Major economic factors, including recessions, high interest rates, and inflation, are the primary causes of bank failures. During a recession, which refers to a significant decline in economic activity over a prolonged period, typically lasting for two consecutive quarters (six months) or more, businesses generally produce less and consumers do likewise, resulting in reduced overall demand for goods and services. This, in turn, leads to decreased employment, income, and economic growth, which can have far-reaching effects on the economy. At this time, many borrowers are likely to default on their bank loans, leading to losses for lending banks.
Some two weeks ago, an American bank failed. Founded in 1983 in Santa Clara, California, Silicon Valley Bank (SVB) was a respected financial institution that primarily served technology industries. Known for catering to startups, venture capital firms, private equity firms, and public companies in the technology, life sciences, healthcare, and energy sectors, SVP’s services included investment banking, asset management, and private banking. Days later, another bank based in New York tumbled. Signature Bank was a full-service financial institution with 40 branches in the US.
Bank failures have become sporadic occurrences in the US’s financial history. According to financial authorities, there were 563 bank failures from 2001 through 2023.
Several reasons can be cited why banks fail. Some of the main causes in the US include economic factors, regulatory failures, and mismanagement, from which Ethiopian bankers can draw lessons from the adverse US experience.
Inflation, a continual increase in the general price level of goods and services in an economy over a period of time, can also increase the cost of doing business, leading to lower profits for banks. It also diminishes the value of assets held by banks, such as loans. This decline in asset value usually increases the rate of default and losses to lenders. Similarly, higher interest rates generally lead to decreased borrowing due to higher borrowing costs, resulting in lower demand for loans and reduced bank profitability.
A more common cause of collapse can be attributed to the failure of policymakers to do the right thing: regulate banks.
Critical bank regulations include capital and liquidity requirements, anti-money laundering rules, and consumer protection laws. Proper regulation of banks ensures the stability of the financial system and the protection of borrowers and consumers. A lack of accountability for banks and failure to enforce regulations tend to contribute to the mismanagement of banks. Poor decision-making, excessive risk-taking, or engaging in unethical behavior can be attributed to mismanagement. All of these make up the recipe for bank failures. It leads to losses, decreased confidence from customers, and ultimately failing banks.
Banks can also fail due to inadequate capitalization or scant diversification of their assets.
Bank failures have adverse economic and social impacts. They can lead to job losses and the contraction of the credit market. Their closure can also lead to a loss of confidence in the financial system, making it difficult for other banks to operate.
What can Ethiopia and other emerging economies learn from bank failures in the US?
Even though the two banking sectors are different and face different problems, the Ethiopian banking sector can still learn a lot from them. Compared to its counterpart, Ethiopia’s financial sector has a long way to go to expand financial services to the bulk of its population, particularly in rural areas. Given this disparity, Ethiopia can learn from these experiences and apply those lessons to its own banking industry.
The crucial lesson, in my opinion, is the significance of establishing institutions that are independent of the government and have the authority to take action to lessen the effects of bank failures and other financial catastrophes that can impede economic growth.
The American Federal Reserve System (Fed) is a good example. While the Fed’s Board of Governors is appointed by the President and confirmed by the Senate, its members serve 14-year terms free from any political pressure. With job security until the end of their term, they exercise full authority in coordinating and guiding the operations of commercial banks, focusing on sound monetary policy.
To prevent banks from failing in the first place, the Fed lends funds to banks at a discounted rate, which is typically lower than market rates. A failing bank with liquidity problems can also turn to the Fed for emergency funding. If the bank becomes financially insolvent, the Fed will work with other regulating agencies, such as the Federal Deposit Insurance Corporation (FDIC), to merge the failing bank with a healthy bank while safeguarding the deposits of all bank customers.
The Fed and other regulatory institutions ensure that the failures of a few banks do not infect the rest of the financial system and the whole economy.
Established by the Imperial Ethiopian Government in 1963, Ethiopia’s central bank, the National Bank of Ethiopia (NBE), is mandated with conducting monetary policy, supervising financial institutions, and maintaining the stability of Ethiopia’s financial system.
In recent years, the Ethiopian banking system has undergone some reforms purportedly designed to improve access to financial services and enhance financial stability, including the liberalization of interest rates, the introduction of credit bureaus, and the adoption of international accounting and auditing standards. While these steps are moves in the right direction, the banking system still faces several challenges, including limited access to finance for small and medium-sized enterprises and a high level of non-performing loans.
The NBE should remain independent from the influence of political parties and political leaders to avoid conflicts of interest and potential corruption. The operations and decision-making of the central bank and other financial institutions need to be free of political influence or inappropriate interference. Politically motivated influence on financial decision-making is likely to harm the economy and the public interest.
In countries like Ethiopia, where deposit insurance is not comprehensive, bank failures can result in losses for depositors. When depositors lose confidence in the banking system, bank runs are most likely to occur, leading to rushed withdrawals of funds that can cause commercial banks to become insolvent. To prevent or mitigate the impact of potential bank failures, Ethiopian policymakers need to take a variety of proactive measures.
These preventive actions may include providing deposit insurance to protect depositors, establishing emergency liquidity facilities to provide funding in times of crisis, and implementing stronger regulatory and supervisory frameworks to promote financial stability.
Ethiopia can create a banking system that is resilient and can withstand economic shocks in its development journey by learning from the lessons learned by other countries. This can be done by creating strong regulatory frameworks, increasing oversight of the banking sector, and ensuring that banks have adequate capital reserves to withstand economic downturns.
Yonnas Kefle (PhD) is the CEO of GTDC and has served as an economist at the Bureau of Labor Statistics, as a labor attaché at the US Department of State, and as an adjunct professor of economics at Frederick Community College and Pennsylvania State University. He can be reached at [email protected].
Contributed by Yonnas Kefle (PhD)
