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Senate Banking Committee Reviews Small Bank Studies

By    |   Friday, 14 June 2013 01:44 PM

On June 13, the Senate Banking Committee, chaired by Tim Johnson, D-S.D., held an hour-long hearing titled "Lessons Learned from the Financial Crisis Regarding Community Banks." A handful of senators heard reports from Richard Brown, chief economist of the FDIC; Jon Rymer, inspector general of the FDIC; and Lawrence Evans, director of financial markets and community investment at the Government Accountability Office (GAO).

Whenever an event or document is titled "Lessons Learned," it invites the audience to question whether the lessons purported to be learned have actually been learned. I have formulated a working hypothesis that not only has the FDIC not learned very much from the most recent episode of the ongoing financial crisis, it is doubtful that it has learned much from previous episodes of the crisis.

What is more, it is highly doubtful that any of the so-called financial regulators have learned anything except how to make excuses and accrete power after every failure. Specifically, after the failure of the savings and loan industry and widespread bank failures in the 1980s, Congress enacted two statutes, the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) and FDIC Improvement Act (FDICIA), in 1989 and 1991, respectively, to make sure that such costly failures would "never happen again."

So today's FDIC is the new and improved version that was empowered to assess deposit insurance premiums based on the risks posed by the banks and to administer a policy called "prompt corrective action," which means that the agency can take action to contain bank losses before they could mature into huge losses for the Deposit Insurance Fund (DIF). In the intervening 20-odd years, these powers were essentially not implemented; if they had been, the 2008 episode could have been avoided, or at least its costs rendered less destructive to the economy.

Yet the FDIC and the other so-called financial regulators stumble along, touting their newest powers conferred but yet to be implemented under the Dodd-Frank Act, seemingly oblivious to the fact that they are doing little but mark time until the next flare-up occurs and a new round of excuses will be needed.

It is a fact that after many years of neglect, the DIF remains below its statutory coverage ratio, and plans to replenish the fund call for it to achieve a ratio of 1.35 percent by 2020. At the meeting where these plans were approved, then-FDIC Chairman Sheila Bair giggled that there was still plenty of time to change them. The current state of the fund is nothing to giggle about, at roughly 32 basis points, with any positive number touted as a great achievement.

The credibility of deposit insurance will depend for the indefinite future on its Treasury drawing authority rather than on industry support. For 10 years, the industry avoided premiums entirely on the same ground, expressed at the time by Rep. Spencer Bachus, R-Ala., that paying premiums would take money from the economy.

The rest of this article will present key points — one hesitates to say "highlights" — of the presentations and the senators' questions, followed by some concluding remarks:

1. Richard Brown, FDIC chief economist. Brown presented the results of the Community Banking Study commissioned last year by FDIC Chairman Martin Gruenberg, which was part of a larger community banking initiative "to refocus our efforts to communicate with community banks and to better understand their concerns."

The study identified three factors that contributed to failures during the crisis: 1) rapid growth, 2) excessive concentrations in commercial real estate lending (especially for acquisition and development) and 3) funding through highly volatile deposits.

2. Jon Rymer, FDIC inspector general. Rymer presented the findings of a study released Jan. 3 titled "Comprehensive Study on the Impact of the Failure of Insured Depository Institutions," which also found imprudent behavior on the part of banks that expanded into real estate development lending to take advantage of the real estate boom.

The report credited the regulators with fulfilling their responsibilities under "unprecedented circumstances," but it cited required material loss reviews as showing that the regulators "could have provided earlier and greater supervisory attention to troubled institutions that ultimately failed."

3. Lawrence Evans, director of the GAO. Evans also found that each of 10 states, located in three separate regions of the country, that had experienced a housing boom had experienced 10 or more failures of banks with less than $1 billion in assets and that these were due to the factors identified by the other witnesses — "credit losses on commercial real estate (CRE) loans, particularly loans secured by real estate to finance land development and construction. Many of the failed banks had often pursued aggressive growth strategies using nontraditional, riskier funding sources and exhibited weak underwriting and credit administration practices."

However, he went on to cite faulty accounting models for estimating loan loss reserves, and he noted that Financial Accounting Standards Board has proposed a more forward-looking model that would incorporate a broader range of credit information. He also found that loans for acquisition, construction and development at failed banks often represented 250 percent of capital and that the biggest contributor to failure was the practice of continuing to carry real estate loans at historical cost rather than writing them down to reflect declining market values under "fair value accounting" rules.

The tone of the questions was that community banks are being subjected to excessive regulation that is putting them at an unfair competitive disadvantage versus larger banks and constraining loan growth. The FDIC's Brown responded that his work did not support this view, although the banks don't have systems that break out the overhead attributable to regulatory cost.

However, what data they do have found those costs steady at 2.9 percent, and he added that lending is slow due to continued high exposure to CRE, often making up half of bank loan portfolios.

I was shocked, but not surprised, to observe that the senators appeared to be oblivious to the fact that the financial regulators had once again allowed problematic concentrations in CRE loans to occur, just as they had in the 1980s before the enactment of stronger measures that the regulators have chosen not to apply. An educated guess is that this phenomenon is due to the cozy relationship between legislators and regulators and the financial services industry, so that banks, large and small, are regulated, if that is the word, in effect by their own lawyers or by other regulatory staff who tend to identify their own interests with that of the banks.

The result, over a period of decades, has been the exposure of the financial system to losses equal to at least $15 trillion, as found by several studies conducted independently, including one by the Federal Reserve Bank of Dallas, whose president, Richard Fisher, has called for downsizing of the "too big to fail" banks.

Therefore, I suggest that if Congress were to address itself to a strategy that would break this pattern — costly failures due to the risky practices of highly leveraged banks — it would require a radical restructuring of bank regulation and supervision so that it would be done by regulators that were less captured by the industry than the FDIC, Office of the Comptroller of the Currency and Federal Reserve have shown themselves to be.

At a recent speech to the Levy Institute in New York, Thomas Hoenig, former president of the Federal Reserve Bank of Kansas City, now vice chairman of the FDIC and himself an advocate of breaking up the too big to fail banks, criticized the examination and supervision practices of the bank regulators, although he did not propose a structural solution.

It has occurred to me that the catastrophic damage caused by lax, industry-friendly regulation calls for a radical solution.

Perhaps the GAO would offer a degree of independence that would enable it to make accurate assessments of the condition of banks and apply prompt corrective action in a manner that would ensure that losses would be borne by investors and creditors, rather than by taxpayers and consumers.

This would be the direction to look for lessons learned, but since the senators are still preoccupied with responding to complaints of banker constituents whenever regulators try to do their job, there are bound to be more crisis episodes and more expensive lessons to be learned.

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On June 13, the Senate Banking Committee, chaired by Tim Johnson, D-S.D., held an hour-long hearing titled "Lessons Learned from the Financial Crisis Regarding Community Banks."
Friday, 14 June 2013 01:44 PM
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