Wednesday, September 1, 2010

The Number of Problem Banks Continues to Rise. Surprise!

The most important thing for government regulators at this time is to handle the problems in the banking industry in an orderly fashion. Don’t panic; don’t show fear; just keep plugging ahead.

This seems to be exactly what the FDIC and the Federal Reserve are doing.

The FDIC announced that there are now 829 banks on the problem watch list as of June 30, 2010. Given that 45 banks failed in the second quarter of 2010 this means that 99 additional banks were added to the list. One should note that this figure, 99 banks, compares with 113 banks that were added to the list in the first quarter of 2010. The highest number ever reached for the problem list was 993 and this came in 1993.

Remember, though, that Elizabeth Warren indicated in Congressional testimony that there were 3,000 banks that faced serious problems with respect to loans and assets on their books that probably needed to be written down and that these banks had not seen the full effect of the problems in the commercial real estate sector.

One can also add that these institutions have not really recognized the problems that state and local governments are having in their finances. Note that Pennsylvania’s capital, Harrisburg, announced that it will default on a $3.29 million municipal-bond payment in two weeks making it the second largest general-obligation municipal bond default this year.

With the 32 banks that have failed so far in the third quarter, the total number of failures in the year reached 118, well ahead of the pace from last year when only 140 banks were closed overall.

Using the rule of thumb that one-third of the banks on the problem list will fail over the next 18 months, this would mean that we will experience 276 more bank failures and an average rate of bank failures at 3.5 per week during this time span. In 2010, the pace of bank failures has hovered around this average.

But, the FDIC is working through this tremendous case load in an orderly fashion. There are very few surprises and this is the best thing that can happen given the condition of the banking system.

The Federal Reserve is also contributing to this work out situation in the banking industry. Perhaps the most important thing it is doing is the subsidization of the large banks in the United States. By keeping its target interest rate around zero percent, the Fed is paying a big bonus to the big banks and the payoff for this policy is that the profits at the largest financial institutions have been at record levels and that about 75 percent of the assets of the banking system seem to be well protected.

The profit picture of the banking industry improved in the second quarter with the industry recording the highest level of profits since before the financial crisis. The FDIC reported that nearly two-thirds of United States banks reported a year-over-year improvement. The biggest booster to this performance was the reduction loan-loss provisions.

However, it should be noted that 20 percent of the banks, primarily the smaller banks, reported a net loss and that more than 60 percent of banks, mainly the smaller institutions, continued to increase their loan loss reserves.

Another place where one can find information on the problems the commercial banking industry is having is the report of the Federal Reserve on Enforcement Actions taken by Federal Reserve Banks against some of the financial institutions it regulates.

So far in the third quarter of 2010, the Federal Reserve has engaged in 56 enforcement actions against financial institutions bringing the total up to 192 for the full year to date. Last year only 172 enforcement actions were taken.

Enforcement actions can take one of two forms: a written agreement or a prompt corrective action directive.

The most recent written agreement is a legal action taken by the Federal Reserve Bank of Kansas City, the State of Colorado Division of Banking and First American Bancorp and First American State Bank, both of Greenwood Village, Colorado. This written agreement aims to bring the banks into compliance with every “applicable provision” of the Agreement reached between “the Bancorp, the Bank, and their institution-affiliated parties”, the Reserve Bank and the Division. The agreement specifically deals with Board Oversight, Credit Risk Management, Lending and Credit Administration, Asset Improvement, Internal Audit, Allowance for Loan and Lease Losses, Capital Plan, Earnings Plan and Budget, Liquidity/Funds Management, Dividends and Distributions, Debt and Stock Redemptions, Cash Flow, and, Compliance with Laws and Regulations. The specifics of each of these sections present a very definite list of things the bank(s) must do in order to comply with the agreement. Furthermore, specific dates are given for achieving compliance. And, “The provisions of this Agreement shall not bar, estop, or otherwise prevent the Board of Governors, the Reserve Bank, the Division or any other federal or state agency from taking any other action affecting” the affected parties or this successors and assigns.

The most recent Prompt Corrective Action is that taken against the First Community Bank of Taos, New Mexico. In this agreement very specific actions are required such to “increase the Bank’s equity” and to “enter into and close a contract to be acquired by a depository institutions holding company or combine with another insured depository institution.” The Bank is restricted from making capital distributions or the payment of dividends. The Bank shall not “solicit and accept new deposit accounts, etc.. The Bank shall restrict the payment of bonuses to senior executive officers and increases in compensation of such officers.” And, the bank is restricted in terms of asset growth, acquisitions, branching, and new lines of business.

These enforcement actions are very serious and a reading of some of them can give one an idea of the problems that exist “out there” in the banking industry. And, 192 of these have been given out so far this year!

As more and more information is made available, the more one realizes that the banking industry is being re-constructed. In the next five years or so we will observe a banking industry that is much smaller than the one that exists today and this industry will be even more dominated by the larger institutions making up the industry. I believe that the number of domestically chartered banks in the United States will fall from a present level of about 7,800 banks to around 4,000 banks. I believe that the largest 25 domestically chartered banks in the United States will control about 75 percent of the banking assets in the country up from around 67 percent now.

I am more confident about this latter number than the former one. It is hard to believe that 3,975 banks can profitably be operated when they only control 25 percent of the banking assets. The smaller banks are just not going to be profitable and cannot compete in the world of the 21st century!

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