The FDIC's badly inaccurate 'problem bank list' should be shut down

Nathan Howard/Bloomberg

The FDIC has another problem, and it is unrelated to its toxic workplace scandal detailed in an independent report leading to the resignation of its longtime director. I am referring to the FDIC's mythical problem bank list, or PBL, which has proven to be as reliable as dart-throwing stock pickers when it comes to identifying big banks that are likely to fail.

The three big $100-plus billion-asset banks that failed last year, with combined assets exceeding $500 billion and costing the FDIC $35 billion, along with another that was privately rescued this year, were not on their list. However, a big bank that was on their list for more than four quarters in 2021 and 2022 did not fail.

The bottom line is that the FDIC's problem bank list is itself a problem and should be shut down.

The FDIC identifies problem banks that could fail to hopefully minimize potential losses. The FDIC is ultimately backstopped by taxpayers through the Treasury Department's Federal Financing Bank, as we saw twice when the Deposit Insurance Fund was negative. Thus, everyone wants to get this right, not just regulators or bankers.

The FDIC's Quarterly Banking Profile publishes its PBL with the number of problem banks and their combined assets. Problem banks have the two worst CAMELS composite safety and soundness ratings of 4 or 5 due to "financial, operational or managerial weaknesses that threaten their continued financial viability."

CAMELS ratings have been poor predictors of recent big bank failures, since regulators robotically rate banks in the order of the acronym: Capital, Asset quality, Management, Earnings, Liquidity and Sensitivity to risk.

The FDIC has been identifying problem banks since the 1970s, and a study dating back to that decade found that, even then, "for all practical purposes banks classified by examiners as 'problem' banks are those with low net capital ratios." Only 1% to 2% of banks are in this category during noncrisis periods, compared to 11% in 2010.

The regulatory blind faith in capital is once again evident with the Federal Reserve's proposal to increase capital ratios for large banks in response to recent big bank failures.

The three big banks that failed last year and the one that nearly failed this year all had regulatory acceptable capital levels and CAMELS ratings. Thus, none of them was on the PBL. But, all of them were problems, actually really big and costly problems.

The regulatory CAMELS focus is not only myopically misplaced on capital but is totally backward and should be reversed to SLEMAC. The three big bank failures were primarily the result of mismanaged interest rate risk and the predictable liquidity problems that followed.

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Instead of the $47.5 billion of problem bank assets reported in the CAMELS PBL as of December 2022, a SLEMAC PBL would have been $579 billion — 12 times larger — by counting the three brewing failures with serious risk management and liquidity problems.

Making the CAMELS PBL problem even worse are false positives. The most glaring example was during the fourth quarter of 2021, when PBL assets skyrocketed by nearly $56 billion to $170 billion, but the number of PBL banks actually declined. The logical conclusion was that a $100-plus billion-asset bank was added. That mystery big bank stayed on the PBL for the first three quarters of 2022 until it was removed during the fourth quarter of 2022.

Instead of CAMELS supervisors hammering banks with their capital club, we need SLEMAC supervisors who understand interest rate risk management techniques to see how banks are dealing with more than $500 billion of unrealized losses, including their so-called HTM or "Hide 'Til Maturity" portfolio.

The best proof that SLEMAC supervisors do not exist is the Fed's own post-mortem of Silicon Valley Bank, or SVB. It documented SVB's shocking removal of interest rate hedges in 2022 based on its disastrous prediction that rates, which rose from .25% to 1.75% in the second quarter alone, would reverse direction.

The Fed concluded that "the complete removal of these interest rate hedges was a significant error by SVB management that should have been a further red flag for FRB San Francisco and the Board about the bank's risk management practices." Unlike Fed CAMELS supervisors, SLEMAC supervisors would have placed SVB on the PBL in early 2022, a year before its failure.

Another example of failing CAMELS supervisors is the FDIC's autopsy of First Republic Bank. It concluded the "FDIC missed opportunities to take earlier supervisory actions" regarding that bank's "failure to sufficiently manage its interest rate risk [that] resulted in significant unrealized fair value losses."

The FDIC's Material Loss Review of Signature Bank concluded it failed due to "insufficient liquidity and contingency funding mechanisms and inadequate risk management practices," another example of CAMELS supervisors being unwilling or unable to do their job.

Perhaps the only way to encourage banks to improve interest rate risk management is for the Financial Accounting Standards Board to require all investments be marked to market. This is currently required of banks holding bond mutual funds and other equity securities with readily determinable market values.

That FASB requirement resulted in some bond mutual funds bringing their duration down to just two years at the end of 2021 in anticipation of non-transitory inflation. Had SLEMAC supervisors required SVB and other banks with huge underwater investment portfolios to do that, they would still be around instead of underground.

Since it is unlikely that the current CAMELS PBL will be replaced with a relevant SLEMAC PBL, the best public policy solution is for the FDIC to shut down the PBL program. No program is better than a broken program.

An alternative is for the FDIC to make that program irrelevant by disclosing CAMELS ratings, as I recommended to them over 20 years ago. Like the disclosure of enforcement actions, this would not only increase market discipline by banks but also provide needed transparency to insured and uninsured depositors as well as shareholders.

The new FDIC director will be focused on cleaning up their serious workplace problems. The director's No. 1 goal, however, is to maintain stability and public confidence in our financial system, and this can best be done by considering the above recommendations.