Problem Banks Took “Risks They Did Not Understand”

In a recent interview with Forbes, FDIC Chairman Sheila Bair readily acknowledged that the primary reason for banking losses and failures was due to banks taking on excessive risk in their loan portfolios.  Chairman Bair also discussed her ideas on regulatory changes that will prevent a future banking crisis, the health of the FDIC insurance fund and the FDIC exposure to Citigroup.

Forbes – Too many financial institutions took risks they did not understand for short-term profit. So I’m a strong advocate of the “basics” and prudence when it comes to money. When the economy gets healthy again, I hope for a new “back-to-basics society.” A new “old world” where banks and other lenders promote real growth and long-term value, where your generation rediscovers the peace of mind of financial security that comes from: thinking before spending, cutting up the credit cards and maybe even living at home for a year to save some money to pay off student loans.

…when you have a handful of giants, with global reach, and a single regulator … you’re making a huge bet that a few banks and their regulator … over a long period of time … will always make the right decisions at the right time.

So, instead of hoping that these risks will be competently managed … we also need a “fail-safe” system where if any one large institution fails, the system carries on without breaking down. We need to reduce systemic risk by limiting the size, complexity and concentration of our financial institutions.

One way to organize a system-wide regulatory monitoring effort is through the creation of a systemic risk council (SRC) to address issues that pose risks to the broader financial system.

Chairman Bair expressed strong confidence that the FDIC has the ability to fully protect all FDIC guaranteed deposits.

The DIF (Deposit Insurance Fund) balance declined from $17.3 billion at the end of 2008 (amended from the originally reported unaudited balance of $19 billion) to $13 billion on March 31, 2009. However, the FDIC Board of Directors approved an amended restoration plan in February that is designed to restore the DIF reserve ratio to 1.15% within seven years. The FDIC has already set aside $28 billion in reserve to cover projected losses for the next 12 months. In addition, the FDIC will collect more than $8 billion in premiums during the second quarter, including $5.6 billion from the special assessment the FDIC Board approved on May 22.  In addition, Congress recently raised the FDIC’s borrowing authority from the Treasury from $30 billion to $100 billion.

The FDIC Chairman estimated that the potential cost to the DIF on FDIC guarantees of Citigroup could reach a massive $10 billion dollars.

According to publicly available information, Citi has approximately $300 billion in insured deposits, about $62 billion in TLGP backed debt and an insurance wrap on $300 billion in assets that the FDIC has potential exposure for $10 billion.

The FDIC Chairman, of course, has to express confidence in the US banking industry.  Recent government actions have helped to alleviate concerns about a broad based banking collapse and the banking industry has been able to raise billions in new capital.  Despite this, the amount of troubled loans has grown in almost every bank loan category as asset values continue to erode and borrowers’ constrained cash flows inhibit their ability to service debts.  Ultimately, the recovery time for the banking industry will depend on whether or not the US can achieve sustainable economic growth.