Over a four year period ended in December 2011 and representing the height of the banking crisis there were 414 failures of insured U.S. banks. Of these, 353 or 85 percent would be classified as smaller banks with less than $1 billion in assets and ten states had ten or more of these small bank failures.
Because of questions asked about factors contributing to the failures, the effectiveness of FDIC's resolution methods, and the effects on the banks' local communities the GAO recently conducted a study focusing on small bank failures in those state with the largest numbers to determine if there were local contributing factors. Its report was issued today.
The ten states were concentrated in the western, midwestern, and southeastern regions of the country all of which had experienced strong growth in their housing market in the preceding ten years. GAO found that the failures of banks in those states were largely driven by losses on commercial real estate (CRE) loans. These banks had also often pursued what GAO called aggressive growth strategies such as using brokered deposits for funding and employing looser underwriting standards. The rapid grown of these banks' CRE portfolios left them vulnerable to the sustained real estate and economic downturn that began in 2007. While some local officials told GAO that some losses were caused by declines in the value of the CRE collateral, data was not available to assess the extent of this possible cause.
Fair value accounting also has been cited as a potential contributor to bank failures, but between 2007 and 2011 fair value accounting losses in general did not appear to be a major contributor, as over two-thirds of small failed banks' assets were not subject to fair value accounting. The Treasury Department and the Financial Accounting Standards Board have observed that the current accounting model for estimating credit losses is based on historical loss rates, which were low in the pre-financial crisis years and that earlier recognition of loan losses could have potentially lessened the impact of the crisis. Instead banks had to recognize the losses through a sudden series of provisions to the loan loss allowance, thus reducing earnings and regulatory capital. The Standards Board has proposed a loan loss provisioning model that focuses on expected losses and would result in earlier recognition of loan losses so banks could incentivize prudent risk management practices. The proposal should also help address the cycle of losses and failures that emerged in the recent crisis as banks were forced to increase loan loss allowances and raise capital when they were least able to do so.
The FDIC used shared loss agreements for about half the banks it closed during the crisis. Under these agreements FDIC absorbs a portion of the ultimate losses on some assets of the failed bank that are purchased by the acquiring bank. It is the consensus of parties interviewed by GAO that use of these agreements, which are projected to cost FDIC about $42 billion over their contract life, potentially saved the Deposit Insurance Fund another $40 billion. They are also credited for attracting bidders for the assets. FDIC said it benefited from reductions in its own immediate cash needs, moved assets quickly into the private sector, and provided less disruption to the bank's customers through use of the agreements.
GAO found that the acquisitions of failed banks by healthy banks appear to have mitigated potentially negative effects of the failures on local communities. Failures and acquisitions can have an impact on bank concentration and thus on competition but GAO found only a limited number of areas where banking may have become significantly more concentrated, sometimes because the acquiring bank came from out of market.
Another concern was that the failures might impact the availability of credit but GAO found that, failing banks had generally reduced their extension of credit as they failed and acquiring banks increased net credit after the acquisition. Post acquisition credit standards, however, were generally tighter so any increase in credit usually favored those small business owners with good credit histories and strong financials.
Involvement in local philanthropy was not generally affected by the failures as again involvement in local causes generally fell as small banks were failing and increased under new ownership although the acquiring bank might have a different focus for its philanthropic activities.
Finally, GAO econometrically analyzed the relationships among bank failures, income, unemployment, and real estate prices for all states and the District of Columbia for the 1994 through 2011 period and found that bank failures were more likely to affect a state's real estate sector than its labor market or broader economy.
The GAO did not make any recommendations based on its study but said it plans to continue to monitor the activities of the accounting standard setters to address concerns with the loan loss provisioning model.