My dear departed mentor and co-author, George Benston, spent considerable time in the classroom describing why banks were a different kind of corporate creature. Prominent among these distinctions was the need to establish minimum capital standards.
The market and the public policy discussion have missed his wise counsel as the financial system careened from one crisis to the next. With the Senate having passed financial reform legislation, and as the Federal Deposit Insurance Corp. contemplates prospects for hundreds of troubled banks, let us consider what purpose capital standards serve and how we might handle remaining banking problems effectively and with minimal market disruption.
Regulators and legislators agree that bank capital requirements will rise. The benefits of more capital are self-evident, but measuring capital is both treacherous and begs the question of setting ideal targets.
For publicly traded bank stocks, is market capital the right metric? Too much volatility. Value-at-risk? Widely discredited. Fair-value accounting? Healthy banks rightly protest that this exposes a bank to punitive, fire-sale liquidation pricing.
But isn't this exactly the information that the FDIC, as deposit insurer, requires to assess a bank's rising cost of resolution? Indeed, under the prompt-corrective-action law, the FDIC must act when the book value of capital hits defined thresholds. Based on recent history, we can test how well capital as measured under this law has worked. From this, maybe policymakers and regulators can reconsider the merits of mechanical capital-testing and the usefulness of these tests in pursuit of least-cost resolutions.
In 2009, 140 banks failed. On the day of each failure, the FDIC released an announcement of the closure, the resolution structure (if known) and estimated losses. The FDIC projected losses from the 140 failures averaging 25% of total assets — a negative equity ratio of 25%. For the reporting period immediately prior to failure, these 140 institutions claimed capital ratios of positive 4% — a swing of 29 percentage points as measured against total assets.
What is the utility of these stated capital ratios in a liquidation scenario? From a policy perspective, seeking to limit risks to the Deposit Insurance Fund and the American taxpayer, what does it mean to require a bank to achieve and sustain a 10% capital ratio as opposed to today's "well-capitalized" requirement of 5%? Such shifts pale in comparison to the measurement error cited above.
These numbers challenge us to think more imaginatively about bank failures, the capital-raising hurdles faced by many deserving banks, market and community disruptions stemming from such failures and the FDIC's statutory mandate to pursue least-cost resolutions. No doubt, some banks, due to poor management or unmet local market demands, should fail as banks rationalize and consolidate. Likewise, the many banks run by dedicated, conscientious officers and employees, which serve a local market's need for deposit-gathering and credit allocation, deserve to be preserved. Here, too, the limitations on capital measurement raise serious policy questions.
FDIC cease-and-desist orders against "problem" institutions typically contain two mandates: to dramatically curtail classified assets and to raise capital. For most banks operating under a C&D, this is tantamount to a death sentence.
If management liquidates classified assets in today's market, the realized losses will only deepen capital shortfalls. But potential bank capital providers shy away from troubled institutions until they are cleansed of problem assets.
In any case, investors prefer to negotiate over the carcass of an institution post-failure. We have discussed this with many distressed-asset and bank capital investors. There are no attractive "deals" to be had for still-operating institutions in competition against loss-sharing or other risk-limiting purchases and assumptions of failed banks.
To its credit, the FDIC has experimented with creative structures to limit its losses after a bank fails. It has yet to apply the same creativity to preserving marginal banks by promoting the disposition of classified assets and encouraging capital raising.
Deep pools of capital exist for both classified assets and investments in a clean bank charter. Combining these pools of capital to save a tottering institution requires a third leg to the stool: the FDIC's direct capital support.
Consider the example of a watch-list institution with total assets of $1 billion and tangible capital of $50 million — or a 5% tangible capital ratio. Market-clearing bids for classified assets may require a further writedown of $50 million, rendering the institution insolvent.
Obviously, bank management can never pursue this balance sheet clean-up in isolation. Simultaneously, a bank capital provider may be interested in the cleansed bank charter and willing to commit $25 million to partially recapitalize the bank. This still leaves the bank significantly undercapitalized, with a 2.5% leverage ratio.
Marrying this tandem bid with FDIC support of $50 million, however, would elevate the institution to good health and a clean balance sheet, infusing new capital from an outside investor and avoiding unnecessary local disruptions. From the FDIC's perspective, averting this bank's failure may have averted a cost to the DIF of $250 million (the 25% of total assets average cost of failures in 2009), and the agency satisfies its mandate to execute the least-cost resolution.
Admittedly, this fact pattern may only apply to a narrow band among the hundreds of banks on the FDIC's watch list. But direct FDIC support along with fresh capital and a purge of nonperforming assets achieves many benefits, including the encouragement of local lending activity, preserving community banks in otherwise underserved communities, conserving the DIF's dwindling resources and giving deserving managers of salvageable banks an important story to attract needed new capital.
New capital sources are crucial for restoring vibrancy to the banking industry. The FDIC's well-considered participation in recapitalizations is critical to attracting this new capital.