Problem Bank List At 20 Year High As Regulators Let Zombie Banks Remain Open

The number of banks on the confidential FDIC Problem Bank List is at a 20 year high.  As of September 30, 2011, there were 844 institutions on the Problem Bank List, the largest number since 1992 when the total was 1,066.

Since the beginning of the financial crisis in 2008, a total of 417 banks have failed nationwide, yet the number of problem banks remains stubbornly high.  Considering the large number of banking failures over the past four years, the number of problem banks should have declined as failed banks fell off the Problem Bank List.

At the end of 2009, the number of problem banks totaled 702.  Despite the closing of 252 banks since December 2009, the number of problem banks has increased by 142 to 844.

Continued weakness in the banking industry has resulted in a new crop of problem banks.  Another, perhaps more serious reason for the stubbornly high level of problem banks is due to the leisurely pace at which regulators are closing insolvent banks.

According to a study done by The Wall Street Journal, seriously undercapitalized banks are being allowed to remain open for much longer periods of time than in the past.

The Journal’s analysis shows 66% of 2011’s failed banks were “significantly undercapitalized”—a regulatory threshold in which capital is far below preferred levels—for at least six months before they failed, compared with 29% of 2010’s failures. The median reported Tier 1 risk-based capital ratio, a key measure of a bank’s health, was 25% lower at the time of failure for 2011’s failed banks than for 2010’s.

The Government Accountability Office said in June that regulators had been “inconsistent” and often hadn’t acted quickly enough in addressing signs of banks’ deterioration. Banks on regulators’ watch lists that ultimately failed spent a median time of 21 months on the lists before failure, the GAO indicated.

It is only when it becomes “critically” undercapitalized—an even lower threshold than “significantly” undercapitalized, when tangible equity is less than 2% of assets—that the law requires regulators to move toward a potential seizure.

Darrell Duffie, a Stanford University finance professor, said regulators manage troubled banks to avoid or at least limit any loss to the government’s deposit-insurance fund. As long as no imminent loss is likely, “they’re going to let the bank ride for some time.”

The Journal also noted that regulators want to give “potentially viable” banks enough time to recover.  According to Kris Whittaker, deputy comptroller at the Office of the Comptroller of the Currency, “If we believe there’s a realistic chance…we’re more willing to let them get that capital raise.”

The deputy comptroller’s remarks sound reasonable until the condition of banks that are finally closed is examined.  For example, a look at the failure of The First State Bank last week clearly indicates that the deputy controller’s comments are self serving and misleading.  As discussed in the post on The First State Bank failure, at the time of closing, over 40% of the failed bank’s assets were considered to be worthless by the FDIC.

A troubled economy along with slumping real estate values resulted in The First State Bank being overwhelmed by defaulted loans.  The Bank had one of the highest troubled asset ratios on record at 950% and had been struggling with an exploding level of bad loans since the beginning of 2009. Statistically, problem banks with a troubled asset ratio of over 100% almost always wind up failing.

Regulators have delayed closing problem banks with the hope that the economy would turn around or that new capital could be raised.  Unfortunately, the economy has not turned around and investors are not willing to risk capital in the banking sector.

Allowing an under capitalized problem bank to remain open may only increase losses when regulators finally close the bank.  The $216.2 million loss to the FDIC Deposit Insurance Fund for the failure of The First State Bank is a substantial 40.2% of total assets.  By comparison, the average loss to total asset ratio for all failed banks for 2011 was only 20%.

The First State Bank was by any measure hopelessly insolvent for years and carrying assets that turned out to be overvalued by at least $200 million as indicated by the loss taken by the FDIC.  Allowing zombie banks to remain open long after they are past the point of recovery prolongs the banking crisis and is the foundation for a lack of confidence in bank soundness.

Perhaps the OCC deputy comptroller can come up with a better explanation for allowing insolvent banks to remain open that is more closely aligned to reality.  Could the fact that 2012 is an election year have anything to do with the slow closing pace of insolvent banks?