The trigger for a Friday shutdown by the FDIC is undercapitalization. But while capital is "the last straw," it does not serve as a good long-term predictor of bank failures.

Of the 322 banks that failed from 2008 to 2010, 293, or 91% were undercapitalized or worse the quarter before they were seized.  The majority of failed institutions held the worst capitalization designation, "critically undercapitalized." 

Yet the 322 banks remained well capitalized on average only 403 days and adequately capitalized only 298 days in advance of failure. In addition, failed banks most commonly took only nine months to move from the well capitalized category to failure, and six months from adequately capitalized to failure.  The minimum days from well capitalized to failure was only 100, or a little over three months. So why then is capital’s predictive power so poor?

La Jolla Bank was well capitalized on Sept. 30, 2009. Just three months later, it was significantly undercapitalized, and only 50 days later, the bank was seized by regulators.  How did the bank’s equity evaporate so quickly?  The answer is simple; the bank’s allowance for loan and lease losses was flawed. 

La Jolla’s loan quality started to deteriorate starting after the first quarter of 2009.  Specifically, noncurrent loans and leases went from 3.97% to 22.56%, in nine months. The bank was slow to provision for losses, which allowed the bank to report positive net income for each of the three quarters leading up to the bank’s failure.  Then all of a sudden it expensed almost $323 million for losses, an amount more than 11 times the bank’s tangible equity.  This entry immediately depleted the bank’s capital, instantly moving La Jolla’s capitalization status from the best classification, well capitalized, to the worst, critically undercapitalized.

Capital’s poor predictive power is the result of a bank’s ability to decide how much to expense to their provision for loan losses, and when to provision.  Of course, regulators evaluate a bank’s ALLL methodology, but the fact of the matter is that banks can manipulate earnings, and consequently capital, through decisions about loss provisioning. If a bank liberally provisions for expenses, it can deflate earnings and pay less in taxes or no taxes at all if it reports a loss. Conversely, a bank can conservatively provision for losses and report a big profit, satisfying shareholders, and ultimately increasing capital ratios as well.

A provisioning methodology based on a percentage of originated loan type would solve this problem of the ability to fudge net income, and consequently capital, through the current provisioning for loan and lease losses process. If banks provisioned for losses upfront based on the type of loan originated, it would solve the problem associated with the poor predictability of capital. 

For example, if a bank originates a construction and development loan, it will need to provision at the time of origination an amount equal to the bank’s historical loss rate for C&D loans. In the case of start-up bank, a standardized percentage by loan type would be used until the bank had sufficient loan data to use its own percentages.

Alex Cullen is a credit analyst at a bank in Chicago. This piece is adapted from his research paper “Why Do Banks Fail?