Epidemic of Bank Failures – Why are Banks Failing?

Bank failures are a major topic of concern in this economy.  Banks fail for two basic major reasons, lack of liquid assets or lack of equity. The deficiency in equity is typically caused by the foreclosure of real estate loans that the bank made.

liquid assets are the cash that a financial institution either has readily available or in another financial institution account.  financial institutions also have lines of credit with other financial institutions, the Federal Reserve Bank or Federal Home Loan Bank.  Theses lines must be collateralized with collateral which can be marketable securities or loans.  Banks not only rely upon these borrowing lines,but also on deposits from their customers for their liquid assets.

Equity is mainly the capital that investors have invested in the bank in the form of stock bank stock.  This can be either common or preferred stock.  Common stock is the most prevalent form of stock ownership, and doesn’t have a interest rate and thus interest is not earned on common stock.  The value of the common stock depends upon the value placed upon it by buyers and sellers of the stock.  The stock can be traded on any of the national stock exchanges, or may be “unlisted” which means that purchasers and sellers trade the stock specifically with each other.   Preferred stock is also a prevalent form of stock ownership in a bank.  Typically preferred stock has a stated interest rate and may have other features that give it a preference over common stock in the sale or liquidation of the bank’s stock.  Also included in a banks capital are the retained earnings of the bank, or more commonly in these times,retained losses of the bank.  Retained earnings add to capital and retained losses are a subtraction from the capital of the bank.   These are the most common types of financial institution equity and are commonly termed “Tier 1 Capital”.  Other forms of capital may include the bank’s allowance for losses on loans which is an approximation of what the bank may lose on certain non-performing loans which are loans that the borrowers are cannot make their payments.  These allowances are included in “Tier 2 Capital” which is considered in some capital calculations that are prescribed by the regulators. Other qualifying borrowings such as many forms of subordinated borrowings may also be included in “Tier 2 capital”. (1)

So why would a bank run out of liquidity or cash.  The most common reason is that the bank has operating losses from the foreclosure of real estate assets which generally become known to the public, and the public loses confidence in the ability of the bank to pay the depositors their money.  Most bank accounts are  insured up to $250 thousand dollars by the FDIC, and in fact non-interest bearing transaction accounts are insured up to their full balance even if it exceeds $250,000(2).   Also, many banks have relied upon wholesale internet deposits, and when their financial losses reduce their capital below what the regulators deem to be “well capitalized” or “adequately capitalized, then they are not allowed to renew their deposit accounts, and must repay the brokered deposits. (3)  Their borrowing lines can also be “frozen” once their equity reaches a level that is thought to be less by the federal government agency, which means that they can not only borrow new money but may be required to repay their current lines of credit.   There is also a new FDIC regulation that takes effect January 2010 that restricts the interest rates that banks may pay on their deposit accounts up to .75% above the average rate for that specific kind of deposit if the bank’s capital levels fall below the well capitalized level. (4)  So you can see that as the bank’s capital declines, there are many negative impacts to the bank’s ability to raise liquid assets or “cash” to pay for operating expenses and fund deposit withdrawals, thus if a financial institution is not able to fund it’s normal operating expenses or deposit withdrawals, then the federal government is forced to close the financial institution.

Once total equity falls below 3% of total assets a financial institution is not considered adequately capitalized and the FDIC must take what is termed “prompt and corrective action” (5)  which means that the regulators, (FDIC, OCC or the OTS)(6) must take affirmative action to either make sure that the financial institution obtains more equity or place the bank into receivership which is basically when the regulators come in and take over operations of the bank.

The current trend is that the bank will be issued either a Memorandum of Understanding (MOU) or a Cease and Desist Order (C & D) which means that the bank to raise capital, decrease problem loans, and may address other operational issues such as improving underwriting standards, and loan portfolio management policies.   In the current capital market environment it is nearly impossible for a financial institution that has significant ” problem assets” to raise capital because the troubled asset problems are so great that the projected returns are not attractive to investors.  Thus the bank will continue to incur operating losses as more loans go bad and eventually the FDIC, OCC , or the OTS will be forced to take over the bank.

The most current policy in the takeover process is for the regulators to find another bank to purchase the “troubled bank”.  The FDIC has a web site that it lists the financial information regarding the troubled bank.  Those banks that wish to “bid” on the bank may access this data base and calculate their bid.     The acquirer will make a bid for the deposits which may range from 1-3% of the deposit balances.   The loan portfolio is then stratified into “performing” and “non-performing loans.  The FDIC will place a limit upon the losses that the acquiring bank may incur on the disposition of the loans acquired.  Typically the regulators will accept the first 80% of losses on performing loans, and the first 95% of non-performing loans.

This procedure has been much more beneficial than the initial strategy of having the regulators sieze the financial institution and liquidate the bank’s assets through an auction on the national auction site Debtx .  Typically the auction results have been very low.  The price for non-performing loans would typically be anywhere from 5- 50% of the face value of the loans and performing loans would receive a price of 50-80% of the face value of the loans.(7)  The large amounts of loans and real estate that have been “dumped” on the market through this auction process have further exacerbated the decline in real estate values in the United States.  Thus, it is the hope that the new process of allowing banks to acquire a failed bank will slow the process of dumping real estate on the market which results in the foreclosure of real estate assets, and the acquiring banks will be better able to manage the real estate sales process than the bank regulators. 

 

(1) FDIC Laws, Regulations and Related Acts.  Minimum Leverage Capital Requirements,  Part 325 Capital Maintenance, Federal Register 3804 1-25-2002

(2) FDIC Laws and Regulations and Related Acts.  12-CFR part.; 370 Final Rule regarding Limited Amendment of the Temporary Liquidity Guarantee Program, FDI C Transaction Guarantee Program

(3) Federal Deposit Insurance Act.  Sec 29. “Brokered Deposits”; 12.CFR 337.6(a)(2)

(4) Federal Register Vol. 74 No. 21 Feb. 3, 2009; 12 CFR, part 337, Interest Rate Restrictions on Institutions that less than Well Capitalized.

(5) Federal Deposit Insurance Corporation, Risk Management Manual of Examination Policies,  Sec 15.1 Formal Administrative Actions.

(6) Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, Office of Thrift Supervision.

(7) Debtx doesn’t release the results of its auctions.  The price ranges have been obtained from personal experience in bidding on loans and properties on Debtx as well as from discussions with Debtx representatives.  The price ranges in this article are estimates based upon this information.

 

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