Banks Die Too Fast for the Regulators
DAMIAN PALETTA / Wall Street Journal 23jan2009
WASHINGTON — Banking regulators across the country are struggling with a new phenomenon: Banks are failing with accelerating speed, exposing holes in the regulatory infrastructure designed to catch collapsing institutions.
The two small banks that failed a week ago, National Bank of Commerce in Berkeley, Ill., and Bank of Clark County, in Vancouver, Wash., both fell before regulators hit either one with public enforcement actions that would have alerted the public to their condition and allowed regulators to demand changes. National Bank of Commerce, for one, was reeling from losses related to its investments in mortgage giants Fannie Mae and Freddie Mac.
Of the 25 banks that failed in 2008, nine toppled before regulators publicly cracked down, including IndyMac Bank and the banking operations of Washington Mutual Inc., two of the biggest seizures in U.S. history. Two banks failed after being under an enforcement action for only two or three days.
Regulators also agreed to prop up Bank of America Corp., Citigroup Inc., and Wachovia Corp., even though none of them faced any type of formal enforcement action related to their safety and soundness.
The problem illustrates a fundamental weakness in the country's regulatory infrastructure. The government is positioned to help banks if there is erosion in their capital levels, referring to the cushion banks hold against unexpected losses.
But that isn't what happened last year. Instead, many banks faced a liquidity crisis as customers and business partners lost faith, shutting off the banks' access to short-term cash.
"In 2008, we have seen institutions fail with greater velocity than in prior years," says Scott Polakoff, senior deputy director at the Office of Thrift Supervision. "That greater velocity is driven by liquidity crises, not capital crises."
The Obama administration has promised to overhaul supervision of financial institutions because of the cracks exposed during the financial crisis. That process likely will take months. Meantime, federal regulators are bracing for more than 20 bank failures in the first quarter of this year.
Regulators typically crack down on weak institutions following periodic exams. But banks are falling into trouble faster than in previous downturns. By the time problems are discovered, many of those banks are beyond repair, regulators have found.
"For the most part, I think it was a tidal wave," says Rob Braswell, the top bank regulator in Georgia, where five banks failed last year. Only one was under a public enforcement action at the time.
Hitting a bank with an enforcement action makes it easier for regulators to force changes at a bank, such as shaking up management and prohibiting certain lending practices. The Office of the Comptroller of the Currency recently directed examiners to step up public enforcement actions earlier in the process.
Regulatory powers are in many ways designed to tighten the pressure on banks if their capital levels dwindle. After the savings-and-loan crisis, regulators set up a system requiring "prompt corrective action" if capital levels fell below a certain point. Such a designation essentially gives a bank a few months to improve its condition or face government seizure.
Of the 25 banks that failed last year, just one was covered by a "prompt corrective action." That suggests that the system isn't working, especially when liquidity crises erupt.
"Liquidity kills banks faster than anything, and regulators just don't have time to issue cease-and-desist orders and take formal enforcement actions," says Jaret Seiberg, a Washington analyst at Stanford Group, a financial-services company. "We've seen banks die within a matter of days and weeks. You go from having a cold to buried."
Regulators now have to weigh whether to give banks public enforcement actions earlier. But such a move could scare depositors and investors, worsening a bank's condition.
"When you've got this institution teetering on the edge of the cliff, you are going to do everything you can possibly do to help that institution survive," says John Douglas, former Federal Deposit Insurance Corp. general counsel who is now a partner at law firm Paul, Hastings, Janofsky & Walker LLP. "You don't want to be the cause of the failure."
To catch weak institutions sooner, regulators have increased the frequency of examinations for at-risk banks, and the FDIC is bulking up its team that handles weak banks and bank failures.
Regulators are also looking at ways to improve the way they monitor liquidity risk at banks.
Former Federal Reserve Chairman Paul Volcker issued a report last week through an international grouping of economists and policy makers that called for regulators to demand "a sizable diversified mix" of funding sources to ensure banks don't run out of liquidity, among other things.
Mr. Volcker and his colleagues also said regulators should force banks to disclose much more information about their sources of liquidity.