First written as an internal World Bank working paper in 1986, this article went on to win an international audience and was translated into ten languages, including Russian and Chinese. It was co-published by the World Bank and Oxford University Press in 2002.
End Abstract1 Introduction
1. This chapter is not intended to be a rigid manual or pass any ethical judgement on bankers’ behaviour. Rather, it is a model made up of features that repeat themselves historically around the world, both in developing countries and in developed ones.
2. Contrary to the theory that financial crises are only due to macroeconomic factors, this chapter stresses the role of bank management (not to mention ineffectual supervision) as a major element in all banking crises, and as a potential originator or multiplier of losses and economic distortions. It also stresses the fact that even good bankers, when in trouble, often become bad bankers, through a step-wise process of deteriorating attitudes.
3. Poor management and ineffective supervision are relevant not only to the crisis of individual institutions, but also to widespread and systemic crises affecting all or most of a banking system. Of course, crises may also be caused by economic upheavals, inappropriate monetary or exchange rate policies and/or abrupt deregulation. In those cases, both good banks and bad banks can be found, depending on the quality of their management. In fact, good management may enable banks to survive and stay reasonably healthy in the midst of macro-problems. On the other hand, even in times of stability, bad management will lead to deeper crisis, by compounding losses, misallocating resources and contributing to inflation through high interest rates. Therefore, applying only macroeconomic remedial action to general financial crises, without simultaneously addressing their micro and institutional side, may prove ineffective or even counterproductive.
4. Banking supervision appears as a key element to prevent or limit the damage caused by poor management. The concept of supervision is used here to cover regulation, supervision proper and remedial action (from conventional enforcement to restructuring of institutions). If good regulation, supervision and remedial mechanisms are in place, bad management is less likely to exist. And if it exists, it is less likely to be deep and to last. Remedies can be put to work to stop and reverse deterioration. And because of the acceleration potential of deterioration, the sooner, the better.
5. The features of the model described and the lessons to be learned are merely sketched out in this chapter for the sake of simplicity.
2 An Attempt to Define Management
6. The above assertions make it important to analyse the managerial problems that lead banks to fail and to examine what regulations and supervision could do to prevent or remedy them.
7. Regulators in the US have a system to rate banks according to the quality of capital, assets, management, earnings and liquidity. They call it the CAMEL system, after the initials of those items. Each particular institution is given periodical marks by the supervisors, according to the performance in a series of aspects that make up each of those areas. Averages for each area and for the whole exercise are used to rate banks from 1 to 5, from very good to failing banks.
The elements used as a basis to rate an institution’s management are as follows:
competence
leadership
regulatory compliance
ability to plan
ability to react to changes in the environment
quality of policies and ability to control implementation
quality of management team
risk of insider dealing
succession prospects
A satisfactory response to those concepts might make a good definition of good management. If all banks were well managed, the only reasons for failure would be those due to the economic background. Even in those cases, the need for regulation and supervision would exist, in a similar way that traffic laws and policemen would be necessary even in a country of good drivers. Both banking and driving are risky activities for third parties.
8. Let us draw a picture of things that could certainly happen in the context of non-existent or ineffective
regulation and
supervision. Types of mismanagement can be grouped into four categories:
- (a)
- (b)
- (c)
desperate management (la fuite en avant) and
- (d)
These do not have to occur in a sequential manner, though they often do. In fact, when technical mismanagement leads to losses or to the need for a dividend reduction, it frequently unleashes ‘cosmetic’ and ‘desperate’ management responses sequentially. Fraud may be a part of the process from the very beginning, but it is dealt with at the end, as a part of the dynamics that make good managers become bad managers. Illiquidity comes at the end of the process. In the meantime, the bank in question may have lost its capital several times over.
9. Whereas non-financial institutions may experience illiquidity despite underlying solvency, a peculiarity of banking is that insolvency invariably precedes illiquidity. The dimensions of their portfolios, the leverage banks operate with and their ability to raise money by offering high rates of return and publishing fictitious financial statements are the key differences between financial and non-financial firms.
3 Technical Mismanagement
10. Technical mismanagement may occur
- (a)
when a new bank is set up under new managers who are not ‘fit and proper’;
- (b)
when control of an existing bank is acquired by new owners; and
- (c)
when an existing bank that used to be well managed proves unable to plan ahead for changes or fails to acknowledge and honestly report a deteriorating situation, and to remedy it.
11. Technical mismanagement may involve a whole variety of inadequate policies and practices. The most relevant ones are overextension, poor lending, lack of internal controls and poor planning.
12. Overextension and quick growth are some of the major sources of failure. Overextension means lending sums of money that are not in proportion to the bank’s capital, which is to say its cushion against potential losses. It may also mean diversifying activities to geographical or business areas the bank is not familiar with or is not well equipped to manage. Overextension is often connected with seeking growth for the sake of growth, a typical banker’s syndrome.
13. Poor lending policies are a key danger that may also prove fatal. The key element of bank management is to make sure that deposits, which do not belong to a bank but to its depositors, are lent in such a manner so as to yield a proper return and are recovered by the bank. Policies or practices to avoid are:
(a) Risk concentration. This means making loans representing a high proportion of the bank’ s capital to one single borrower or group of borrowers or to a given sector or industry. This practice may be the result of the free will of the banker (who believes in the eternal health of a given borrower) or the result of irresistible pressure from borrowers on the banker when they are unable to service their debt or even pay their operational overheads. Risk concentration is frequently mixed with connected lending, as described below. Not all concentration leads to failure, but most bank failures are the result of serious loan concentration.
- (i)
loans will be made according to less rigorous c...