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Bank Capital is King, but How Much is too Much?

Publications By Curtis Carpenter on 05/10/2010

Published by the American Banker on May 7, 2010.

Although the banking industry continues to labor under the weight of billions in nonperforming assets and the list of problem banks reached a new high as of year-end, we think we can spot some early signs of stabilization and perhaps even a nascent recovery.  While we anticipate over 200 bank failures in 2010, it is encouraging to note that 45% of banks showed improved asset quality in the fourth quarter.  Capital raises are becoming more common.  If the Federal Deposit Insurance Corporation (FDIC) is successful in auctioning off “clusters” of failed banks, we could see the number of problem banks actually begin to decrease in the second half of 2010.

Uncertainties Stall Merger Activity

With these signs of stabilization, why would bank regulators decide that now is the time to increase required capital levels, when, in fact, it is precisely the wrong time? The industry needs capital forbearance not higher requirements.  The uncertainty created by an uneven regulatory response to the issue of capital is having a paralyzing effect.  Thousands of banks with the requisite capital and management to help clean up the current mess by acquiring problem banks are unwilling to move forward with a merger until they are certain they will have capital sufficient to meet any new standards following the merger.  In addition, private equity firms and others with capital are poised to pour billions of new capital into the industry once it can be determined what the new standards will be.

The Culprit is Weak Regulatory Oversight

It is important to note that the problem at failing community banks during this cycle was not a lack of adequate capital. The problems had more to do with lax regulatory oversight of lending (loan concentrations, out-sized bets on home prices and out-of-market loans) and of excessive reliance on wholesale funding magnified by a prolonged period of unrealistically low interest rates.  The median bank that failed in 2009 had positive equity the quarter prior to failure.  More banks in 2009 were closed due to liquidity and funding concerns than an absence of capital.  One of the most expensive failures in 2009, Guaranty Federal (a thrift with branches in Texas and California) was allowed to stay open for months while operating with a negative capital ratio in excess of 5% of assets while the Office of Thrift Supervision (OTS) shopped for a buyer.

More Capital is not the Answer

Bank failures over the past 18 months have cost the U.S. taxpayer zero!  All of the losses incurred by the FDIC in cleaning up the current problems are being financed by banks out of their current capital through FDIC assessments.  Community banks have not been bailed out!  The Troubled Asset Relief Program (TARP) dollars that flowed into banks and thrifts will be fully repaid to the Treasury at a net profit to the taxpayers.  However, it appears that the desirability of a “capital cushion” afforded by the TARP program to the nation’s largest banks has somehow found its way into proposed regulatory reform for community banks.

The current standards for capital in community banks are perfectly adequate. Raising capital requirements for community banks is the wrong response to this crisis.  In the last banking crisis (over 20 years ago), banks with good management were given forbearance and were required to submit a “capital plan” that would demonstrate how they could return to required levels of capital through earnings retention and managed growth.  Cease and Desist orders (C&D’s) were given only to those banks with owners and management that refused to cooperate with regulators as a form of punishment for bad behavior.  In the current cycle, “prompt corrective action” is the charge, and C&D’s are given based upon a formula without the exercise of any professional judgment on behalf of the regulators. We continually hear from bankers throughout the country that the opinions of their regional regulator are arbitrarily overridden by superiors at headquarters in Washington.

Presently, clear, consistent regulatory guidance is lacking, causing banks to control balance sheet growth and risk, which has the effect of reducing profitability and returns on capital.  This restricts capital growth in two ways: it lowers internally-generated capital and drives external capital to industries with better risk/reward profiles.  Banks with good management should be given time to work through asset quality issues or to acquire problem banks under current capital standards.  Until this issue is resolved, community banks across the country cannot assume their usual role as the wellspring of economic growth.