The 2% Rule
It is often said that generals are always fighting the last war. The same could be said of the regulators in the current Great Recession. Here, the last war was the savings and loan debacle. The S & L as a business model was destroyed by interest rate deregulation in the late 1970s and early 1980s. Previously, S & Ls borrowed short by taking deposits and lent very long by extending home mortgages. That model only works in a market with regulated interest rates. Rather than letting S & Ls fail when the inevitable rate mismatch took hold, Congress and the regulators rewrote the rules to permit the S & Ls to expand their operations to include enterprises with different risks. Also, S & L regulators kept institutions open long after they were hopelessly insolvent because those regulators did not have funds available to do much else. None of these thumbs in the dyke held, and the inevitable had to be faced and paid for.
Congress, declaring never again, and attempting to shift most of the blame to the regulators, amended the banking laws to require regulators to close financial institutions as soon as their GAAP leverage capital ratios fell below 2%. There is no way to say it tactfully, that was a stupid response to a unique crisis primarily created by market pressures to deregulate rates.
Banks need not fail because their tangible capital ratios fall below some bright line number. Banks are liquidity businesses. They can continue to operate with no capital (or even less) as long as they can continue to generate cash necessary to meet their customers’ needs. If this 2% closure rule had been in place in the 1970s, all the banks in Atlanta and most throughout Georgia would have been closed. Hindsight tells us that would have made no sense and would have impaired Georgia’s economic development for decades. History, tells us that in dire economic circumstances, given the deposit insurance system’s protection against “runs,” banks with stable core business usually can overcome their problems with time and build back capital deficiencies. The fact that “watchful waiting” could not solve the mismatch problem created by an obsolete S & L business model is not a lesson usefully carried over to the current economic dislocations.
The 2% rule was supposed to reduce failed bank losses to the deposit insurance fund. Whether it succeeded in reducing average FDIC losses per bank failure is impossible to say based on available data. Bank failure loss data since 1986 is available at the FDIC web site. That data indicates that prior to the 2% rule failures cost the insurance funds 17.9% of the average failed bank’s (or thrift’s) assets from 1986 to 1991, the height of the thrift crisis. Subsequently, after the 2% rule, average failed bank losses as a percentage of assets dropped precipitately. Then, in 2009 to 2010 losses increased to 23.4% of the average failed bank’s assets. It is thus apparent that losses are larger as a percentage of assets under generally adverse economic conditions than they are under more favorable conditions. The greater financial distress during 2009-2010 compared with 1986-1991 precludes any confident conclusion about the impact of the 2% rule on relative loss ratios. However, one thing is striking, though not surprising, about the numbers. They demonstrate that, assuming problem assets are fully written down at the time of failure, the remaining “good” assets are disposed of in depressed economic environments at a substantial loss averaging more than 15% of total bank assets. In that context, 2% of assets does not seem like much to save if you can avoid a distressed disposal of the “good” assets.
The banks in Georgia that failed did not do so because they continued to “incur” losses after it became apparent that we were in a very serious real estate led recession. When that realization occurred, lending came to a dead stop. Those Georgia banks failed because of losses on loans already on their books before that realization. Whether anyone is entitled to claim “I told you so” or not, any damage was done and not then curable. What has been euphemistically called deterioration in asset quality leading to failure was really gradually growing realization of the amount of damage already done. In that context, since any loss had be incurred and was not increasing, I do not believe that a rational insurance company, and that is what the FDIC is supposed to be, would close a bank that was making money before its provision for loan losses and other real estate expense (but after deposit insurance premiums) just because its estimated tangible capital had fallen below some bright line number. Doing so needlessly forces the insurance company to absorb the 15% liquidation loss on the “good” assets, a loss that can be avoided, absent an intervening liquidity failure, by letting the bank earn its way back to health. Yet, those are the facts relating to a number of failed Georgia community banks with core businesses. The insurance fund, the communities involved and the Georgia economy would have been better off had those banks been permitted to remain open. GAAP is flexible enough to have allowed that result even with the congressionally imposed 2% rule.
Regulators want all problem assets written down to the absolutely lowest realizable value. Bankers generally do not disagree with that philosophy. In good times when failure is not an issue, there is much to be said for that approach, though I admit to a level of frustration when I see such values become “target values” in workouts while I know they originally were “worst case” values. In bad times perhaps such values could be used in the regulatory process to instill discipline and measure performance toward regulatory required goals. However, when GAAP is more flexible, and Congress requires banks to be closed when tangible GAAP capital falls below 2%, good judgment mandates that regulators take advantage of GAAP’s flexibility in the best interests of the insurance fund, the communities served by local banks and the economies in which they operate.
That sounds like something Shelia might have said to Ben and Tim.
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