Administration Fiddles While Banking System Burns
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When a bank’s nonperforming loans reach 5% of total loans, regulators begin to question that institution’s solvency, according to former bank regulators cited in a Bloomberg story. But what happens when the entire banking system’s bad loans reach or exceed this level? Based on data contained in the Federal Deposit Insurance Corporation’s most recent Quarterly Banking Profile (QBP), we may soon find out.
At the end of June, 4.35% of all loans in the United States banking system were 90 days or more past due (“noncurrent” in the FDIC’s delicate terminology). This is the highest proportion of nonperforming loans in the 26 year history of the data series. Between April 1 and June 30, bad loans grew by 14.3%, jumping from an already worrisome 3.76% of total loans. Another quarter like this and the banking system as a whole will be technically insolvent on an accrual basis.
As of now, the FDIC has placed 416 banks on its “problem institution” list, about 5% of all insured institutions – and the highest percentage since June 1994. Some estimate that over twice this number will ultimately fail. Estimating bank failures is fraught with difficulty because the actual failure is not only an economic event – assets of insufficient value to support the claims of creditors – but also a political one, as failure requires a political body to affirmatively elect to place the institution into a receivership or conservatorship.
The political event is obviously what complicates forecasting bank failures. According to a commentary published by Institutional Risk Analyst, there may well be over 2,000 banks that have already failed from an economic perspective, but because of differences in how rules are applied by bank regulators (Office of Thrift Supervision, the Office of the Comptroller of the Currency, state regulators, and the Federal Reserve) or differences in the accounting rules applied to the character of their holdings (whole loans, securities, derivatives), only some subset of this total will actually fail and be placed in receivership or conservatorship.
The most significant determinant of failure today is the size of the institution. The Administration has focused its attention on instilling confidence in the largest institutions to avoid another “systemic event” akin to last year’s Lehman bankruptcy. The “stress test” for the 19 largest bank holding companies earlier this year, and subsequent subordination of Treasury’s preferred share holdings, made it clear to investors and counterparties that there would be no further mega-bank failures. While the Administration would argue that this political decision was made out of concern for a large default’s economic consequences, the predictable result has been to allow large institutions to capture more of the market for banking services. Large institutions are also borrowing at interest rates that are 0.34 percentage points lower than the rate received by other institutions. In 2007, the differential was only 0.08 percentage points.
Through July, the FDIC’s Temporary Liquidity Guarantee Program (TLGP), had provided explicit government guarantees on $320 billion of debt, but only half of 1% of that debt was issued by banks with assets under $10 billion even though these smaller banks account for 98.6% of all insured depository institutions. And this understates the discrepancy because the TLGP has conditioned market participants to expect federal intervention whenever a “systemically significant” institution has trouble rolling over its maturing debt obligations; large banks’ non-TLGP debt capital is less expensive because market participants have concluded that it could be repaid at maturity through the issuance of new government-guaranteed debt.
The Administration has succeeded in convincing the largest banks’ creditors and counterparties that it will not allow for a default event. The trillions of dollars of implied credit support provided by this policy has succeeded in lowering these institutions’ cost of capital and reduced the potential for a debilitating systemic event. But, as the FDIC’s QBP makes clear, this policy has not addressed the fundamental problem of bad loans backed by substandard collateral. Much as the Administration may wish to declare victory and move on to other matters, there is still no exit strategy for a policy that has pushed failed banks and banking services into the hands of the “too big to fail” institutions whose own solvency is underwritten by taxpayer resources.