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Anatomy of a Bank Failure
At this writing, at least two Tennessee banks have failed, Tennessee Commerce Bank in Franklin and BankEast in Knoxville. There may be others. Prior to Friday, Jan. 27, 2012, the last bank to be closed in Tennessee was the Bank of Alamo in 2002. Tennessee has weathered the recessionary economy better than many of our sister states, has been fortunate to have a state banking department that has worked to keep banks open rather than close them at the first sign of distress, and has a generally conservative banking community that understands the value of plenty of capital.
Bank failures are not new and are not unique to this economy. In the 1920s alone, more than 5,000 banks failed in the United States, spawning the advent of the Federal Deposit Insurance Corporation (FDIC) as a safety net for depositors. In the 1980s in Tennessee, the Commissioner of Financial Institutions closed more than 30 state-chartered banks. The failures of the ’80s cannot be blamed on a bad economy, but rather, for the most part, on insider abuse and fraud. While regular readers of this column may find some of this story repetitive, now that Tennessee has experienced its first bank failures in a decade, lawyers are likely to hear from their clients on the subject.
The Straw That Breaks the CAMELS Back
What differentiates a bank that is likely to fail from one that’s safe and sound? The answer is generally found in the regulatory acronym used by bank examiners to “grade” a bank’s condition. CAMELS stands for capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risks. Banks are rated on a scale of 1 to 5, with 1 being practically perfect and 5 being on the way to the bank bone yard. Each component is given a rating, and then the bank receives a composite rating. The composite is not an average of the other ratings and is sometimes highly subjective. For this reason, a bank’s CAMELS rating is not public information.
A bank that has virtually no criticized or past-due loans, that is a high-earning institution, and that does not have any other significant risk factors is considered “well-capitalized” if its Tier 1 leverage capital ratio is 5 percent or above. This ratio is calculated by dividing a bank’s “Tier 1 capital” by its average total consolidated assets. Included in Tier 1 capital are shareholders’ equity and reserves. In today’s world, however, a 5 percent Tier 1 leverage ratio would land a typical bank on the regulators’ troubled list. It is more typical for banks to maintain a ratio of capital and reserves to total assets at between 8 percent and 9 percent. The rule of thumb is that a bank will fail or be forced to merge with a stronger institution once its Tier 1 leverage capital falls below 2 percent.
Banks with a significant volume of criticized assets (principally loans and foreclosed real estate) and non-performing assets (which include loans that are 90 days or more past due) will be required to have more capital. A capital cushion is there to help protect the bank from disastrous loan or securities losses. The bad news is that once a bank becomes “troubled,” it is far less likely that it will be able to raise capital. A bank cannot borrow money for recapitalization purposes, and if it has a holding company, there will be regulatory constraints on the bank parent’s ability to borrow – after all, lenders want to be repaid, and if a bank is constrained from paying dividends to its parent company, the parent can’t repay the loan to recapitalize the bank. If ever there were a Joseph Heller situation, it’s this Catch-22.
Asset quality drives the need for additional capital and reserves. A bank with a portfolio of performing loans is earning money, thereby contributing to the capital of the bank. A bank whose loan portfolio is filled with badly underwritten, non-performing loans cannot depend on earnings for capital augmentation, and regulators will “classify” loans on the bank’s books, force impaired and past-due loans to be put on non-accrual status, or require the bank to charge-off loans that the examiners feel are not collectible. Since regulators love ratios, the “coverage ratio,” or the ratio of a bank’s classified loans to its capital, is an indicator of financial strength. The higher the capital and the lower the level of criticized assets, the better. A coverage ratio of more than 50 percent signals growing concern; more than 100 percent and a bank should stop what it’s doing and put heart and soul into collecting bad loans and raising capital.
The management component of the CAMELS system is sometimes the hardest to determine. Examiners will assume that if a bank’s capital adequacy, asset quality and earnings are less than satisfactory, the management rating must reflect the same level of concern.
A bank’s earnings derive from interest earned on loans, the sale of securities held for investment, and non-interest income earned from fees. The largest component of earnings is interest income, and along with asset quality and capital, the CAMELS rating on earnings is an indicator of financial strength or weakness.
Perhaps the most critical measure of a bank’s ability to remain open is its liquidity. Regulators are forced to close any insured depository institution if the institution cannot meet its liquidity needs. Depositors loan the bank their money and expect to be repaid upon demand, but a bank does not keep enough cash secreted away in its vault to honor the demand of every depositor. The bank has lent the depositors’ money to borrowers. Back-up liquidity includes the ability to draw on lines of credit at other financial institutions, borrow from the Federal Home Loan Bank or the Federal Reserve, and the purchase of funds — called Fed funds — from other banks. When a bank’s condition worsens, these back-up facilities for liquidity are also curtailed or eliminated altogether, leaving the possibility of a run on the bank that the bank cannot stem. Banks are required to have contingency funding plans that detail what they would do if certain triggering events occur.
Finally, a bank’s sensitivity to shifts in interest rates is a factor considered by regulators. The sensitivity to market risk component reflects the degree to which changes in interest rates, foreign exchange rates, commodity prices, or equity prices can adversely affect a financial institution’s earnings or economic capital. Examiners will consider a bank’s ability to identify, measure, monitor and control market risk, as well as the adequacy of its capital and earnings in relation to its level of market risk exposure. Without getting too far into the weeds, a bank that has not balanced the rates it pays on deposits with the rates it charges on loans may find itself in a rate-sensitive environment that may impact the bank’s capital and earnings. There are sophisticated models that help a bank manage its interest rate risk, and I’ve never seen a bank fail because its model failed, but it is theoretically possible.
Besides these more measurable factors, sometimes, as in the 1980s in Tennessee, a bank may fail because of insider abuse or other fraud. Fortunately, it’s rare in today’s world of more sophisticated internal routines and controls, but a determined crook can bypass all the security a bank can install. The late John Roberts, former United States Attorney for the Middle District of Tennessee, once asked this writer if there were any circumstance in which I could support the death penalty. I quipped that a banker who steals from his own bank should get the chair. I think General Roberts took me seriously.
In summary, the grounds under which a bank may be closed are these:
- Its capital is insufficient to meet its obligations.
- The bank has engaged in substantial dissipation of assets due to any violation of statute or regulation or any unsafe or unsound banking practice.
- The bank is in an unsafe or unsound condition.
- The bank has engaged in a willful violation of a final cease-and-desist order.
- There has been a willful concealment of the bank’s books, records, or assets from banking regulators.
- The bank is likely to be unable to pay its obligations or meet its depositors’ demands in the normal course of business.
- The bank has incurred or is likely to incur losses that will deplete all or substantially all of its capital, and there is no reasonable prospect for the bank to become adequately capitalized.
- There is a violation of any law or regulation or an unsafe or unsound practice that is likely to cause insolvency or substantial dissipation of assets or earnings, weaken the bank’s condition, or otherwise seriously prejudice the interests of the bank’s depositors or the deposit insurance fund.
- The bank consents to the appointment of a receiver.
- The bank ceases to be an insured institution.
- The bank is undercapitalized and has no reasonable prospect of returning to capital adequacy or fails to undertake prompt corrective action.
- The bank is critically undercapitalized or otherwise has substantially insufficient capital.
A bank is usually closed without prior notice but is entitled to a hearing on the merits of the matter if the bank believes that it has been closed unjustly. For a state-chartered bank, the bank must challenge the commissioner’s decision in the Chancery Court of Davidson County. The late Chancellor C. Allen High heard from the directors of Peoples Bank & Trust of Wartburg, Tenn., in February 1985, challenging the commissioner’s right to take possession of the bank. The directors were unsuccessful on the merits.
Once a bank’s primary regulator determines that the bank must be closed, the chartering authority (in the case of a state-chartered bank, the commissioner of the Department of Financial Institutions; in the case of a national bank, the comptroller of the currency) takes possession of the bank, usually late on a Friday afternoon, having filed the appropriate papers with the local chancery court, in the case of a state bank. The chancellor signs the order authorizing the chartering authority to take possession of the bank and appoint the FDIC as receiver. The chartering authority and the FDIC have been in constant contact with one another to plan for an orderly transition, including putting the institution to be closed “out for bid” to a select number of qualified purchasers. When the FDIC is appointed, the agency typically takes one of two actions: it contracts with the winning bidder to purchase at least some of the assets of the failed bank and to assume the deposit liabilities; or it commences the liquidation of the bank if no purchaser can be found. In 2002, the small, rural Bank of Alamo was liquidated by the FDIC; 10 years later, both Tennessee Commerce Bank and BankEast were acquired by larger companies. The FDIC will typically negotiate with various bidders for the failed bank in an effort to get the best deal it can for the deposit insurance fund. The branches of the failed bank open on Monday morning under new management, new signage, and an army of folks scurrying around working on the transition that began on the Friday night before. It’s always a long, stressful weekend.
Shareholders of a failed bank lose their investment, but deposits are insured if a failed bank is sold. If the bank is liquidated, depositors are only protected up to $250,000 in that bank. As receiver the FDIC has the authority to repudiate certain types of agreements with the bank, such as leases and executory contracts; obtain a stay of any litigation against the bank; and initiate lawsuits against officers, directors and other institution-affiliated parties that may have contributed to the failure of the institution. The FDIC typically hires outside counsel to represent the agency in these investigations prior to filing suit.
We can debate whether a bank is a business like any other — with the right to fail if it doesn’t perform — but when a bank accepts federal deposit insurance and a charter from either the comptroller of the currency or the state banking authority, it ceases to be a business accountable only to its shareholders. The laws, regulations and statements of regulatory policy that govern banks are designed to protect depositors and customers, not investors, and while I may respectfully disagree at times with government’s interpretation of those laws, they are necessary for the orderly regulation of an industry that plays a crucial role in all of our lives.
Thomas Jefferson said that “[w]hen a man assumes a public trust, he should consider himself as public property.” That’s certainly how bank regulators see it.
- 12 U.S.C. §1821(c)(5).
- See “Bank on It” in the October 2011, issue of Tennessee Bar Journal for additional discussion, particularly about suits by the FDIC against attorneys, accountants, and other institution-affiliated parties.
- To Baron von Humboldt, 1807; B. L. Rayner, Life of Jefferson (1834)
KATHRYN REED EDGE is a member of Miller & Martin PLLC, a regional law firm with offices in Nashville, Chattanooga and Atlanta. She heads the firm's Financial Services Practice Group and concentrates her practice in representing regulated financial services companies. She is a past president of the Tennessee Bar Association and a former member of the editorial board for the Tennessee Bar Journal.