Fragility is a situation that bank becomes susceptible to the given financial crisis.
Weakness of the any banking would come out at time of financial crisis in form of bank run (mass withdrawal of deposits.), loss of the trust and weakening of capital structure of bank.
The following are the causes which makes bank fragile:
Maturity mismatch: Banks borrow for short term and lend for long term. This often helps bank to increase the margin or NII. For an example: Libor of 3 months will be always lower than Libor of 1 year hence, any bank here would prefer to borrow at 3 months Libor. Therefore, banks keep borrowing for lower term and lend for more than 1 year. This enhances margin or Net interest income (NII) for the bank. At same time bank is exposed to maturity mismatch. Maturity mismatch of asset vs liability. Asset or lending of bank remains for long term say 5-year mortgage loan and against that bank would have borrowed for 3 months term! If bank fails to obtain borrowing after 3 months it will pose huge problem to bank.
Fractional reserve banking system: Banks are supposed to hold very little or fractional amount as reserve on their balance sheet. These reserves are just a fraction or small percentage of total deposits or liabilities. This give rise to huge risk for entire banking system. Systemic risk can storm entire banking system and have a cascading financial impact.
Leverage: Approach of high leverage or High debt to equity, always keeps banks on debt roll-over mode. Banks keep borrowing to repaying existing debt on maturity.
High lending or Low lending: Banks often seems to be lending in bulk during normal and expansionary phase of the economy. Bank behave inversely in times of bad phase of economy. They reduce lending money in bad economy. This approach should be calibrated by bank and banks must do appropriate.
High bonus and reward to traders: Banks keep incentivizing top performers in organization. Most of the time it is observed that they keep incentivizing for taking extra risk to earn the profit. Such profits may become nightmares. Example: Nick Leeson of Barings Bank.
Fattening of trading book: The Bank’s trader may keep adding risky securities to hedge portfolio. These securities may not serve the purpose of hedge in times of crisis
Liquidity planning: Liquidity planning proves to be myth when market falls badly. No amount of planning can save a bank from a systemic risk. Systemic risk poses huge illiquidity in market and it is almost impossible for banks to sustain such phase for longer term. Central bank often resolves it by purchasing illiquid asset of banks and it is called as “lender of last resort”. Central banks have allowed emergency credit window to protect the banks from illiquidity.
However, it is clear that banking system is fragile overall. Banks in race to increase profitability or Net Interest Income and Net interest margin they keep on borrowing for short and lending for long term.
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