Wednesday, April 23, 2008

Wave of bank failures expected

The Financial Times has a front page article today (4/23) entitled, "Regulator fears wave of bank failures".

The regulator in question is US Comptroller of the Currency John Dugan, whose office overseas 1,700 national banks and nearly two-thirds of the assets in the nation's commercial banking system.

In an interview with the FT, Mr. Dugan said that bank failures could rise above "historical norms" after a four-year period in which no financial institution under his watch had failed.

""We're going to have some more bank failures that will come back more to historical norms and may go above that with time," he said. "That is a natural consequence of the economy going from historically exceptionally benign credit conditions to something that is more normal to something you would get in a downturn."

Mr Dugan's comments come as US banks report big spikes in reserves for expected losses on consumer and small business loans, reflecting the spread of the credit crisis from Wall Street to the broader economy.

Yesterday, Atlanta-based SunTrust (NYSE:STI) said profit fell by nearly half to $283.6m as provisions rose 10-fold to $560m. Ohio's Fifth Third (NASDAQ:FITB) bank said profits fell 19 per cent to $292m as provisions rose to $544m from $84m last year.

The largest US banks, including Citigroup (NYSE:C) and Bank of America (NYSE:BAC) , have also seen loan losses increase as more consumers fall behind on home equity, credit card, automotive and other consumer loans. The banks have been rushing to raise capital to offset loan losses and writedowns on mortgage-related securities."

I included the last three paragraphs from FT's article because it serves up a nice, quick summary of the recent bank troubles and the spread of last year's subprime problems into a "credit crisis" affecting the broader economy.

Here's another useful excerpt which covers the expected problems at smaller regional banks, a subject we talked about (with insights from Wilbur Ross) in Monday's post:

"Mr Dugan's Office of the Comptroller of the Currency is particularly worried about lending by smaller banks to commercial real estate developers for condominiums and other projects. More than a third of smaller community banks have made commercial property loans that exceed 300 per cent of their capital, the OCC says. By comparison, in 1987, when hundreds of banks failed amid a commercial property collapse, such banks had commercial property loans equal to 175 per cent of their capital.

Mr Dugan said he did not expect failures to rise as high as during the late 1980s and early 1990s - when 534 banks failed in 1989 alone - because banks are better capitalised, have better underwriting standards and did less speculative lending.

"Banks are better capitalised going into this...but the flip side is they are more concentrated," he said. "Part of it depends on the depth of the downturn and duration of the downturn.""

Everything there seems to make sense to me, except for that last paragraph.

I'm not at all knowledgeable about banking, but if community banks are even more exposed to commercial property loans in the current cycle (with loans that exceed 300 percent of capital) than they were in the late 1980s (when loans exceeded 175 percent of capital), wouldn't you expect problems and failures to occur on a similar or greater scale this time around?

Mr. Dugan makes the case that the banks are better capitalised than they were in the last bust cycle, but given the ongoing cascade of (widely unanticipated) problems banks and financial institutions are currently suffering through, I think we'll have to wait and see on that one.

Incidentally, I should note that a quick search on Comptroller Dugan turned up this late 2006 RGE Monitor post on, "The Concerns of Comptroller of the Currency About the Excesses in the Mortgage Market." So there's past evidence of one financial regulator who was not totally "asleep at the wheel", as Nouriel Roubini notes.

Related articles and posts:

"Bad day for banks" - Finance Trends Matter.

"Wilbur Ross seeks $4 billion to purchase US banks" - Bloomberg.

"Wilbur Ross interview on credit losses, regional banks" - Bloomberg.

"Concerns of Comptroller..." - RGE Monitor.