SRC Insights: Fourth Quarter 2009

Supervision Spotlight on the Root Causes of Bank Failures

by Michael E. Collins, Executive Vice President

The unprecedented financial market conditions and prolonged recession placed exceptional stress on the entire banking industry. Nearly 100 banks failed during the first nine months of 2009-the most in 17 years. People often presume that the challenging economy and sluggish housing market were the key drivers behind these failures, particularly since many tended to be geographically clustered in distressed regions. While the external economic environment certainly was influential, it was rarely a standalone factor in a bank's demise. The root causes of problems are often traced to inherent risk exposures or management weaknesses that become more pronounced under stressful conditions and ultimately impair an institution's ability to weather adverse conditions.

Many important lessons are still to be learned from the recent crisis. One exercise is to analyze each individual bank failure, isolate the key factors that led to their demise, look for commonalities that exist among the banks collectively, and apply that information to prevent or mitigate future problems. For example, considerable insight is gleaned from the "material loss reviews" that are performed by the primary regulator's inspector general whenever a failure results in a loss to the depository insurance fund that exceeds the greater of $25 million or 2 percent of the bank's total assets at the time of receivership. In addition, recent examination reports and other supplemental data sources can be referenced for the remaining institutions that are not subject to this mandate.

Historical Research

Regulators and government agencies conducted similar analysis after past downturns. The small body of empirical research that has been compiled on the topic allows us to put the perceived causes of bank failures into a historical context spanning the past 30 years.

While the influence of consolidation trends, legislative changes, sectoral downturns, and regulatory oversight cannot be dismissed, and though fraud or other extenuating factors play an occasional role, it is generally accepted that most bank failures ultimately stem from the default of a significant portion of the bank's asset portfolio. A deeper dive into the cause of asset deterioration reveals some prevalent themes in management's behavior and the risk culture of these institutions.

A report written by the Office of the Comptroller of the Currency (OCC) summarized observations about national bank failures that occurred during the period 1979-1987. The OCC found that "management-driven weaknesses played a significant role in the decline of 90 percent of the failed and problem banks the OCC evaluated."¹ Interestingly, the two main internal problems noted were "overly aggressive activity" and "uninformed or inattentive board of directors or management."

The banking industry endured one of its most challenging periods from 1988-1992. During this interval, an extraordinary number of banks failed over a short period of time, more than any time since the 1930s. A congressional budget office report found that:

"Although many of the problems that beset banks were externally induced, the primary responsibility for bank failures rests squarely on the shoulders of bank managers and boards of directors. This responsibility does not negate ineffective regulation or unforeseen economic developments as causes of failure, but the bank manager is the agent who reacts to economic conditions and the regulatory environment. Some managers made mistakes because they reacted incorrectly to a barrage of unusual factors. In some cases, managers simply failed to diversify asset portfolios, and boards of directors did not insist on reasonable loan practices. Managers of failed banks often pursued aggressive loan policies without reasonable precautions against default. As a result, many bank managers who failed to deal effectively with increased competition and adverse economic shocks presided over the demise of their institutions."²

It is possible to infer that those banks that survived this period did so by holding more liquid assets, managing modest growth in diversified assets, maintaining a suitable buffer of capital, and complying with regulatory requirements.

The FDIC analyzed bank failures during the timeframe 1993-2003 and summarized observations from material loss reviews. Key findings in the report included the fact that "failed banks frequently assume more risk than bank management is capable of handling."³ It also noted that "an inattentive or passive board of directors is a precursor to problems."

The relatively benign 2004-2007 period did not have sufficient observations to warrant a comprehensive study, since only seven bank failures occurred in the period.

Common Causes of Recent Failures

The 2008-2009 period witnessed a prolonged economic recession, unprecedented credit market disruption, high unemployment, falling house prices, and the failure of numerous banks. Some of the earliest bank failures were large institutions felled by complex securities investments and alternative loan types. By contrast, more recent failures have been smaller banks suffering insurmountable losses on more traditional loan types. In both instances, management's practices and aggressive risk tolerance are again called into question.

Our analysis of common factors in recent failures reveals that management deficiencies and ineffective board oversight were noted in the majority of material loss reviews. The other contributing factors most frequently cited are construction and land development loan concentrations, rapid loan growth, overreliance on volatile noncore funding, insufficient allowance for loan and lease losses (ALLL), inappropriate or poorly followed loan policies, and weak internal controls.

One specific area that will receive ongoing attention is commercial real estate (CRE) concentrations. At institutions that failed through the third quarter of 2009, the average CRE concentration, measured as a percentage of total risk-based capital, was well above the supervisory criteria defined in the 2006 interagency CRE guidance. History has shown that the inherent volatility in CRE markets presents considerable risk to the safety and soundness of banks. This risk stems from both the value of the property itself and the way the bank manages the risk. The risk management practices in place should be commensurate with the risk inherent in the portfolio. Common weaknesses include slow adoption of portfoliowide stress testing, lack of formal market analysis, inappropriate interest reserve extensions, and failure to incorporate CRE concentrations into the ALLL methodology.

Challenges Shaping the Regulatory Response

In several material loss reviews, regulators have been criticized for recognizing problems at an early stage, but not acting promptly or forcefully enough. Examiner guidance on this issue can be summarized by the following: "One important aspect of an examiner's job is knowing how to read and react, in a balanced and effective way, to symptoms of problems that may not yet be obvious to bank management and directors. This is sometimes the last point in time when an examiner may make a difference, through effective communications or moral suasion, in whether the bank rights itself or becomes a problem bank."⁴

Since problems can be masked during good times, one future challenge for supervisors is to determine the optimal time to intervene and the strength with which they need to convey their message. During benign times, there is less appetite for change, so greater reliance on leading indicators may be needed in order to react in time to rehabilitate. One response will be to boost the use of stress testing and off-site surveillance to better inform examinations.

More attention will be given to reducing cyclical tendencies that tend to exacerbate problems. As Chairman Ben Bernanke stated, "We should revisit capital regulations, accounting rules, and other aspects of the regulatory regime to ensure that they do not induce excessive procyclicality in the financial system and the economy."⁵ Greater emphasis will also be placed on incentives to ensure that they are properly aligned with the long-term health considerations of the institution.

Regulators recognize the importance of striking a proper balance. The objective is to ensure the safety and soundness of the institution, but to do so in a way that does not unduly constrict credit, impose excessive regulatory burden on the industry, or stifle innovation.

Regulatory reform will help to close coverage gaps, better address systemic risk issues, promote transparency, and enhance consumer protection.

The Importance of an Actively Engaged Board

Perhaps the most common theme seen consistently throughout the years involves the board of directors and the role it plays in an institution's success or failure.

The recent economic crisis has challenged the banking industry and raised the performance expectations set for board members. Directors serve as stewards of their institutions' long-term success and are ultimately responsible for providing the strong governance and oversight needed to navigate through today's dynamic environment and toward sustained profitability.

Effective governance stems from the board's commitment level, clarity about its role, and the extent and nature of its involvement in strategy, management succession, risk management, and compliance. It is also important to recognize and facilitate the key determinants that shape the board's behavior, including interrelationships between a board's activities, its relationship with management, and its understanding of the company.

Conclusion

A well-functioning banking system is a critically important determinant of our country's economic growth. While confidence in the banking industry has been largely restored, some problems inevitably lag the recovery.

Bank failures have a significant impact on local communities and at times can create problems for otherwise healthy banks. It is the regulator's responsibility to safeguard the public's trust in banking, while still promoting industry competition and avoiding moral hazards. The risk of bank failures can be mitigated, but not eliminated.

Ultimately, we should all endeavor to learn from our experience with bank failures, position the industry and regulators for the future, and apply the lessons in ways that make the overall banking industry more resilient.

¹ "Bank Failure: An Evaluation of the Factors Contributing to the Failure of National Banks ," OCC, June 1988.
² "The Changing Business of Banking: A Study of Failed Banks from 1987 to 1992 ," Congressional Budget Office, June 1994.
³ "Observations from FDIC OIG: Material Loss Reviews Conducted 1993 Through 2003 ," FDIC Office of Inspector General, January 22, 2004.
⁴ An Examiner's Guide to Problem Bank Identification, Rehabilitation, and Resolution , OCC, January 2001.
⁵ "The Crisis and the Policy Response ," Chairman Ben S. Bernanke, London School of Economics, London, England, January 13, 2009.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.