Failed bank acquisitions and lending activity

Business Economics, July, 1995 by Kevin Jacques, Peter Nigro

The dramatic number of bank failures during the 1980s were resolved by the FDIC primarily through purchase and assumptions agreements. This resolution method requires the acquiring bank to have sufficient capital to take over the failed bank's assets without becoming undercapitalized As a result, the acquiring bank is less able to originate new loans. This process is referred to as the recycling of assets. Using FDIC receivership data, this study finds changes in capital levels and some types of lending behavior that are consistent with the recycled assets theory.

Throughout the 1980s and early 1990s many changes occurred in banking, including a dramatic increase in the number of bank failures and a dramatic decline in the growth rate of bank lending. The large number of bank failures led to an abundant literature on failure prediction models and on the resolution costs of bank failures to the Federal Deposit Insurance Corporation (FDIC).(1) Research on the decline in bank lending examined a variety of possible causes, including the 1990-91 recession, tougher bank examination standards, and implementation of the Basle risk-based capital standards.(2) Although significant research exists in these areas, limited research addresses how the issues of bank failures and credit availability may be related. One theory, the recycled assets theory, argues that the transfer of assets from failed banks to healthy banks can lead to a shortage of capital at acquiring banks, thereby resulting in a decline in new lending.

The purpose of this paper is to examine whether recent data on bank failures and credit availability are consistent with the recycled assets theory. This issue has important implications for economic activity, because recent research suggests that a significant percentage of businesses, particularly small businesses, are almost completely dependent on banks for credit.(3) If credit is not available from banks, these firms are not able to access financial markets directly.

THE RECYCLED ASSETS THEORY

According to the recycled assets theory, the acquisition of a failed bank can affect the lending of the acquiring bank through its impact on the acquiring bank's capital ratio. Specifically, the recycled assets hypothesis states that banks hold capital in excess of the regulatory minimum because raising new capital from external sources, in the event of a capital shortfall, is costly. When a bank fails, the FDIC sells some or all of its assets and liabilities to a well-capitalized, surviving institution. In a failed bank acquisition, the acquiring bank must have sufficient capital to take over the assets of the failed bank without becoming undercapitalized. The acquisition of failed bank assets increases the acquiring bank's total assets, thereby raising the bank's minimum regulatory capital requirement. As a result, the acquired assets absorb some of the bank's currently existing capital. Because new equity is costly, the acquiring institution will not immediately replace the capital that has been absorbed by the recycled assets. Instead, the acquiring bank will either slow or reduce lending to borrowers because it has less capital available to support new lending. Baer and McElravey(4) term this process the "recycling of assets," because it is a transfer of assets from one institution to another and not the origination of new assets.

If the recycled assets theory is correct, certain characteristics should distinguish failed bank acquirers from the general population of banks. Using FDIC receivership and call report data, this paper examines two of these characteristics to see whether the data are consistent with the recycled assets theory. First, recycled assets should absorb a significant portion of available capital at acquiring banks in the period of the acquisition, thereby leading to a reduction in the bank's capital-asset ratio. If the level of recycled assets is minimal, or if raising new capital is inexpensive, then both the bank's lending and capital should be unaffected by the acquisition of failed bank assets. Under these conditions, changes in the lending and capital of acquiring banks should be similar to other banks in the banking industry. A second characteristic that should differentiate acquiring banks is that, because recycled assets absorb capital, acquiring banks should have slower lending growth in the period of the acquisition than the banking industry as a whole. This should be particularly true for commercial and industrial (C&I) loans, which tend to be short-term and callable, thereby making them relatively easy to terminate.(5)

THE DISPOSITION OF ASSETS AT FAILED BANKS

The method of resolution used by the FDIC plays a critical role in the recycled assets theory. Specifically, the frequent use of purchase and assumptions (P&As) in the late 1980s and early 1990s has been particularly important because not all failure resolution methods involve the immediate transfer of assets. Table 1 provides some descriptive evidence on the resolution techniques chosen during this period.(6) Of the five resolution approaches listed, P&As were responsible for 543, or 75 percent, of the 724 total resolutions. The next most frequently used transaction was the insured deposit transfer, which accounted for 12.2, or 16.9 percent of the total resolutions.