Bank failures are a major topic of concern in this economy. Banks fail for two basic reasons, lack of liquidity, or lack of capital. Liquidity is the cash that a bank either has on hand in their vault or in another bank account. Banks also have lines of credit with other banks, the Federal Reserve Bank or Federal Home Loan Bank. Theses lines must be secured with collateral which can be investment securities or loans. Banks not only rely upon these borrowing lines, but also on deposits from their customers for their liquidity.
Capital is primarily the money that investors have invested in the bank in the form of stock. This can be either common or preferred stock. Common stock is the most prevalent form of stock ownership, and doesn't have a rate of interest rate and thus interest is not paid 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 buyers and sellers trade the stock directly 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 the bank's stock. Also included in a banks capital are the retained earnings of the bank, or more typically today retained losses of the bank. Retained earnings add to capital and retained losses subtract from the capital of the bank. These are the most typical forms of bank capital and are usually termed "Tier 1 Capital". Other forms of capital may include the bank's allowance for loan losses which is an estimate of what the bank may lose on certain non-performing loans which are loans that the borrowers are having difficulty in making the payments. These allowances are included in "Tier 2 Capital" which is considered in certain capital calculations that are prescribed by the regulators. Other qualifying borrowings such as certain forms of subordinated debt 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 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 brokered deposits, and when their operating losses reduce their capital below what the regulators deem to be "well capitalized" or "adequately capitalized, then they are not allowed to renew these deposits, and must repay the brokered deposits. (3) Their borrowing lines can also be "frozen" once their capital reaches a level that is deemed to be insufficient by the regulators, which means that they can not only borrow new money but may have to repay their existing borrowings. There is also a new FDIC regulation that takes effect January 2010 that restricts the interest rates that banks may pay on deposits to .75% above the average rate for that particular type of deposit if the bank's capital levels fall below well capitalized. (4) So you can see that as the bank's capital declines, there are many negative impacts to the bank's ability to raise liquidity or "cash" to cover operating expenses and fund deposit withdrawals, thus if a bank can't fund normal operations or deposit withdrawals, then the regulators are forced to close the bank.
Once capital falls below 3% of total assets a bank is no longer adequately capitalized and the FDIC is required to 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 bank raises additional capital or Place the bank into receivership which 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 typically requires 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 virtually impossible for a bank that has significant "problem assets" to raise capital because the loan portfolio 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 recent trend 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 are given access to this data base and formulate 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 process has worked out much better than the initial strategy of having the regulators take over the bank 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 quantities 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 hoped that the new process of allowing banks to acquire a failed bank will slow the process of dumping real estate on the market, 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, 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.
