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Déjà Vu All Over Again: The Causes of U.S. Commercial Bank Failures This Time Around

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Abstract

In this study, we analyze why commercial banks failed during the recent financial crisis. We find that traditional proxies for the CAMELS components, as well as measures of commercial real estate investments, do an excellent job in explaining the failures of banks that were closed during 2009, just as they did in the previous banking crisis of 1985–1992. Surprisingly, we do not find that residential mortgage-backed securities played a significant role in determining which banks failed and which banks survived. Our results offer support for the CAMELS approach to judging the safety and soundness of commercial banks, but call, into serious question the current system of regulatory risk weights and concentration limits on commercial real estate loans.

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Notes

  1. This quotation is commonly attributed to the investor Warren Buffet.

  2. Of course, in late 2008, some – perhaps many – of these large banks were insolvent on a mark-to-market basis, and, thus, could be considered to have failed economically. However, the Troubled Asset Relief Program (TARP) effectively bailed them out. An exception was the demise of Washington Mutual in September 2008; but WaMu was absorbed by an acquirer at “no cost” to the Federal Deposit Insurance Corporation (FDIC), and was not extensively invested in the toxic securities but, instead, had originated toxic mortgages that were retained in its loan portfolio. Also, Wachovia appeared headed for failure but was acquired by Wells Fargo in October 2008 at no cost to the FDIC—an acquisition that Wells Fargo would regret for years to come. Wachovia’s troubles stemmed from the more than $100 billion in pay-option adjustable-rate mortgages (ARMs) that it inherited from Golden West, a thrift that it acquired during 2006.

  3. Only 31 banks failed during the 8 years spanning 2000–2007, and only 30 banks failed during 2008. These samples are too small to conduct a meaningful analysis using cross-sectional techniques. During 2009, more than 100 banks failed, for the first time since 1992, which was the tail end of the last banking crisis.

  4. CAMELS is an acronym for Capital adequacy; Asset quality; Management; Earnings; Liquidity; and Sensitivity to market risk. The Uniform Financial Rating System, informally known as the CAMEL ratings system, was introduced by U.S. regulators in November 1979 to assess the health of individual banks; in 1996, CAMEL evolved into CAMELS, with the addition of a sixth component to summarize Sensitivity to market risk. Following an onsite bank examination, bank examiners assign a score on a scale of one (best) to five (worst) for each of the six CAMELS components; they also assign a single summary measure, known as the “composite” rating.

  5. We exclude from this category the extensive, and still growing, literature on the failures of the subprime-based residential mortgage-backed securities (RMBS). For examples of such analyses, see Gorton (2008), Acharya and Richardson (2009), Brunnermeier (2009), Coval et al. (2009), Mayer et al. (2009), Demyanyk and Van Hemert (2011), and Krishnamurthy (2010).

  6. It is striking that, in the literature reviews provided by Torna (2010) and Demyanyk and Hasan (2009), there are no cites to econometric efforts to explain recent bank failures (except with respect specifically to RMBS failure issues). A more recent paper (Forsyth 2010) examines the increase in risk-taking (as measured by assets that carry a 100% risk weight in the Basel I risk-weighting framework) between 2001 and 2007 by banks that are headquartered in the Pacific Northwest but does not specifically address failure issues.

  7. Torna (2010) considers the following to be “modern banking activities and techniques”: brokerage; investment banking; insurance; venture capital; securitization; and derivatives trading.

  8. As do we, Torna (2010) excludes thrift institutions from the analysis.

  9. Torna (2010) cannot directly identify the banks that are on the FDIC’s “troubled banks” list each quarter because the FDIC releases the total number of troubled banks, but keeps their identities confidential. As an estimate of those identities, Torna considers “troubled banks” specifically to be the number of banks at the bottom of the Tier 1 capital ranking that is equal to the number of banks that are on the FDIC’s “troubled banks” list for each quarter. Torna’s method provides only a crude approximation to these identities because this method ignores all but one of the CAMELS components that likely go into the FDIC’s determination of “troubled bank” status.

  10. In two studies of bank and thrift failures occurring during the 1980s, Thomson (1992) and Cole (1993) take a different approach to account for regulators’ failure to close technically insolvent financial institutions. Thomson (1992) uses a two equation model where the first equation estimates capital-adequacy ratio and the second equation estimates closure as a function of the predicted value from the first equation. Cole (1993) uses a two-equation bivariate probit model, where the first equation estimates insolvency and then the second equation estimates closure. Regulators are also interested in the determinants of failure costs, but that is beyond the scope of our analysis here. See Schaeck (2008) for a recent study that examines issues related to estimating bank failure costs.

  11. It is worth noting that 57 of the 74 commercial banks that failed during the first half of 2010 (77%) are members of our “technical failure” group.

  12. However, in our logit regressions for 2008 and 2007, there are only 263 banks in the FAIL category because two (of the 265 FAIL) banks were de novo start-ups in 2009 and, thus, filed no financial data for 2008 or 2007.

  13. We also exclude savings banks, even though they use the same Call Report forms as commercial banks, because they too are usually focused in directions that are different from those of commercial banks. Their inclusion does not qualitatively affect our results.

  14. Almost all U.S. housing statistics lump one-to-four residential units into the single-family category.

  15. Other financial variables that we tried, but that generally failed to yield significant results, included Trading Assets; Premises; Restructured Loans; Insider Loans; Home Equity Loans; and Mortgage-Backed Securities (classified into a number of categories).

  16. A potential issue of multicollinearity should be mentioned: If the variable Nonfarm-Nonresidential Mortgages is excluded from the regressions, most of the other variables retain the signs and significance shown in Table 8, and the variable Residential Single-Family Mortgages becomes a consistently significant negative influence on failure.

  17. Of course, if a Type-2-error bank were to be put into a receivership by the FDIC, the losses to shareholders and senior managers could be larger, although still likely to be far less than the costs of Type I errors.

  18. It is likely the case that some of the “misclassified survivors” will subsequently fail, which would reduce our Type 2 error rate.

  19. Also, all bank holding companies are regulated by the FRS, but not all banks are members of holding companies.

  20. Of the 74 banks that failed in the first half of 2010, 68 (92%) were in this modified group of 347 technical failures.

  21. We are grateful to seminar participants at the Federal Reserve Board for many of these suggestions and to Scott Frame for the suggestion regarding FHLB advances.

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Authors and Affiliations

  1. Kellstadt College of Commerce, DePaul University, 14 E. Jackson Blvd. Suite 900, Chicago, IL, USA

    Rebel A. Cole

  2. Stern School of Business, New York University, 44 W. 4th Street Room 7-65, New York, NY, USA

    Lawrence J. White

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  1. Rebel A. Cole
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  2. Lawrence J. White
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Correspondence to Rebel A. Cole.

Additional information

The authors acknowledge helpful comments or discussions of Viral Acharya, Lamont Black, John Boyd, Bob DeYoung, Scott Frame, Ed Kane, Paul Kupiec, Haluk Unal, and an anonymous referee; as well as participants at a Federal Reserve Board research seminar held July 8, 2010, in Washington, DC; at a Stern-NYU research seminar held Sep. 24, 2010, in New York City, NY; and at the FDIC’s 10th Annual Bank Research Conference held Oct. 28–29, 2010, in Arlington, VA.

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Cole, R.A., White, L.J. Déjà Vu All Over Again: The Causes of U.S. Commercial Bank Failures This Time Around. J Financ Serv Res 42, 5–29 (2012). https://doi.org/10.1007/s10693-011-0116-9

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