Bank Failure, consolidation, systemic risk and early warning system.

Essay by pureairUniversity, Master'sA+, April 2003

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Naturally, people would prefer not to imagine the failure of banks. But bank failures have happened from time to time in many countries despite the best endeavours of managers and regulators. And it would be unwise to ignore this possibility in Australia because a bank failure is not only very damaging for the depositors immediately affected, but it can create a series of problems flowing well beyond that particular institution. This flow-on damage can occur in various ways, including through effects on depositor confidence, but perhaps the most important channel is the payments system. For instance, if a bank in difficulty has large unsettled payment obligations to other banks, those banks will inevitably share some of the pain. Moreover, there could then be further effects which cannot be predicted with any precision.

One reason for bank failure is that banks and their supervisors have to contend with a steadily growing array of risks.

Derivatives risk, operational risk and environmental risk have all come to prominence in the past decade or so. And public relations risk is a major ongoing challenge for banks. Among all these risks, the most significant risk in recent years is the systemic risk. This risk is partly increased by the transformation of the international financial system which had rendered the system more crisis-prone. Central to this transformation was a growing process of financial consolidation, that is, concentrating financial activity and financial decision making in a few financial institutions. It had been found that, in a study done by IMF , there was a high level of merger, acquisition and strategic alliances activity in the 1990s among financial firms and this level of activity is increasing over time with a noticeable acceleration in consolidation activity in the last three years of the decade. As result, numbers of...