Inside Financial Services

Strong Capital Levels Aren’t Enough

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In American Banker, Alex Cullen demolishes the myth-beloved by regulators and academics everywhere-that sufficiently ample capital can be counted on to be a reliable bulwark against a bank’s failure. Wrong! Take a look:

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? [Emph. added.]

So while most failed banks were indeed undercapitalized at the moment the FDIC put them down, in the months leading up to their failure (that is, when capital levels should matter most) the doomed banks were usually considered pictures of health. Capital is a poor predictor of failure.

Here’s why: in a credit downturn of sufficient severity (like, for example, the one the economy is now coming out of) credit losses will sometimes be so high and appear so quickly that no reasonable amount of capital and provisioning will dependably withstand them. Some banks will simply be done in by their own lending, no matter how strong their balance sheets look.

Look at an example Cullen provides to see how quickly things can go bad once credit turns: La Jolla Bank, a (once) $3.5 billion institution based in La Jolla, California. At September. 30, 2009, La Jolla was considered well-capitalized. But just three months later, it was significantly undercapitalized. And only 50 days after that, the bank was seized by regulators. Cullen describes what happened:

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. . . . [Emph. added.]

Losses 11 times tangible equity! How’d you like to set a provision in anticipation of that? Cullen says the problem at La Jolla was that management had too much leeway. “Capital’s poor predictive power is a result of a bank’s ability to decide how much to expense their provision for loan losses and when to provision,” he says.

That’s baloney. First, I don’t care what provisioning methodology you choose, if your non-performing loans and leases eventually top 22%, you won’t have provisioned enough, and you’ll have a problem. Losses will be devastating.

But more to the point, Cullen’s wrong to point the finger solely at management in the first place. Three years into the credit crunch, La Jolla’s managers weren’t the only ones with a say in rating the bank’s loan book. The auditors were involved, too, and, more important, so were the regulators. For whatever reason, they all missed the deterioration. In the end, non-performers sextupled in nine months.

The Bank of La Jolla experience is a good example of what the adequate-capital-solves-everything crowd needs to keep in mind when they bang the drum for ever higher levels of bank capital. Sometimes, no amount of capital is enough to sustain losses-and even a management with the best will in the world will fail to foresee the huge losses once they arrive.

Adequate capital is important, of course. But it’s a long way from being the all-purpose cure for the problems of the banking system some people think. The industry needs good management sound underwriting strong auditors, and effective (as opposed to more) regulation.

What do you think? Let me know!

7 Responses to “Strong Capital Levels Aren’t Enough”

  1. Dan B.

    Tom you are correct in your final paragraph – it is strong management and effective regulation backed by sound capital. But don’t count on auditors to assess loan quality.

  2. jsc173

    I remember a finance professor who asked my class, “Is leverage a good thing or a bad thing?” Trying to be the teacher’s pet, I jumped at the chance to answer. He said, “What do you think?” And I said, “Yes.” He said, “What?” And I said, “You asked if leverage is a good thing or a bad thing and the answer is yes. It’s both.” He chuckled and we went on to discuss the simple negative fact of leverage — it can kill an apparently healthy “host” very quickly. If all the banks you mentioned had capital ratios of 15% or 20%, almost all would still be alive. To believe the capital ratio the regulators call “well capitalized” is enough to hold off the credit onslaught of a near-depression decline in the economy is flawed thinking. Further, until relatively recently an extraordinarily well capitalized bank would still get a big thumbs up even if they maintained ridiculously high levels of concentration in their portfolio. That fact, more than the absolute level of capital, brought down most. Without a rational risk management strategy that looks at capital vs concentrations in a meaningful (e.g., forget historical analysis) and logical (e.g., what can go bad will go bad) manner, we will repeat this again the next time around.

  3. Fraudster

    What you are saying is simply that banks Capital levels were/are self serving fiction created by the banks’ own classification of their assets. Regulators need to force banks to realistically assess their holdings.

  4. Jimmy Smith

    Great piece!

    I was wondering if you could write an article about how we, investors, may analyze the *quality* of loans? Since as you point out this is more important in many cases than the capital levels that the banks present.


  5. DLB

    Can’t argue with you Tom. If someone is really, really bad at their job no amount of capital will prevent them from throwing money away by loaning it to bad credit risks. But higher capital standards provide a better cushion to protect good lenders during difficult times. Just a fact. And in the end (as I’ve stated here before) capital standards are going much higher because almost everybody has too much debt relative to income in this country and regulators don’t want to go through 2008-2009 again.

  6. Ward

    Doesn’t this fact argue ruin the argument of the non interventionist…ie free market types who argue against the “bailouts” capital infusion. Doesn’t this also make some level of deposit insurance a sensible thing even though it creates moral hazard?

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