Several recent bank failures - Bank of New England and madison National, among others - came as no surprise to people in the banking industry. Uninsured depositors started pulling out of these banks a year or more before they were closed.
The congressional banking committees have excoriated the regulators for not closing these institutions fast enough. Legislators have been clamoring for statutory requirements that direct regulators to place specific sanctions on institutions with declining capital levels.
The logic of mandated regulatory intervention seems compelling. An institution's capital level represents the investments of private owners that cushion a bank, and thus its depositors, from loss. As a bank's capital - its owners' stake in the institution - declines, why not close it before its value is exhausted?
All agree with the premise of the argument for mandated intervention. Banks in imminent danger of failure should be closed as soon as possible. Besides presenting a risk to their depositors and the deposit insurance fund, banks on the brink create economic uncertainty and instability.
Congress' attempt to tie the hands of regulators and require that they intervene when institutions reach given capital levels is, however, misguided. Mandatory intervention is a penny-wise, pound-foolish solution.
The strategy's flaw is its over-reliance on capital as the only indicator of a bank's health.
State bank regulators have long insisted on high levels of capital in the institutions they supervise. We have objected to federal regulatory reforms that effectively reduce the amount of capital institutions must hold.
While we recognize that capital is the best preventive medicine against bank failure, we know it is not the key factor in determining whether an institutions is viable. Capital is a trailing, not a leading, indicator of a bank's health.
Capital is one element bank regulators consider in assessing an institution - the others are asset quality, management, earnings, and liquidity (components of the "Camel" rating). Asset quality and earnings are both more relevant to an institution's ability to recover than its capital level.
A Judgment Call
Management, however, is the key to a bank's survival. And management is simply not quantifiable by any objective measure. Regulators evaluate management according their own trained judgment.
An undercapitalized institution, while by definition unhealthy, is not necessarily in danger of imminent failure. Depending on where the bank and its surrounding economy are in the business cycle, the bank may be on tis way up or on its way down.
Six months, the amount of time H.R. 6 would allow the institution before mandatory closure, is in many cases not enough time to determine whether the bank is recovering or continuing to decline.
Mandated sanctions based only on capital would force unnecessary bank closures.
Stockholders will be reluctant to invest further in an institution shackled with sanctions. If, because of mandated sanctions, they perceive regulators to be on an inexorable course to close the institution, they will see further infusions of capital as pouring money down a hole. Certainly a bank under mandatory sanctions would find it difficult to attract new investors.
The Kiss of Death
There is no evidence that this plan will save the deposit insurance fund any money. As the Federal Deposit Insurance Corp. chairman, L. William Seidman, pointed out in a June 12 letter to Sen. William Roth, R-Del., the value of an institution and its attractiveness to potential buyers drops dramatically after the government takes over.
The FDIC's policy has properly been to attempt to save as much of an institution's value as possible, to reduce its own losses. Mr. Seidman pointed out that almost a third of undercapitalized banks, representing more than half of the assets in undercapitalized institutions, regained adequate capital levels within two to four years. Closing these institutions would have cost the FDIC an unnecessary $1.6 billion to $2.1 billion.
Bank customers should be alarmed about the imposition of required regulatory sanctions. These sanctions would reduce regulators to automatons who must rely only on capital numbers to dictate their actions. Regulating a problem bank is similar to handling a loan workout. It requires experience, judgment, and flexibility. Bank regulators must have discretion in this process.
A Dangerous 'Solution'
The combination of blind faith in capital levels and mandatory penalities is a simplistic, dangerous, and potentially expensive "solution." With flexibility, some institutions can be saved even if others cannot. Reliance on a single measure of health guarantees that even those banks that might make it will be closed, with the FDIC picking up the tab.