When Should a Bank Be Closed?

There is valid reason to believe that the Federal Deposit Insurance Corp. is using the wrong criteria in deciding when to close a bank.

One cannot fault federal insurers for erring on the side of speed rather than taking a wait-and-see approach when they feel a bank may not be able to survive. The savings and loan debacle taught a bitter lesson. There is no question that shutting many thrifts earlier would have saved the Federal Savings and Loan Insurance Corp. and the taxpayers a fortune.

Keeping Thrifts on Life Support

In the S&L case, though, the Congress and the regulators were so solicitous of the industry that they kept so-called "brain dead" thrifts alive for years -- by lending them capital, allowing goodwill to serve as capital, and even changing the accounting rules.

There is the joke about the doctor who says, "If you can't afford the operation, for a slight fee I will touch up the X-rays." That is just what regulatory accounting procedures did for the S&Ls; generally accepted accounting procedures would have indicated that they should have been closed down.

Is Capital the Right Gauge?

After witnessing a $20 billion problem mushroom into a problem that will cost $500 billion (if we take 30 years to meet taxpayer claims), one can understand why the FDIC might be trigger-happy in closing banks it feels cannot not survive.

The problem is that the agency uses a bank's capital position to assess survival potential. If a bank seems to have enough capital to cover losses in the immediate future -- so shareholders, not depositors, would bear the losses -- the bank is left open. If capital is judged inadequate, the bank is closed before the well runs dry.

But is capital is a decent test of a bank's prospects today.

On the books, certainly, a bank with assets larger than deposit liabilities has some capital that can serve as a cushion for losses. But this is true only if, should be bank be closed, the assets could be liquidated for their value as stated in the bank's books.

Assets' Real Worth

However, historical accounting lets assets remain on the books at cost. And loan-loss reserves, which discount overall asset value on the books, are highly subjective.

As a result, it is doubtful that sale of a bank's assets could bring anything near what the books say they are worth -- especially if the assets were sold in a hurry to meet deposit withdrawals that occur when rumors of trouble develop.

A capital cushion may look good on a statement and in reports to the FDIC, but utilizing it to back deposits may be a different story.

Assessing Earnings Potential

Instead of using a static measure like bank capital adequacy, the regulators should determine the bank's prospects for earning profits now and in the future -- profits that can build up capital over time.

Cash flow alone gives no accurate prognosis of a bank's health. As long as there are no depositor runs, a bank -- unlike any other business -- can lose money and still have a positive cash flow.

When a bank has an outflow to cover deposit interest, it merely adds the outflow to the depositor's account; banks need not pay cash, as any other business would.

If the spread of interest earned over interest paid leaves a profit after all expenses are paid and noncredit income is factored in, then every day the bank stays open it is stronger than the day before. So why close it?

A banker told me this story:

An employee was found to have been stealing. When he was making $13,000 a year, he stole $3,000 annually. But when his pay was raised to $14,000, he stole only $2,000. And when salary hit $16,000, he stopped stealing.

In fact, when his pay reached $17,000, he paid back $1,000. The man felt he was worth $16,000 a year, and that's what he took.

Putting aside the man's dishonesty, I might observe that the bank would have done well to leave him alone when he was repaying it.

The Case for Keeping It Open

When the FDIC does close a bank, are America's taxpayers better off? In some cases, the answer is no.

Often the bank has put in new management that is no longer making bad loans, is reducing expenses, and is working night and day to turn the bank around.

To close a bank under these conditions seems a tragedy. It is harsh on the staff and a drain on the taxpayers -- a drain that a little patience might have avoided.

Capital is an accounting concept, not necessarily a good measure of an institution's health. If it can generate profits now, no matter how unsavory, unlucky, or unwise its past might be, there's good reason to give it a shot at survival.

It would be great if the FDIC saw things this way.

Mr. Paul S. Nadler is a contributing editor of the American Banker and professor of finance at the Rutgers University Graduate School of Management.

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