Why Do Banks Fail?

Abstract

Why do banks fail? Quite simply, the “last straw” that forces regulators to close an institution is undercapitalization. So the question becomes; how does a financial institution’s capital become depleted? Loans are the largest asset on a bank’s balance sheet, and consequently, they have the greatest potential to negatively impact a depository institution’s capital if they go bad. 97.5% of the 322 banks that failed between 2008 and 2010 had loan quality problems in the quarters leading up to their forced closures. Problem loans are the primary driver for bank losses via a decrease in interest income and an increase in loss provisioning expense. For the failed 322, problem loans were accumulated through high levels of organic growth achieved by sacrificing credit quality, purchasing risky loan participations, and initiating out-of-territory lending. The failed banks also developed concentrations in commercial real estate and construction and development loans; the latter of which performed the worst during this time frame. The Texas Ratio exhibits robust bank failure predictive power, and once a bank crosses the 100% mark, the chances of rehabilitation are a mere 5.06%. Outside of loan quality, losses on investment securities including trust preferred securities and preferred shares of Fannie and Freddie also exhausted capital, resulting in closures. There were three examples of fundamental “earnings failures,” that is, banks that exhibited sound asset quality in the quarters leading up to failure, and whose capital evaporated solely due to their sustained operating losses. Liquidity failures, while present in the “shadow banking sector,” are quite rare in the FDIC insured banking sector. The few liquidity failure examples are the result of the regulation that restricts non-well capitalized banks from rolling over or renewing their brokered deposits.