets to repay debt, take the initiative to shrink the balance sheet. The second one is that these financial institutions attract new equity investment to expand the size of their own capital. Compared to the second method, the first one is more directly. However, large number of financial institutions sale their risky assets at the same time, which can cause many problems. One the one hand, it will naturally drive down the price of risky assets, which lead to the market volatility. One the other hand, this action can decline the asset which the financial institutions have not yet sold. In other words, this action will aggravate the fall in asset price. It might even evolve into a vicious circle.

In conclusion, the real estate price is seriously related to the capital ratios. We can forecast the bank failure from the capital ratios as well as real estate price. On the demand side, the real estate industry is seriously depended upon the capital because of investment demand and living demand. On the supply side, banks and financial institutions are likely concerned about the short-term risk as long as the house prices and land prices are expected to rise. Therefore, banks and institutions are willing to lend. However, increase in real estate price and bank credit is easy to form a cycle and this cycle will last for a long time. So only the real estate industry could absorb a large number of bank funds, and only it will be dragged the bank into the quagmire.

2.4 Internal problems forecast bank failure.

According to the Office of the Comptroller of the Currency (1988), the bank’s board of directors should responsible for the conduct of bank’ affairs. This report also shown that there are 81% of the failed banks due to the nonexistent or poorly followed loan policies and about 59% of bank failure are due to the inadequate problem loan identification systems. That means the long-term health of the financial institution is depended on the rigorous debt audit mechanism.

The United States had a rapid financial development since 1990s, and this trend lead commercial banks to suffer more pressure than before. Particularly, the non-banking institutions are allowed to provide deposit and loan services to residents and businesses with information technology support since 1999. The status of commercial banks as an intermediary had a strong challenge. Consequently, the U.S commercials bank had to seek other income beside the traditional interest income and the rising real estate prices allowed commercial banks to have new profit due to the land loans and mortgage loans. The U.S commercial banks continued to increase land loans and mortgage loans to compensate for the impact of financial liberalization. However, these commercial banks continued to relax the conditions for approval and launch innovative loan products in order to attract loans. As the result, according to the financial report (2003), the United States sub-prime mortgage business continued to expand from 3% in 2000 to 8% in 2003.

In conclusion, bank’s risk management and incentive systems lack the awareness of controlling long-term risk. We can forecast the bank failure and crisis of 2007-8 from some previous bank failure cases that the growth of land and mortgage loan can push up the real estate price and the bank mangers will not evaluate the real collateral price as long as the land price stand at a high level. As the result, the fact in 2003 is that the loose monetary policy increases the fund of bank, while the deregulation of financial management induces the fall of land loans demand. Therefore, the banking competition is more intense and relaxing the loan control standards became an inevitable choice. Compared with capital ratios and rising real estate price, whether the loan audit mechanism is rigorous has been a significant argument for many years.

3. Conclusion

In this essay, I try to utilize capital ratios, rising real estate price and unhealthy loan audit mechanism to forecast the bank failure between 2007 and 2008. In fact, the economy began to have inflation after the loose monetary policy implement for a long time. At that moment, central banks began to raise benchmark interest rate. As asset prices (real estate takes up the large proportion) bubble is mainly caused by the bank fund, rising interest rate will increase the cost of borrowers. In the latter half of rising interest cycle, bank shares began to decline because the investors worried about the quality of future asset. As the bank shares continue to fall, the bank non-performing loans will increase. As a result, some small banks capital began to wear and tear. Because the financial industry is contagious, the bank failure is an inevitable consequence.

References;

1. Steven A, Holmes (1999) ‘Fannie Mae Eases Credit to Aid Mortgage Lending’ .New York Times.
2. Global financial stability report (2003). IMF Multimedia Services Division.
3. Estrella A Park S, and Peristiani S (2000) ‘Capital Ratios as Predictors of Bank Failure’. Economic Policy Review.
4. OCC (1998) ‘Bank Failure: an evaluation of the factors contributing to the failure of national banks’ Washington DC Office of the Comptroller of Currency
5. Damodar N. Gujarati (2009) ‘Essentials of Econometrics’. The Mcgrow Hill Companies.