FDIC Girds For Bank Failures

As banks struggle, regulators prepare for the worst.
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Shaky loan portfolios continue to darken the landscape for the nation's banks, as federal regulators prepare for the possibility of an uptick in failures of financial institutions, according to recent government reports.

A record-high $31.3 billion set aside by banks for loan losses, record trading losses and goodwill expenses dragged down fourth-quarter net incomes of insured banks to a 16-year low, according to the Federal Deposit Insurance Corp.'s quarterly banking profile released Tuesday. The cumulative increase to loan-loss provisions was the largest increase in 20 years.

The FDIC report comes on the heels of study from the Government Accountability Office made public last week, which found the FDIC recorded an estimated liability of $124 million at the end of 2007 for the anticipated failure of some insured institutions and also identified potential losses of $1.7 billion should vulnerable insured institutions also fail.

All of this is happening as the FDIC, established during the Great Depression to provide a backstop to depositors during a rash of bank failures, solicits banks' input on ways to accomplish as orderly a wind-down as possible in the event of a major bank's demise. The FDIC sent a notice out to banks requesting their ideas last month.

"The notion that a bank is too big to fail shouldn't be out there," says Jim Marino, of the FDIC's Division of Resolutions and Receiverships.

The grim picture for banks was reiterated by FDIC's report Tuesday. It noted that non-current loans exceeded reserves for first time since 1993. Loans that are 90 days past due, jumped 32.5% to $26.9 billion, the single-largest increase in a quarter in 24 years. The only loan category with an improving picture was farm loans, no doubt aided by soaring commodity prices.

The fourth quarter was notable for several other firsts and record-breaking numbers. Trading losses came to $10.6 billion, making this the first quarter the industry has ever reported a net trading loss. Less than half of the insured banks reported improved earnings for 2007, making this the first time in 23 years that a majority of the banks have not posted earnings increases. It's also the first time since the mid-1970s that non-interest income has declined. On a positive note, domestic deposits rose to $170.6 billion, the largest quarterly increase. But the bad news is that the industry's ratio of deposits to total assets hit an all-time low.

While no major banks have yet failed in the current crisis, some big names have experienced significant troubles.

Washington Mutual

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is one national bank that has been particularly hard hit by poor mortgage and other loans. WaMu cut its dividend and set aside $1.5 billion in the fourth quarter to cushion against greater delinquencies on subprime mortgages and home-equity loans. A number of regional banks, like

National City




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also recently increased loan-loss provisions.

"The problems are in all categories, and given the thin coverage of the banking system for such losses, rising charge-offs and loan loss reserves are likely to bite deeply into earnings," wrote John Hussman in a September market comment for Hussman Funds.

FDIC spokesman David Barr pointed out that even as assets increase, the agency is restricted in its ability to get more income for the Depository Insurance Fund (DIF). The DIF is administered by the FDIC and is funded through investments and payments by insured banks. The payment is calculated both on the balance of deposits as well as on the degree of risk posed to the insurance fund. However, Congress sets the ratio level and even though it was raised last year to 1.25, the current level of reserves to insured deposits is only at 1.22. In 2006, it was 1.32.

"Ninety percent of the banks haven't been paying in because the reserve ratio isn't low enough," he said. "Congress increased the number last year, but exempted older banks. We're restricted to income on Treasuries."

So the FDIC is going to be hitting up banks for more money at a time when many can least afford it. The goal for the DIF ratio is to be at 1.25 by 2009. "The number of problem banks is increasing, but still historically low," Barr said. "However, the assets are increasing."

A rise in bank failures exemplifies the burgeoning problem. Douglas National Bank in Missouri failed in January and the three banks that failed in 2007. The FDIC's Marino said that typically three to six banks fail each year, but there were no bank failures during 2005 and 2006, when banks were raking in fees for loans.

Last month, the FDIC issued a two-part Notice of Proposed Rulemaking, seeking comments related to the potential failure of large insured depository institutions. Marino has been working on this project for two years.

When a bank fails, the FDIC has to be able to look at all the accounts of a depositor and figure out how much is insured. "Banks do not know the insurance status of their customers, nor do they really care," Marino said. "What we're saying to larger institutions is that you're going to have to help us out."

Marino said banks with regulatory problems typically used to fail on a Friday, allowing the FDIC to step in and sort But with liquidity issues, failures can come at any time. Moreover, electronic banking leads to a lot of nightly processing, so it's usually not until 4 a.m. in the morning that the FDIC gets a glimpse of the balances.

The proposed rule the FDIC is considering would require the largest institutions to modify their deposit systems so that the FDIC could calculate deposit insurance coverage quickly in the event of failure.

Today's trouble in the banking sector has a long way to go before it rivals the Depression, when 4,000 banks failed. But the symptoms then were similar: banks were bogged down with foreclosures and left with unsalable assets. The banks struggled with liquidity issues, which the

Federal Reserve

did little to help.

Today's Fed is bending over backwards to create liquidity. Just last month when the Fed's own reports noted that banking reserves had gone into

negative territory, the Fed stressed that by making short-term liquidity available through its term auction facility, the banks would have plenty of money. But that money is achieved through loans and not real capital.

Hussmann in September observed that reserves had fallen to their lowest level relative to non-current loans since the third quarter of 2002 and non-current loans experienced the largest uptick since the fourth quarter of 1990 -- representing the last two notable economic downturns.

"Recall that 1990 and 2002 were periods when recessions were already well underway," he wrote. "If we're already seeing these signs of credit stress at the peak of an economic expansion, the figures we observe in a recession are likely to be a lot worse."