GAO report examines causes of 2008 bank failures

Commercial Real Estate (CRE) loan losses and the use of brokered deposits were common threads in many of the financial institution failures.
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Photo: Source: GAO, License: N/A

Number of bank failures by state

Photo: Source: GAO, License: N/A

Quarterly average CRE and ADC (acquisition, development and construction) loan balances as a percentage of total loan balances at failed and open small banks in the 10 states, 2001-2011.

The U.S. Government Accountability Office (GAO) in January released an extensive study detailing the causes and consequences of recent community bank and thrift failures that occurred between 2008 and 2011. The study was requested by the U.S. Congress in the aftermath of the country’s recent economic troubles.
Commercial Real Estate (CRE) loan losses and the use of brokered deposits were common threads in many of the financial institution failures, the GAO study found. Failed banks “also had often pursued aggressive growth strategies using nontraditional, riskier funding sources and exhibited weak underwriting and credit administration practices,” the report added.
Fair-value accounting has been cited as another potential factor in some failures, the GAO said. However, fair-value accounting losses in general “did not appear to be a major contributor” between 2007 and 2011, “as over two-thirds of small failed banks’ assets were not subject to fair value accounting,” the agency noted.
The report claimed that early recognition of loan losses could have alleviated some of the financial issues faced by banks. The GAO noted that a loan loss provision model proposed by the Financial Accounting Standards Board may help address the cycle of losses and failures that emerged in the recent crisis as banks were forced to increase loan loss allowances and raise capital when they were least able to do so.

What GAO found:
* Ten states concentrated in the western, midwestern, and southeastern United States—all areas where the housing market had experienced strong growth in the prior decade—experienced 10 or more commercial bank or thrift (bank) failures between 2008 and 2011 (see map). 
* The failures of the smaller banks (those with less than $1 billion in assets) in these states were largely driven by credit losses on commercial real estate (CRE) loans. The failed banks also had often pursued aggressive growth strategies using nontraditional, riskier funding sources and exhibited weak underwriting and credit administration practices. The rapid growth of CRE portfolios led to high concentrations that increased the banks’ exposure to the sustained real estate and economic downturn that began in 2007.
* GAO’s econometric model revealed that CRE concentrations and the use of brokered deposits, a funding source carrying higher risk than core deposits, were associated with an increased likelihood of failure for banks across all states during the period. 
* Fair value accounting also has been cited as a potential contributor to bank failures, but between 2007 and 2011 fair value accounting losses in general did not appear to be a major contributor, as over two-thirds of small failed banks’ assets were not subject to fair value accounting. 
* The Department of the Treasury and the Financial Stability Forum’s Working Group on Loss Provisioning have observed that the current accounting model for estimating credit losses is based on historical loss rates, which were low in the prefinancial crisis years. They said that earlier recognition of loan losses could have potentially lessened the impact of the crisis, when banks had to recognize the losses through a sudden series of provisions to the loan loss allowance, thus reducing earnings and regulatory capital.
* The Financial Accounting Standards Board has issued a proposal for public comment for a loan loss provisioning model that is more forward-looking and focuses on expected losses, which would result in banks establishing earlier recognition of loan losses for the loans they underwrite and could incentivize prudent risk management practices. Moreover, it should help address the cycle of losses and failures that emerged in the recent crisis as banks were forced to increase loan loss allowances and raise capital when they were least able to do so.

Source: Financial Institutions: Causes and Consequences of Recent Bank Failures, U.S. Government Accountability Office, January 2013.