The financial crisis & our banking system.
Many say that things will never be the same. I say they are correct. The economy has already taken its toll on many who have lost their jobs or their businesses. The economy continues to have us all on edge as to what will be next. Though the downturn is far from over, there will be great days ahead when the economy swings back in gear. Then we will be faced with increased interest rates, new banking standards and a host of inherent problems that come with inflation.
By now everyone has heard enough about the reasons we, as a country, are in the shape we are in: the building boom, loose credit, lowered credit standards, sub-prime loans, no-doc (no financial documentation) loans, etc. What brought us to this point and where are we today?
Through the end of July 2010, we have already seen 108 bank failures compared with 140 all last year. Bank failures continue and are on the rise.
In short, things are not getting better. In economics 101 we learned that the banking system is the heart of any country's economy. In order to thrive and grow, a country needs a strong banking system that people can trust. Banks provide businesses with financing for their capital needs in order to run effectively and profitably. Without adequate financing, businesses will not be able to capitalize properly to re-tool and expand. In turn, the economy will suffer and become stifled and stagnant. Our government is working hard to keep the banking system viable and healthy so it can provide financing for businesses, which will help the economy grow.
Everyone knows of local banks in their geographic area that have been acquired by other banks. Rather than close operations that are in trouble, suitable banks are often found to acquire them. These banks are financially strong enough to absorb the weaker bank and remain viable. We also know of banks that are under direction of memorandums by the regulators. These memorandums give direction to the bank so it can get its balance sheets in order and become financially sound.
Though we realize this increased regulation should have been in place long ago, it comes at a bad time. Now, when businesses need banks more than ever, banks are saying they can't help them. So the snowball effect will continue in a downward spiral until it reaches the bottom. In the meantime, we are all tightening our belts and hoping to survive the storm. This regulation of the banks, though a difficult pill to swallow, is very important even if the timing is wrong. The banking system must be strengthened so businesses can operate knowing their deposits are safe and can borrow for needed capital in the future.
Bank's Balance Sheet
If you were to look at a bank's balance sheet, you would see that the main or largest asset is its loan portfolio. Equipment buildings, etc. are only a small percent of any bank's assets. Regulators focus on the quality of the loan portfolio. Most of the bank failures are due to loans going bad and banks taking unexpected write-offs. Why do I say unexpected? The file may show a million dollar loan has collateral of $1,500,000. No problem, right? However, the appraisal may be four years old. When the property is sold in a distressed situation the bank may end up writing off a large portion of the loan which was considered a viable asset on their balance sheet the month before. The loss goes against the bank's retained earnings or equity and reduces the bank's capital position.
Inadequate capital is one of the primary concerns of the regulators. Most failures occur because banks are rapidly losing their capital and becoming insolvent - insolvent, not in terms of being able to pay their bills, but insolvent in terms of the balance sheet and having insufficient capital. This was the premise of the Troubled Asset Relief Program (TARP). The primary purpose of the TARP monies borrowed from the government was not for lending back out to businesses but to sustain and fortify capital positions of banks as they encountered troubled assets that needed to be written off. When the sub-prime loan issue hit, the government saw what was coming and immediately the TARP monies were approved to lend to banks. Again, the country cannot afford for the banking system to fail.
This leads us to the bank regulator's question: "Do the banks really know if an asset in their loan portfolio is good if they do not have adequate records from their customers to verify their repayment ability or current appraisals to confirm collateral values?"
How do the regulators determine the strength of a bank's loan portfolio? All customers of a bank are risk rated. When making a loan, the five "C's" are considered (Character, Cash Flow, Capital, Collateral and Conditions of the loan). These same criteria, for the most part, are evaluated on a perpetual basis to determine a customer's on-going risk rating.
Cash flow will be looked at first to see if there are positive earnings to contribute to equity and also to determine repayment ability (cash flow). One may show a loss due to depreciation but the real consideration is repayment strength. Is there enough cash flow to make all of their payments? The standard debt coverage considered by most banks is a ratio of 1.2 to 1. This merely means the cash flow of the business should be 1.2 times what their payment obligation is.
The next item is collateral. Is the bank adequately secured? Are new appraisals needed to determine this? Customer risk is determined based on the collateral, repayment strength, capital position and the conditions of the loan. This is the same criteria the regulators are using to evaluate the risk of individual banks. It is this risk scoring that determines the overall risk of the loan portfolio and in turn tells the regulators how viable and "at risk" the banks are.
For the past few years, banks have seen the risk in their loan portfolio increase tremendously. As the risk level increases, the bank must increase their Reserve for Loan Losses. This is a balance sheet category where monies are set aside to draw from in the case of any future loan losses. The monies put in this reserve reduce the banks liquidity, ties up working capital and is an expense reducing the bank's earnings - all things that cost the bank dearly.
Despite the soberness of this article and perhaps considered by some as depressing, I feel it is important to share what is going on in the banking world in an economic crisis like most of us have never seen. There is much more to the picture, but this article hopefully answers a lot of questions you may have. I also hope that it will help you see some of the reasons why you may be encountering some differences with your bank in terms of more questions and more information.
A better day is definitely around the corner. All things go in cycles. Hopefully, we all have learned something to make us better prepared for the cycles to come! mn
Year Number of Total Assets Of Loss to FDIC's Failed Banks Failed Banks Depositors Insurance Fund (DIF) 2007 3 $ 2,602,500,000 $113,000,000 2008 25 $ 373,588,780,000 $15,708,200,000 2009 140 $170,867,000,000 $ 36,432,500,000 2010 108 $80,173,900,000 $19,050,800,000 Total 276 $627,232,180,000 $71,304,500,000
Keith M. Silfee
Vice President Business Relationship Manager
National Penn Bank 24 South Third St. Oxford, PA 19363