Financial Institutions: Causes and Consequences of Recent Community Bank Failures
Published: 2013-06-13T00:00:00

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) were small institutions with less than $1 billion in assets. Small banks often specialize in small business lending and are associated with local community development and philanthropy. The failures of these banks have raised questions about contributing factors. Further, the failures have raised concerns about the accounting and regulatory requirements needed to maintain reserves large enough to absorb expected loan losses (loan loss allowances)--for example, when borrowers are unable to repay a loan (credit losses).
This statement is based on findings from GAO's 2013 report on recent bank failures ( GAO-13-71 ) required by Pub. L. No 112-88. This testimony discusses (1) the factors that contributed to the bank failures in states with the most failed institutions between 2008 and 2011; (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 as appropriate.
section_title: What GAO Found
paragraphs: Ten states concentrated in the western, midwestern, and southeastern United States--areas where the housing market had experienced strong growth in the prior decade--each experienced 10 or more commercial bank or thrift (bank) failures between 2008 and 2011. The failures of small banks (those with less than $1 billion in assets) in these states were largely driven by credit losses on commercial real estate (CRE) loans, particularly loans secured by real estate to finance land development and construction. Many of the failed banks had often pursued aggressive growth strategies using nontraditional, riskier funding sources and exhibited weak underwriting and credit administration practices. The Department of the Treasury and the Financial Stability Forum's Working Group on Loss Provisioning observed that earlier recognition of credit losses could have potentially lessened the impact of the crisis. The accounting model used for estimating credit losses is based on historical loss rates, which were low in the prefinancial crisis years. In part due to these accounting rules, loan loss allowances were not adequate to absorb the wave of credit losses that occurred once the financial crisis began. Banks had to recognize these losses through a sudden series of increases (provisions) to the loan loss allowance that reduced earnings and regulatory capital. In December 2012, the Financial Accounting Standards Board issued a proposal for public comment for a loan loss provisioning model that is more forward looking and would incorporate a broader range of credit information. This would result in banks establishing earlier recognition of loan losses for the loans they underwrite and could incentivize prudent risk management practices. It should also 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.
The Federal Deposit Insurance Corporation (FDIC) used shared loss agreements to help resolve 281 of the 414 bank failures during the recent financial crisis to minimize the impact on the Deposit Insurance Fund (DIF). 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. FDIC compared the estimated cost of the shared loss agreements to the estimated cost of directly liquidating the failed banks' assets and estimated that the use of shared loss agreements saved the DIF over $40 billion.
GAO analysis of metropolitan and rural areas where bank failures occurred and econometric analysis of bank income and condition data suggested that the acquisitions of failed banks by healthy banks mitigated the potentially negative effects of failures on communities. However, the focus of local lending and philanthropy may have shifted. Also, bank officials whom GAO interviewed noted that in the wake of the bank failures, underwriting standards had tightened. As a result, credit was generally most available for small business owners with good credit histories and strong financials. Further, the effects of bank failures could potentially be significant for communities that had been serviced by only one bank or where only a few banks remain.

section_title: Letter
paragraphs: I am pleased to be here today as you examine lessons learned from  recent community bank failures. 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, these failures raise  questions about the impact of the Federal Deposit Insurance  Corporation’s (FDIC) methods for resolving failed banks on the Deposit  Insurance Fund (DIF).
My remarks today are based on our January 2013 report on the impact of  bank failures. My statement will address (1) the factors that contributed  to the failure of banks in states with 10 or more failures between 2008  and 2011, including the extent to which losses related to fair value  accounting treatment affected the regulatory capital positions of failed  banks; (2) market factors that affected FDIC’s choice of resolution method  and the costs that the DIF incurred as a result of these methods; and   (3) the effect of recent small bank failures on local communities. To  address these issues, we analyzed bank income and condition data (call  report data); reviewed inspectors general (IG) reports 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. Those standards require that we plan and perform the  audit to obtain sufficient, appropriate evidence to provide a reasonable  basis for our findings and conclusions based on our audit objectives.
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  accounted for 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 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 that 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 net 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-size 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 appeared  in many cases to have deviated from their approved business plans,  according to FDIC. Large bank failures in the 10 states were associated  with some of the same factors as small bank failures—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 more than 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 commercial banks that remained open 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.
Investment securities classified as available for sale (AFS) represented  the second-largest percentage of assets for all failed and open banks  over the 5-year period we reviewed. For example, in 2008, small failed  commercial banks held an average of 10 percent of their assets as AFS  securities, while small open banks averaged 16 percent. Generally, AFS  securities are recorded at fair value, but the changes in fair value impact  earnings or regulatory capital only under certain circumstances. While  several other asset and liability categories are recorded at fair 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. A loan is considered “collateral  dependent” when the repayment of the debt will be provided solely by the  sale or operation of the underlying collateral, and there are no other  available and reliable sources of repayment. Data are not publicly  available to analyze the extent to which declines in the collateral values of  impaired collateral-dependent CRE or ADC loans drove credit losses or  charge-offs at the failed banks. However, state banking associations said  that the magnitude of the losses was exacerbated by federal bank  examiners’ classification of collateral-dependent loans and evaluations of  the appraisals banks used to support the impairment analyses 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. The regulators added 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.  The guidance also stated that in making decisions to write down loans,  bank examiners were to first focus on the adequacy of cash flows to  service the debt. If the sources of cash flows did not exist and the only  likely repayment source was the sale of the collateral, then examiners  were to direct the bank to write down the loan balances to the fair value of  the collateral, less estimated costs to sell in certain circumstances. For  example, one Federal Reserve official told us that some failed banks  were extending ADC loans on an interest-only basis with no evidence that  the borrower would be able to repay the principal and with underlying  collateral whose value had declined by a very significant amount. In those  cases, examiners questioned whether the banks would ever be repaid the  principal owed. Under these circumstances, absent any evidence that the  borrowers could pay through other means, the examiners would require a  write-down.
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) have 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.
Treasury and the Working Group noted that earlier recognition of loan  losses could have reduced the need for banks to recognize increases in  their incurred credit losses through a sudden series of loan loss  provisions that reduced earnings and regulatory capital. Federal banking  regulators have also noted that requiring management at the failed banks  to recognize loan losses earlier could have helped stem losses.  Specifically, such a requirement might have provided an incentive not to  concentrate so heavily in the loans that later resulted in significant losses.  To address this issue, the Financial Accounting Standards Board has  issued a proposal for public comment for a loan loss provisioning model  that is more forward-looking and focuses on expected losses. This  proposal would allow banks to establish a means of recognizing potential  losses earlier on the loans they underwrite and could incentivize prudent  risk management practices. Moreover, the proposal 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. FDIC officials said that at the height of the financial  crisis in 2008, FDIC sought bids for whole bank purchase and assumption  agreements (in which 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 they would not have  purchased the failed banks without FDIC’s shared loss agreements  because of uncertainties in the market and the value of the assets.  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 281of 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 was 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 agreed 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: The 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, 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, by, for example, raising prices or  reducing the availability of some products and services. But, 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  that indicate 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 potentially significant for those limited  areas that had been serviced by one bank or where only a 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. Officials from  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  bank officials 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 had 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 the acquiring bank 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 Johnson, Ranking Member Crapo, and Members of the  Committee, 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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