Financial Institutions: Causes and Consequences of Recent Failures of Community Banks
Published: 2013-03-20T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Between January 2008 and December 2011--a period of economic downturn in the United States--414 insured U.S. banks failed. Of these, 85 percent (353) had less than $1 billion in assets. These small banks often specialize in small business lending and are associated with local community development and philanthropy. These small bank failures have raised questions about the contributing factors, including the possible role of local market conditions and the application of fair value accounting under U.S. accounting standards.
This statement is based on findings from the 2013 report on recent bank failures (GAO-13-71). This testimony discusses (1) the factors that contributed to the bank failures in states with the most failed institutions between 2008 and 2011 and what role, if any, fair value accounting played in these failures; (2) the use of shared loss agreements in resolving troubled banks; and (3) the effect of recent bank failures on local communities. To do this work, GAO relied on issued report GAO-13-71 and updated data where appropriate.
GAO did not make recommendations in the report.
section_title: What GAO Found
paragraphs: Ten states concentrated in the western, midwestern, and southeastern United States--all areas where the housing market had experienced strong growth in the prior decade--experienced 10 or more commercial bank or thrift (bank) failures between 2008 and 2011. The failures of the smaller banks (those with less than $1 billion in assets) in these states were largely driven by credit losses on commercial real estate (CRE) loans. The failed banks also had often pursued aggressive growth strategies using nontraditional, riskier funding sources and exhibited weak underwriting and credit administration practices. Fair value accounting also has been cited as a potential contributor to bank failures, but between 2007 and 2011 fair value accounting losses in general did not appear to be a major contributor, as over two-thirds of small failed banks' assets were not subject to fair value accounting. During the course of our work, some state banking associations said that the magnitude of the credit losses were exacerbated by federal bank examiners' classification of collateral-dependent loans and evaluation of appraisals used by banks to support impairment analysis of these loans. Federal banking regulators noted that regulatory guidance on CRE workouts issued in October 2009 directed examiners not to require banks to write down loans to an amount less than the loan balance solely because the value of the underlying collateral had declined, and that examiners were generally not expected to challenge the appraisals obtained by banks unless they found that underlying facts or assumptions about the appraisals were inappropriate or could support alternative assumptions.
The Federal Deposit Insurance Corporation (FDIC) used shared loss agreements to help resolve failed banks at the least cost during the recent financial crisis. Under a shared loss agreement, FDIC absorbs a portion of the loss on specified assets of a failed bank that are purchased by an acquiring bank. FDIC officials, state bank regulators, community banking associations, and acquiring banks of failed institutions GAO interviewed said that shared loss agreements helped to attract potential bidders for failed banks during the financial crisis. During 2008- 2011, FDIC resolved 281 of 414 failures using shared loss agreements on assets purchased by the acquiring bank. As of December 31, 2011, Deposit Insurance Fund (DIF) receiverships are estimated to pay $42.8 billion over the duration of the shared loss agreements.
The acquisitions of failed banks by healthy banks appear to have mitigated the potentially negative effects of bank failures on communities, although the focus of local lending and philanthropy may have shifted. For example, GAO's analysis found limited rural and metropolitan areas where failures resulted in significant increases in market concentration. GAO's econometric analysis of call report data from 2006 through 2011 found that failing small banks extended progressively less net credit as they approached failure, and that acquiring banks generally increased net credit after the acquisition. However, acquiring bank and existing peer bank officials GAO interviewed noted that in the wake of the bank failures, underwriting standards had tightened and thus credit was generally more available for small business owners who had good credit histories and strong financials than those that did not. Moreover, the effects of bank failures could be significant for those limited areas that were serviced by one bank or where few banks remain.

section_title: Letter
paragraphs: I am pleased to be here today as you examine issues related to recent  bank failures and community banks. Between January 2008 and  December 2011, 414 insured U.S. commercial banks and thrifts (banks)  failed. Of these, 85 percent (353), were small banks with less than $1  billion in assets. Banks of this size tend to be community banks with a  relatively limited geographic scope of operations and often specialize in  providing credit to local small businesses. Typically these banks are also  associated with local community development, leadership, and  philanthropy. The failures of these community banks, which were largely  concentrated in certain parts of the country, occurred against the  backdrop of the worst financial crisis since the Great Depression and  raised a number of questions. Among these are the role played by local  market conditions and related economic factors; the application of fair  value accounting under generally accepted accounting principles (GAAP);  and the potential effect on the communities where the banks were  located, particularly in terms of credit availability, income and  employment, and philanthropic activity. In addition, there are questions  about the impact of the Federal Deposit Insurance Corporation’s (FDIC)  methods for resolving failed banks on the Deposit Insurance Fund (DIF).
GAO, Financial Institutions: Causes and Consequences of Recent Bank Failures,  GAO-13-71 (Washington, D.C.: Jan. 3, 2013). This report was mandated by Pub. L. No.  112-88, § 3, 125 Stat. 1899, 1902 (2012). As part of this act, the FDIC Inspector General  (IG) was also required to conduct a separate study on the impact of bank failures. these issues, we analyzed call report data; reviewed inspectors general  (IG) reviews of individual bank failures; conducted econometric modeling;  and interviewed officials from federal and state banking regulators,  banking associations, banks, and market experts. We also coordinated  with the FDIC Inspector General on its study. We conducted this  performance audit from February 2012 to December 2012 in accordance  with generally accepted government auditing standards.
subsections: section_title: Background
paragraphs: Ten states concentrated in the western, midwestern, and southeastern  United States—all areas where the housing market had experienced  strong growth in the prior decade—experienced 10 or more bank failures  between 2008 and 2011 (see fig.1). Together, failures in these 10 states  comprised 72 percent (298), of the 414 bank failures across all states  during this time period.
Within these 10 states, 86 percent (257) of the failed banks were small  institutions with assets of less than $1 billion at the time of failure, and 52  percent (155), had assets of less than $250 million. Twelve percent (36)  were of medium-size banks with more than $1 billion but less than $10  billion in assets, and 2 percent (5) were large banks with assets of more  than $10 billion at the time of failure.
section_title: Bank Failures Were Largely Related to Nonperforming Real Estate Loans, but Also Highlighted the Impact of Impairment Accounting and Loan Loss Provisioning
paragraphs: In the 10 states with 10 or more failures between 2008 and 2011, failures  of small and medium-size banks were largely associated with high  concentrations of commercial real estate (CRE) loans, in particular the  subset of acquisition, development, and construction (ADC) loans, and  with inadequate management of the risks associated with these high  concentrations. Our analysis of call report data found that CRE (including  ADC) lending increased significantly in the years prior to the housing  market downturn at the 258 small banks that failed between 2008 and  2011. This rapid growth of failed banks’ CRE portfolios resulted in  concentrations—that is, the ratio of total CRE loans to total risk-based  capital—that exceeded regulatory thresholds for heightened scrutiny  established in 2006 and increased the banks’ exposure to the sustained  downturn that began in 2007. Specifically, we found CRE concentrations  grew from 333 percent in December 2001 to 535 percent in June 2008. At  the same time, ADC concentrations grew from 104 percent to 259  percent. The trends for the 36 failed medium-size banks were similar over  this time period. In contrast, small and medium-sized banks that did not  fail exhibited substantially lower levels and markedly slower growth rates  of CRE loans and as a result had significantly lower concentrations of  them, reducing the banks’ exposure.
With the onset of the financial crisis, the level of nonperforming loans  began to rise, as did the level of subsequent charge-offs, leading to a  decline in net interest income and regulatory capital. The rising level of  nonperforming loans, particularly ADC loans, appears to have been the  key factor in the failures of small and medium banks in the 10 states  between 2008 and 2011. For example, in December 2001, 2 percent of  ADC loans at the small failed banks were classified as nonperforming.  With the onset of the financial crisis, the level of nonperforming ADC  loans increased quickly to 11 percent by June 2008 and 46 percent by  June 2011. As banks began to designate nonperforming loans or  portions of these loans as uncollectible, the level of net charge-offs also  began to rise. In December 2001, net charge-offs of ADC loans at small  failed banks were less than 1 percent. By June 2008, they had risen to 2  percent and by June 2011 to 12 percent.
CRE and especially ADC concentrations in small and medium-size failed  banks in the 10 states were often correlated with poor risk management  and risky funding sources. Our analysis showed that small failed banks in  the 10 states had often pursued aggressive growth strategies using  nontraditional and riskier funding sources such as brokered deposits.
The IG reviews noted that in the majority of failures, management  exercised poor oversight of the risks associated with high CRE and ADC  concentrations and engaged in weak underwriting and credit  administration practices. Further, 28 percent (84) of the failed banks had  been chartered for less than 10 years at the time of failure and according  to FDIC, appeared in many cases to have deviated from their approved  business plans. Large bank failures in the 10 states were associated with  some of the same factors as small banks—high-risk growth strategies,  weak underwriting and risk controls, and excessive concentrations that  increased these banks’ exposure to the real estate market downturn.The  primary difference was that the large banks’ strategies generally relied on  risky nontraditional residential mortgage products as opposed to  commercial real estate.
To further investigate factors associated with bank failures across the  United States, we analyzed data on FDIC-insured commercial banks and  state-chartered savings banks from 2006 to 2011. Our econometric  analysis suggests that across the country, riskier lending and funding  sources were associated with an increased likelihood of bank failures.  Specifically, we found that banks with high concentrations of ADC loans  and an increased use of brokered deposits were more likely to fail from  2008 to 2011, while banks with better asset quality and greater capital  adequacy were less likely to fail. An FDIC IG study issued in October  2012 found that some banks with high ADC concentrations were able to  weather the recent financial crisis without experiencing a corresponding  decline in their overall financial condition. Among other things, the IG  found that these banks exhibited strong management, sound credit  administration and underwriting practices, and adequate capital.
subsections: section_title: Credit Losses and Charge- offs from Nonperforming Loans Contributed Significantly to Bank Failures Nationwide, but Losses Due to Fair Value Accounting Did Not
paragraphs: We found that losses related to bank assets and liabilities that were  subject to fair value accounting contributed little to bank failures overall,  largely because most banks’ assets and liabilities were not recorded at  fair value. Based on our analysis, fair value losses related to certain types  of mortgage-related investment securities contributed to some bank  failures. But in general fair value-related losses contributed little to the  decline in net interest income and regulatory capital that failed banks  experienced overall once the financial crisis began.
We analyzed the assets and liabilities on the balance sheets of failed  banks nationwide that were subject to fair value accounting between 2007  and 2011. We found that generally over two-thirds of the assets of all  failed commercial banks (small, medium-size, and large) were classified  as held-for-investment (HFI) loans, which were not subject to fair value  accounting. For example, small failed commercial banks held an  average of 77 percent of their assets as HFI loans in 2008. At the same  time, small surviving (open) commercial banks held an average of 69  percent in such loans. Failed and open small thrifts, as well as medium- size and large commercial banks, had similar percentages.
Some assets and liabilities, such as securities designated for trading, are measured at  fair value on a recurring basis (at each reporting period), where unrealized gains or losses  flow through the bank’s earnings in the income statement and affect regulatory capital.  However, for certain other assets and liabilities that are measured at fair value on a  recurring basis, such as AFS securities, unrealized fair value gains and losses generally  do not impact earnings and thus generally are not included in regulatory capital  calculations. Instead, these gains or losses are recorded through other comprehensive  income, unless the institution determines that a decline in fair value below amortized cost  constitutes an other than temporary impairment, in which case the instrument is written  down to its fair value, with credit losses reflected in earnings. value and impact regulatory capital, together these categories did not  account for a significant percentage of total assets at either failed or open  commercial banks or thrifts. For example, in 2008, trading assets,  nontrading assets such as nontrading derivative contracts, and trading  liabilities at small failed banks ranged from 0.00 to 0.03 percent of total  assets.
As discussed earlier, declines in regulatory capital at failed banks were  driven by rising levels of credit losses related to nonperforming loans and  charge-offs of these loans. For failed commercial banks and thrifts of all  sizes nationwide, credit losses, which resulted from nonperforming HFI  loans, were the largest contributors to the institutions’ overall losses when  compared to any other asset class. These losses had a greater negative  impact on institutions’ earnings and regulatory capital levels than those  recorded at fair value.
During the course of our work, several state regulators and community  banking association officials told us that at some small failed banks,  declining collateral values of impaired collateral-dependent loans— particularly CRE and ADC loans in those areas where real estate assets  prices declined severely—drove both credit losses and charge-offs and  resulted in reductions to regulatory capital. Data are not publicly available  to analyze the extent to which credit losses or charge-offs at the failed  banks were driven by declines in the collateral values of impaired  collateral-dependent CRE or ADC loans. However, state banking  associations said that the magnitude of the losses was exacerbated by  federal bank examiners’ classification of collateral-dependent loans and  evaluation of appraisals used by banks to support impairment analysis of  these loans. Federal banking regulators noted that regulatory guidance in  2009 directed examiners not to require banks to write down loans to an  amount less than the loan balance solely because the value of the  underlying collateral had declined and that examiners were generally not  expected to challenge the appraisals obtained by banks unless they  found that any underlying facts or assumptions about the appraisal were  inappropriate or could support alternative assumptions.
section_title: Current Accounting Practices for Loss Provisioning May Have Delayed Reporting of Credit Losses during the Recent Crisis
paragraphs: A loan loss provision is the money a bank sets aside to cover potential  credit losses on loans. The Department of the Treasury (Treasury) and  the Financial Stability Forum’s Working Group on Loss Provisioning  (Working Group) observed that the current accounting model for  estimating credit losses is based on historical loss rates, which were low  in the years before the financial crisis. Under GAAP, the accounting  model for estimating credit losses is commonly referred to as an “incurred  loss model” because the timing and measurement of losses are based on  estimates of losses incurred as of the balance sheet date. In a 2009  speech, the Comptroller of the Currency, who was a co-chair of the  Working Group, noted that in a long period of benign economic  conditions, such as the years prior to the most recent downturn, historical  loan loss rates would typically be low. As a result, justifying significant  loan loss provisioning to increase the loan loss allowance can be difficult  under the incurred loss model. country had identified multiple concerns with examiner treatment of CRE loans and related  issues. GAO, Banking Regulation: Enhanced Guidance on Commercial Real Estate Risks  Needed, GAO-11-489 (Washington, D.C.: May 19, 2011). losses earlier on the loans they underwrite and could incentivize prudent  risk management practices. Moreover, it is designed to help address the  cycle of losses and failures that emerged in the recent crisis as banks  were forced to increase loan loss allowances and raise capital when they  were least able to do so (procyclicality). We plan to continue to monitor  the progress of the ongoing activities of the standard setters to address  concerns with the loan loss provisioning model.
section_title: FDIC Used Shared Loss Agreements to Attract Bidders at Least Cost to the Deposit Insurance Fund
paragraphs: FDIC is required to resolve a bank failure in a manner that results in the  least cost to the Deposit Insurance Fund (DIF). FDIC’s preferred  resolution method is to sell the failed bank to another, healthier, bank.  During the most recent financial crisis, FDIC facilitated these sales by  including a loss share agreement, under which FDIC absorbed a portion  of the loss on specified assets purchased by the acquiring bank. From  January 2008 through December 31, 2011, FDIC was appointed as  receiver for the 414 failed banks, with $662 billion in book value of failed  bank assets. FDIC used purchase and assumption agreements (the direct  sale of a failed bank to another, healthier bank) to resolve 394 failed  institutions with approximately $652 billion in assets. As such, during the  period 2008 through 2011, FDIC sold 98 percent of failed bank assets  using purchase and assumption agreements. However, FDIC only was  able to resolve so many of these banks with purchase and assumption  agreements because it offered to share in the losses incurred by the  acquiring institution. According to FDIC officials, at the height of the  financial crisis in 2008, FDIC sought bids for whole bank purchase and  assumption agreements (where the acquiring bank assumes essentially  all of the failed bank’s assets and liabilities) with little success. Potential  acquiring banks we interviewed told us that they did not have sufficient  capital to take on the additional risks that the failed institutions’ assets  represented. Acquiring bank officials that we spoke to said that, because  of uncertainties in the market and the value of the assets, they would not  have purchased the failed banks without FDIC’s shared loss agreements.
Because shared loss agreements had worked well during the savings and  loan crisis of the 1980s and early 1990s, FDIC decided to offer the option  of having such agreements as part of the purchase and assumption of the  failed bank. Shared loss agreements provide potential buyers with some  protection on the purchase of failed bank assets, reduce immediate cash  needs, keep assets in the private sector, and minimize disruptions to  banking customers. Under the agreements, FDIC generally agrees to pay  80 percent for covered losses, and the acquiring bank covers the  remaining 20 percent. From 2008 to the end of 2011, FDIC resolved 281  of the 414 failures (68 percent) by providing a shared loss agreement as  part of the purchase and assumption. The need to offer shared loss  agreements diminished as the market improved. For example, in 2012  FDIC had been able to resolve more than half of all failed institutions  without having to offer to share in the losses. Specifically, between  January and September 30, 2012, FDIC had to agree to share losses on  18 of 43 bank failures (42 percent). Additionally, some potential bidders  were willing to accept shared loss agreements with lower than 80 percent  coverage.
As of December 31, 2011, DIF receiverships had made shared loss  payments totaling $16.2 billion. In addition, future payments under DIF  receiverships are estimated at an additional $26.6 billion over the duration  of the shared loss agreements, resulting in total estimated lifetime losses  of $42.8 billion (see fig. 2).
By comparing the estimated cost of the shared loss agreements with the  estimated cost of directly liquidating the failed banks’ assets, FDIC has  estimated that using shared loss agreements has saved the DIF over $40  billion. However, while the total estimated lifetime losses of the shared  loss agreements may not change, the timing of the losses may, and  payments from shared loss agreements may increase as the terms of the  agreements mature. FDIC officials stated that the acquiring banks were  being monitored for compliance with the terms and conditions of the  shared loss agreements. FDIC is in the process of issuing guidance to the  acquiring banks reminding them of these terms to prevent increased  shared loss payments as these agreements approach maturity.
section_title: Impact of Bank Failures on Local Communities Was Mixed
paragraphs: The acquisitions of failed banks by healthy banks appear to have  mitigated the potentially negative effects of bank failures on communities,  although the focus of local lending and philanthropy may have shifted.  First, while bank failures and failed bank acquisitions can have an impact  on market concentration—an indicator of the extent to which banks in the  market can exercise market power, such as raising prices or reducing the  availability of some products and services—we found that a limited  number of metropolitan areas and rural counties were likely to have  become significantly more concentrated.
We analyzed the impact of bank failures and failed bank acquisitions on  local credit markets using data for the period from June 2007 to June  2012. We calculated the Herfindahl-Hirschman Index (HHI), a key  statistical measure used to assess market concentration and the potential  for firms to exercise their ability to influence market prices. The HHI is  measured on a scale of 0 to 10,000, with values over 1,500 considered  indicative of concentration. Our results suggest that a small number of  the markets affected by bank failures and failed bank acquisitions were  likely to have become significantly more concentrated. For example, 8 of  the 188 metropolitan areas affected by bank failures and failed bank  acquisitions between June 30, 2009, and June 29, 2010, met the criteria  for raising significant competitive concerns. Similarly, 5 of the 68 rural  counties affected by bank failures during the same time period met the  criteria. The relatively limited number of areas where concentration  increased was generally the result of acquisitions by institutions that were  not already established in the locales that the failed banks served.
However, the effects could be significant for those limited areas that were  serviced by one bank or where few banks remain.
Second, our econometric analysis of call report data from 2006 through  2011 found that failing small banks extended progressively less net credit  as they approached failure, but that acquiring banks generally increased  net credit after the acquisition, albeit more slowly. Acquiring and peer  banks we interviewed in Georgia, Michigan, and Nevada agreed.  However general credit conditions were generally tighter in the period  following the financial crisis. For example, several noted that in the wake  of the bank failures, underwriting standards had tightened, making it  harder for some borrowers who might have been able to obtain loans  prior to the bank failures to obtain them afterward. Several banks officials  we interviewed also said that new lending for certain types of loans could  be restricted in certain areas. For example, they noted that the CRE  market, and in particular the ADC market, had contracted and that new  lending in this area had declined significantly.
Officials from regulators, banking associations, and banks we spoke with  also said that involvement in local philanthropy declined as small banks  approached failure but generally increased after acquisition. State  banking regulators and national and state community banking  associations we interviewed told us that community banks tended to be  highly involved in local philanthropic activities before the recession—for  example, by designating portions of their earnings for community  development or other charitable activities. However, these philanthropic  activities decreased as the banks approached failure and struggled to  conserve capital. Acquiring bank officials we interviewed told us that they  had generally increased philanthropic activities compared with the failed  community banks during the economic downturn and in the months  before failure. However, acquiring banks may or may not focus on the  same philanthropic activities as the failed banks. For example, one large  acquiring bank official told us that it made major charitable contributions  to large national or statewide philanthropic organizations and causes and  focused less on the local community charities to which the failed bank  had contributed.
Finally, we econometrically analyzed the relationships among bank  failures, income, unemployment, and real estate prices for all states and  the District of Columbia (states) for 1994 through 2011. Our analysis  showed that bank failures in a state were more likely to affect its real  estate sector than its labor market or broader economy. In particular, this  analysis did not suggest that bank failures in a state—as measured by  failed banks’ share of deposits—were associated with a decline in  personal income in that state. To the extent that there is a relationship  between the unemployment rate and bank failures, the unemployment  rate appears to have more bearing on failed banks’ share of deposits than  vice versa. In contrast, our analysis found that failed banks’ share of  deposits and the house price index in a state appear to be significantly  related to each other. Altogether, these results suggest that the impact of  bank failures on a state’s economy is most likely to appear in the real  estate sector and less likely to appear in the overall labor market or in the  broader economy. However, we note that these results could be  different at the city or county level.
Chairman Capito, Ranking Member Meeks, and Members of the  Subcommittee, this concludes my prepared statement. I would be happy  to answer any questions that you may have at this time.
section_title: Contacts and Acknowledgments
paragraphs: If you or your staff have any questions about this testimony, please  contact Lawrance Evans, Jr. at (202) 512-4802 or evansl@gao.gov.  Contact points for our Offices of Public Affairs and Congressional  Relations may be found on the last page of this report. GAO staff who  made key contributions to this testimony include Karen Tremba, Assistant  Director; William Cordrey, Assistant Director; Gary Chupka, Assistant  Director; William Chatlos; Emily Chalmers, Robert Dacey; Rachel  DeMarcus; M’Baye Diagne; Courtney LaFountain; Marc Molino, Patricia  Moye; Lauren Nunnally; Angela Pun, Stefanie Jonkman; Akiko Ohnuma;  Michael Osman; and Jay Thomas.
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