Bank Failures: What you need to know

Adapted from a letter to BCNB customers

With the proliferation of bank failures, I thought it was time to share some information on banking industry fundamentals. By learning these basics, you can better understand the current financial crisis and have a better perspective for judging your financial providers, both now and in the future.

The most logical way to look at bank fundamentals is to pretend you’re a bank examiner and use their approach – the CAMEL rating. At each annual exam, examiners look at the components of the CAMEL rating and score the bank. The components are: C (Capital Adequacy), A (Asset Quality), M (Management), E (Earnings), and L (Liquidity).

Successful banks must have a strong capital position, high-quality assets and a solid earnings stream with reliable sources of non-interest income and good expense controls. Not surprisingly, a strong management team is the key that pulls everything together. They determine the appropriate investment strategies, implement a credit monitoring system to quickly identify weakening assets, and establish appropriate policies and procedures.

Although they may appear independent of one another, one component’s weakness will cause failure in the others.

A bank, or for that matter any business, must be adequately capitalized in order to survive, especially during difficult economic times. We have seen many well-publicized failures of major companies whose capital became insufficient after their earnings stream was compromised or their assets were significantly devalued.

Many of the banks that failed started the economic downturn with minimal capital. They grew their institutions quickly during the good times without adding to their capital accounts. When the earnings stream deteriorated due to credit losses and a lower level of earning assets, the capital levels quickly began to erode. A solid, consistent earnings stream is critical to maintaining a strong capital position.

Most banks failing this year are doing so because of asset quality issues. For many banks, their failures happened rather quickly. Low-quality assets can deteriorate fast and banks can find themselves in trouble when they can’t easily liquidate poor- quality assets.

Many of the failed banks did so because they could not meet the cash withdrawal demands of their customers. Depositors wanted their money, but the bank was out of cash and had poor-quality assets that no investors were willing to buy…at any price. Thus, the bank had inadequate levels of liquidity and no assets to convert to cash to meet customers’ demands.

Because earnings are critical, management closely monitors earning assets. These are assets that earn interest income such as overnight investments, longer-term security investments and loans. An appropriate level of earning assets is the only way to ensure a solid, consistent earnings stream.

The largest earning asset for a bank is its loan portfolio. If a borrower is unable to make loan payments, the bank places the loan in non-accrual status, which means it is not recognizing any income on that loan. Many times, this is the first step before the bank considers taking possession of the collateral. Conversely, once a borrower gets back on their feet, the loan can be placed back in the earnings bucket again.

The recognition of loan losses is not typically a direct hit to earnings, as banks reserve for the possibility of loan losses on a monthly basis. However, if losses, or the potential for future losses, exceed the level of the reserve fund, additional provision allocations are necessary. These allocations impact earnings and thus result in lower capital levels.

You may have noticed that a lot of the failing banks were startup banks or banks that wanted to grow quickly. The easiest way to do that is with high-cost certificates of deposit and brokered certificates of deposit. Because these are very expensive funding strategies, they had to have higher asset yields to show profits. Thus, they made more risky loans thinking that by charging a higher interest rate they were being compensated for the higher level of risk. Not so. If a loan is not structured properly or the borrower does not have the wherewithal to support the credit, the credit will go into default. Once a credit goes into default, it is difficult to structure the credit to prevent a loss.

When times were good and credit was easy, too many banks strayed from the sound investment strategies they had followed for years. They lowered their underwriting standards and ignored the Five C’s of Credit: Character, Capital, Capacity, Collateral and Conditions. Banks with poor management and weak credit monitoring systems faced severe losses and a high level of non-earning assets. When an earnings stream deteriorates due to credit losses and a lower level of earning assets, the capital levels quickly erode.

The investment portfolio is the other component of earning assets. When I started my career in banking, I recall our management stating firmly, “We take risks in the lending portfolio but we don’t take risks in the investment portfolio.” Too many banks, dissatisfied with the yields received on their investment portfolios or desiring to enhance their income even further, took risks in their investment portfolio.

Banks began to chase after yields, investing in preferred stocks of Freddie Mac, Fannie Mae and very complex securities backed by mortgages in residential and even commercial property. The preferred stock investments became worthless when the government took control of Freddie Mac and Fannie Mae. Banks do not reserve for losses in their investments portfolios. If the value of a security investment becomes impaired, it is an immediate hit to earnings.

If the quality of both the loan and investment portfolios is compromised, it is very difficult for a bank to survive.

Banks such as Boone County National Bank, with good management and good credit monitoring systems, are facing losses due to the weak economy, but they are manageable.

Too many of the banks that failed focused primarily on growing the business as their leadership was compensated based upon growth. They were more concerned about short-term profits than long-term shareholder value. It is unfortunate but many banks, and other businesses, have learned a valuable lesson during this difficult economic period.