Shackling Undercapitalized Banks Wouldn't Stop Failures

A version of the bank reform bill recently passed by the House Banking Committee would have mandated restrictions on any bank whose capital ratio fell below a specified level.

The restrictions would cover dividends, growth of total assets, and the compensation of senior bank officials. And regulators would be authorized to appoint a conservator for any bank whose capital ratio fell below a critical level.

Under the bill, expansion into nonbanking activities would be limited to banking organizations with capital ratios significantly above minimum required levels.

Shaky Assumptions

Legislation such as this, which calls for "prompt corrective action" by bank regulators, is the result of several assumptions:

* That regulators in recent years have been the last ones to move to restrict the activity of banks whose capital has fallen below required levels.

* That this legislation would remedy this perceived laxity on the part of regulators by limiting their discretion in dealing with troubled banks.

* That activities that would be restricted by the legislation have in fact contributed significantly to the rate of bank failure and losses to the deposit insurance fund.

Some tightening of the supervision of undercapitalized banks may be justified. Yet evidence on failed banks and the behavior of undercapitalized banks does not support these three assumptions.

Hidden Discretion

The proposed system of mandatory actions by regulators appears to be very precise. The actions required of regulators in the proposed legislation would depend largely on capital ratios.

But there is a major problem in trying to limit regulators' discretion this way.

The regulators who would be required to take specified actions under this legislation are the same people who would continue to have a lot of discretion in determining when assets are declared losses, thus influencing the capital ratios. If regulators wished to forbear, they could simply let a bank delay recognition of losses in the value of its assets.

As for capital ratios, evidence on the behavior of undercapitalized banks does not support the assumptions that underlie the legislation. I analyzed the behavior of undercapitalized banks in the May/June 1991 issue of the Federal Reserve Bank of St. Louis Review.

Over four consecutive quarters in the years 1985 to 1989, the reviewed banks had ratios of primary capital to total assets below the minimum 5.5% required.

In the entire nation, 531 banks were undercapitalized for over four consecutive quarters. Seventy-two of these banks remained in operation for a year or more with negative equity capital.

These observations support the view that regulators have permitted many banks to remain undercapitalized for long periods.

Generally Prudent Behavior

Yet most of the 531 undercapitalized banks did not engage in the types of activities that would be restricted under the legislation for prompt corrective action.

While being undercapitalized, only about 16% of these banks had asset growth in excess of 10%. Only 8% had asset growth in excess of 25%, and only 14% paid dividends.

During the period of undercapitalization, there was an increase in lending to insiders (officers and directors of the banks) in about 24% of the banks. But these cases were heavily concentrated in one state, under the jurisdiction of one federal regulator.

Nationally chartered banks in Texas account for 63% of all banks in the nation with negative equity during four or more quarters, as well as accounting for 59% of banks with asset growth in excess of 25% while undercapitalized.

The Road to Recovery

The evidence shows that banks that recovered did so by raising their capital ratios above the minimum required levels, and that bank activity in the areas addressed by the bank reform bill did not affect chances for recovery.

Recovery rates of undercapitalized banks that paid dividends, those with relatively rapid asset growth, and those with higher insider loans while undercapitalized were not significantly different from the recovery rates of other undercapitalized banks.

To summarize:

* The legislation for prompt corrective action is based on the view that banks fail because of the risks they assume once their capital ratios fall to relatively low levels.

* The evidence does not support this view.

In most cases, banks fail because of the risk they assume while their balance sheets indicate adequate capital ratios. To reduce the rate of bank failure, it will be necessary to change the incentives for banks to assume risk under such circumstances.

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