Five bank failure case studies

Learn the stories and people behind five of the biggest bank failures in American history.

It’s been a while since I’ve written about failures, so let me make up for it. What you will find below are five bank failure case studies. These case studies cover some of the most prominent bank failures from the early 1970s through the 2008 financial crisis. Each concludes with three important lessons.

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Franklin National Bank
October 8, 1974

Franklin National Bank was founded in 1926. It operated a single location on Franklin Square in Long Island, New York, until World War II, after which it grew rapidly by embracing retail banking.

The bank’s growth was the brainchild of Author T. Roth. Roth joined the bank as a teller in 1935 and led the bank from the second world war until 1968. Roth was aggressive. Franklin National acquired competitors on Long Island, opened branches on Manhattan, merged with a New York City bank, and pioneered retail banking innovations like general purpose credit cards and drive-through tellers.

Franklin National was an early bank to take advantage of New Deal-era laws like the Federal Housing Act's mortgage loan guarantees. It solicited savings from customers who came to the bank for rationing coupons during World War II. And in 1947, Roth turned the main Franklin Square branch into a financial department store; it had a showroom for cars and boats that the bank would finance. Roth had built the biggest bank on Long Island.

All this changed in 1968, when the bank’s largest shareholder teamed up with Roth’s successor in waiting to accelerate Roth’s retirement and gain control of the bank. (The investor, a Sicilian attorney named Michele Sindona, had concurrent ties to the Vatican and the Italian mob and later died under suspicious circumstances in an Italian prison.)

Franklin National began taking more aggressive risks, especially in foreign exchange markets. Global currencies were in turmoil after the Bretton Woods system collapsed in 1970. Franklin National tried to capitalize on this by speculating in currencies like the Italian lira and German mark. On top of this, Franklin National had made a series of questionable international loans, many to obscure foreign entities linked to Sindona. And it financed much of this in the short-term interbank market.

By mid-1974, Franklin National was losing tens of millions of dollars from its forex trading. Its capital was eroding and large depositors started withdrawing funds. The bank turned to the Federal Reserve’s discount window for an increasingly alarming amount of liquidity. As a result, on October 8, 1974, officials from the Federal Reserve and FDIC seized Franklin National and arranged for its operations to be transferred to the European American Bank (later merged into Citicorp).

Three lessons for bankers

1. Speculation doesn’t belong in banking: When you’re dealing with 10x leverage, there isn’t enough room for the amount of error that’s inseparable from speculation. A good bank must be right 99 percent of the time, while a good gambler is lucky to be right 55 percent of the time.

2. There is fraud in every failure: Banks rarely fail for one reason, but instead for a mosaic of causes. One of the most common shared causes of bank failure is insider fraud. In Franklin National’s case, Sindona was trying to weave the bank into the fabric of his multinational criminal enterprise, failing only due to the bank’s acute foreign exchange losses.

3. Avoid the cardinal sin of banking: “There is one financial commandment that cannot be violated,” Jamie Dimon wrote in his 2007 shareholder letter. “Do not borrow short to invest long — particularly against illiquid, long-term assets.” Franklin did just that, borrowing in short-term credit markets to finance often long-term assets, leaving it exposed to rising interest rates and liquidity outflows.

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First Pennsylvania Bank
April 28, 1980

First Pennsylvania Bank was founded in 1782 in what was then the nation’s capital, Philadelphia. It was the second bank chartered in the United States, after the Bank of North America, and the only one of the two to survive into modern times.

First Pennsylvania was a traditional, staid bank for most of its chartered life. But that changed in 1964, when John Bunting became chairman and CEO. Bunting was a economist who had worked at the Federal Reserve. Equal parts sage and maverick, he authored a book on economics in his thirties and was one of the first executives in the banking industry to see the path for a regional bank to grow into a diversified national financial institution.

During Bunting’s tenure, First Pennsylvania acquired mortgage and consumer finance companies from Puerto Rico to California, as well as a majority interest in an Israeli bank. So admired were Bunting and First Pennsylvania, notes his obituary in The Philadelphia Inquirer, that the bank was named employer of choice by the Harvard Business School class of 1973.

By the following year, First Pennsylvania’s balance sheet held $6 billion in assets, triple since Bunting’s arrival. The bank would add another $3 billion by the end of the decade, making it the 23rd largest U.S. bank.

But in the 1970s, pressure to compete with larger national banks led First Pennsylvania to pursue a more aggressive strategy. Bunting reasoned that because interest rates were high in the 1960s, it made sense that they would come down in the 1970s. So Bunting allocated a third of First Pennsylvania’s balance sheet to long-dated government bonds and mortgage-backed securities. These would gain value if rates fell, and lose value if rates rose. In short, Bunting was gambling the bank on a directional bet on interest rates.

The strategy worked, but only briefly. It was a classic case of borrowing short and lending long. When interest rates spiked in the late 1970s under Federal Reserve Chairman Paul Volcker, First Pennsylvania’s bond portfolio plunged in value. (The incident foreshadowed the experience of Silicon Valley Bank.) At the same time, its cost of funds increased, triggering heavy losses. Making things worse, Bunting had expanded the bank’s loan portfolio into speculative commercial real estate.

In early 1980, as interest rates passed 20 percent, the losses on First Pennsylvania’s bond portfolio rendered it insolvent. Large depositors caught wind of its troubles and ran on the bank, which had grown by then to $9 billion in assets. Regulators were concerned that its failure might spark a broader crisis. So instead of seizing the bank, the FDIC and Federal Reserve arranged a $500 million rescue that wiped out its shareholders but preserved the bank.

First Pennsylvania was eventually sold off in pieces, with its core business acquired in 1989 by CoreStates Financial — part of today’s Wells Fargo, by way of First Union and Wachovia.

Three lessons for bankers

1. Avoid directional bets on interest rates: Overwhelming evidence proves that humans are bad at predicting the future course of interest rates. First Pennsylvania was no exception. It bet heavily on long-term bonds in the late 1960s and early 1970s, just before interest rates skyrocketed. It was a classic asset-liability mismatch that destroyed the bank.

2. An institution’s history is relevant but not dispositive: It’s always good to know that an institution has survived through the ages. That suggests a certain ingrained culture of prudence. Yet, as First Pennsylvania proves, even an institution that has existed for centuries can lose its way.

3. The risk of innovation: The most innovative banks at any particular point in time often run into trouble down the road, which is often a product of overeager innovation. In an industry with such narrow margin for error, innovation must be thoughtful and gradual. Like Robespierre, First Pennsylvania flamed a revolution that then consumed it.