The U.S. Banking Crisis Is Not Over: Part 2

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( TheStreet) -- Several weeks back, I wrote that the U.S. banking crisis was not over. As evidence, I pointed to the fact that more than 50% of the 742 banks that borrowed money from the Troubled Asset Relief Program had not even started to pay off their debts. That is costly money for banks -- the dividend rate (read interest) goes from 5% to 9% in four years. That means banks borrowing from TARP in 2008 will start paying 9% this year.

Below, I provide more detail on the problems facing banks that have not repaid their TARP monies. I also look at other indicators of banking problems.

The Role of Regulators

There are two related reasons why banks have not paid off their TARP loans. The first is that they are really strapped. The second is that the FDIC and other bank regulators will not permit it. What do bank regulators worry about? Mostly, the wrong things.

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After decades of meetings in Basel at the Bank for International Settlements, bankers/regulators have come up with three "accords" to manage banks -- Basel I, II, and III (the U.S. never signed Basel III). But the accords and other efforts by regulators did not prevent the banking collapse in 2008. In Europe, sovereign debt was treated as safe as cash, at least until "the Greek problem" surfaced.

What U.S. Regulators Want

To understand what is happening in the U.S. banking industry, you have to understand what the regulators want and how their requirements are slowing TARP repayments. Since I know little about bank regulations, I asked a banker friend of mine who does. He said "The regulators expect each bank to establish their own minimum capital ratios based on each bank's risk profile." During the exam process, the regulators determine the adequacy of their risk profile assessment and the determination of their own internal minimum capital ratios.

He went on to say that the regulators look at a lot of data but focus on three quantitative indicators: the leverage capital ratio, the Tier 1 risk-based capital ratio, and the total risk-based capital ratio. He added that there are "official" numbers for these ratios, but the regulators in many cases now want higher numbers based on the risk profile of the bank. And even higher expectations are coming: The Fed has announced it will require banks to carry more capital in coming years.

Table 1 includes the "official" and "wanted" numbers for these ratios. In addition, the FDIC collects data on 7,357 banking institutions. I used their numbers to generate average data for all banks as well as the number and percent of banks that score less than the "wanted" numbers.

Table 1: U.S. Bank Performance on Regulators Standards (end 2011)

Source: FDIC

Quite clearly, there are a substantial number of banks still in the "gray" zone with the regulators on all three of the indicators they use.

My banking friend wanted me to qualify that statement. He said: "Some of those banks in the 'grey zone' as you put it may be very strong banks that have a low risk profile and thus negating the need for elevated capital levels."

OK. Before investing, you should do your own due diligence.

Do TARP Banks Really Need TARP Money?

In my previous bank article, I included a table listing the banks that had not started paying their TARP loans back by the end of 2011.

In Table 2, I calculated what would happen to the Tier 1 ratios of banks if they did pay back their TARP loans. For this exercise, TARP data came from the April 2 TARP Report and the FDIC data from their latest reporting period, ending 2011. In this table, I also included data from the FDIC on each banks return on assets. A negative ROA is not good -- it means the bank is losing money.

Table 2: What Happens to Tier 1 Ratios If Banks Pay Off TARP Loans

Source: FDIC, TARP Reports

Let's look at Old Second National Bank ( OSBC) as an example. According to my calculations, if Old Second paid off its TARP loan, its Tier 1 ratio would fall to 7.0%. And remember that the regulators now want this ratio to be 10%. My banker friend indicates that the regulators informally now want Tier 1 risk-based ratios to be at least 10%. That would mean all the banks on this list would be under pressure from the regulators not to pay off their TARP loans.

Zions Bank ( ZION)is a particularly interesting case. Since it took out its loan in November 2008, it will start paying 9% this year. On March 28, it paid back $700 million. The Tier 1 data appearing in Table 2 were end-December 2011, so it will not reflect the Tier 1 reduction resulting from this payment.

I estimate that payment reduced Zions' Tier 1 ratio to 8.6. I can just imagine the Zions executives arguing with the regulators over this: Zions -- we don't want to pay 9.5% for money. Regulators -- we'll let you cut your TARP loan in half, but we will not allow your Tier 1 ratio to fall further, and certainly not to 3.8% which is what it fall to if you repaid TARP the entire $1.4 billion that you owe.

The Most Dangerous Banks

Table 3 is my list of the U.S. banks in the most trouble. I arrived at this list by using three different indicators: leverage capital ratio (indicated as LEV), total risk-based capital ratio (TOT) and the return on assets (ROA). I came up with the 20 worst banks on each indicator. I then found those banks included on two or more of the lists. A bold number in the table indicates the indicators where the bank scored in the bottom 20.

Table 3: Dangerous Banks

Source: FDIC

Banks with negative ROAs are the most dangerous on this list. I would urge investors to avoid them or at least perform your own due diligence on any banks on this list, particularly those with a negative ROA. Depositors? Well of course, your deposits are guaranteed up to $250,000 . . . .

Concluding Observations

Above, I have outlined the thinking and findings of the US bank regulators. But do they know anything more than they did in 2008? I doubt it.

As most of you know, I believe trying to regulate banks as currently constituted will never work. They are simply too complex to be regulated effectively.

What to do?
  • Get risky investments out of banks;
  • Force the investment banking arms of these banks to sell off the depository banking; operations
  • And then limit FDIC insurance to banks that manage their own loans and do not trade on their own accounts.
  • Elliott Morss is an economic consultant and an individual investor in developing countries. He has taught at the University of Michigan, Harvard University, Boston University, among other schools. Morss worked at the International Monetary Fund and helped establish Development Alternatives Inc. He has co-written six books and published more than four dozen articles in professional journals.

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