Large banks are not the problem

Northwestern Financial Review, Oct 1-Oct 14, 2003 by Ely, Bert

I was quite shocked to read praise in the August 15-31 North*Western Financial Review of comments Minneapolis Fed President Gary Stern made regarding the allocation of regulators' supervisory resources. Mr. Stern advocates focusing a majority of supervisory resources on banks with more than $10 billion in assets.

Mr. Stern complains that it is excessive to devote 75 percent of total domestic supervision hours to institutions with less than $10 billion of assets, yet as the last decade's experience shows, smaller banking institutions are where the problem is. Mr. Stern proposes to focus more supervisory resources on banks over $10 billion in size yet those banks have not been failing. Banks which do not come close to failing do not pose systemic risk because those are not the banks depositors run from -they run from weak and failing banks.

There is a good reason why larger banks, as a practical matter, do not pose systemic risk - equity market discipline works aggressively to prevent their failure or even a brush with failure. Almost all banks with more than $10 billion in assets enjoy broadbased stockholder ownership and aggressive coverage by stock analysts. Consequently, market discipline kicks in long before a large, weak bank threatens systemic stability - the bank will turn itself around or it will be acquired by a stronger bank, without any FDIC assistance. Unfortunately, supervisory discipline has failed to prevent smaller, closely held banks from failing, which has been costly to the FDIC.

The largest bank failure since the S&L fiasco and the banking problems of the 1980s and early 1990s was Superior Bank, the Pritzker-controlled thrift that failed in July 2001, five months after I publicly predicted its failure. This privately-owned institution had $1.8 billion of assets on June 30,2001. Since 1993, 60 FDIC-insured banks and thrifts have failed - they had a total of $10 billion in assets and generated deposit insurance losses totaling $2.6 billion, according to FDIC data. The combined assets of these 60 banks equal the size of a bank which Mr. Stern believes represents the greatest risk of failure. The six institutions with losses exceeding $100 million each had a total of $6 billion of assets and deposit insurance losses totaling $2 billion.

Sadly, government banking supervisors, including the Federal Reserve, seem not to have learned from these failures as they continue to fail in dealing aggressively with smaller, weak banks. In each of the six most costly failures over the last decade, supervisors responded far too slowly to deteriorating situations in institutions that were very atypical banks. Because these failed banks were privately owned or, if publicly owned, were controlled by insiders, equity market discipline was not present to neutralize regulatory failings. These supervisory failures suggest that the time has come to apply the principles of sports management to banking supervisors - drop the ball, run the wrong way, or repeatedly strike out and you are out of a job.

Two other points raised in the column merit a comment. First, taxpayers will not end up paying for large bank failures. Congress made sure that the banking industry will pay by giving the FDIC unlimited assessment power on bank earnings and capital. In effect, Congress said to America's healthy banks, you will pay the tab when banking supervisors fail to do their job. Second, unlike what often occurred during the S&L fiasco, a "bigtime zombie institution" will not be kept alive indefinitely, unless banking supervisors choose to ignore the prompt corrective action provisions of FDICIA, the banking legislation Congress enacted in 1991 to put some backbone in banking supervision. A

It may be asking too much, but hopefully Mr. Stern and his fellow banking regulators will begin to move more aggressively in dealing with obvious failure candidates within the banking industry. Rarely will those candidates be found among publicly held banking companies with assets exceeding $10 billion.

Bert Ely

Consultant

Arlington, Va.