Wednesday, May 8, 2013

According to a FDIC report, 478 banks have failed since 2007. In 2012 there were 51 USA bank failures (actual count was 50). 45 of those banks had less than $500MM in assets and 50% of them were located in three states, i.e. GA, FL and IL. 42 of the failed banks had 5 branches or less. In just 4 months of 2013, 10 banks have failed. The economy and real estate meltdown continue to take the blame while lending mediocrity solders on. The other most common and obvious reason attributed to bank failure is severe undercapitalization. True, but that is the last straw! Several months and possibly years before failing, a bank will have gone through lengthy and painful processes dealing with delinquent or bad loans - endless credit meetings, examinations audits, numerous reports, collections, write-offs etc. But what are the underlying causes of capital depletion? Capital depletion is caused by a number of events. Top on the list is poor underwriting and credit administration which lead to bad loans. Bad loans don't pay interest as scheduled. Consequently, interest income decreases as allowances for loan loss increase. Other reasons are credit concentration; aggressive organic growth; loss on investment securities; undue reliance on volatile liability; out-of-territory lending; risky participation, fraud; liquidity failure and sustained losses among others. Let me examine these reasons briefly and hopefully some of you will make genuine attempts to avoid capital erosion of your bank's capital: 1. Poor underwriting and credit Administration Most banks are copy cats. They merely follow what the other banks are doing on the market. For example, they will relax credit to win business from a competitor. Some try to cut cost by recruiting mediocre underwriting staff. Some of them have very controlling senior lenders or chief executives who dominate credit decision making while others are grossly understaffed. The list goes on and on. Fortunately, banks can avoid these pitfalls by outsourcing credit underwriting to professional credit underwriters who provide objective credit underwriting and recommendations. 2. Unwarranted credit concentration According to the Comptroller of Currency, pools of individual transactions that may perform similarly because of a common characteristic or common sensitivity to economic,financial, or business developments have been the primary cause of credit related distress. Yet many banks either ignore or completely misunderstand this simple logic by confining analysis to portfolio content and downplaying issues relating to one counterparty, borrower, or group of related counterparties or borrowers, same source of repayment, industry or economic sectors, same collateral, geographical area etc. 3. Aggressive growth Rapid growth strategies lead to high concentrations that end up being funded with nontraditional, riskier funding sources 4. Bad investment securities While banks tend to engage in proprietary trading in un-hedged derivatives, other banks' debt, large blocks of marketable securities, exotic instruments and illiquid investments, regulators believe this to be a high risk undertaking. 5. Participation purchases Often lending officers are too lazy to analyze participation purchase to ensure that they conform with prudent lending practices and in particular their institution's own lending policies. As a result they book risky assets that really have no control of. 6. Fraud Fraud arising from weak controls can lead to huge losses and capital erosion. 7. Liquidity failure Over-lending and non-performing loans deprive banks the working capital needed for operations. 8. Sustained losses Consecutive losses over a period of more than two years can be devastating to a bank, particularly if it is marginally capitalized. 9. Insider loans Inappropriate loans made to directors and insiders for real estate and many other projects that are ill-conceived are likely to result in huge losses and bank failure. 10. Asset/liability mismatch. When a bank's assets are unmatched to the liabilities supporting them, severe problems can arise. For example, if floating deposits finance a fixed rate loan. If interest rates rise, the bank pays more and more interest on deposits while the fixed rate loan pays the same rate. This mismatch can result in a huge loss. When a large portion of a bank's portfolio is mismatched, the results can be devastating. 11. Unfavorable Economic Environment Certain environmental conditions, such as economic collapse, busting of real estate bubble etc. can cause losses for banks. However, banks that pursue prudent lending, adhere to credit policy and engage experienced credit underwriters can survive such an unfavorable phase. 12. Rising non-funding expenses Uncontrolled non-funding expenses can drive cost of doing too high resulting in huge operational losses.