Saving America’s Community Banks

(without cost to the taxpayers)

On December 15, an FDIC press release revealed that the 2010 budget for the regulatory agency will nearly double, as the agency girds up for “an even larger number of bank failures” in 2010.  Over 500 institutions, mainly community based, are now on the troubled list.  The vast majority of these are likely to fail under the current regulatory regime.  These institutions are the ones that typically lend in the community but can no longer do so because of tumbling real estate values which have decimated their capital bases.  Communities, of course, need such institutions to support economic growth.

In ’08, the federal government, using the credit of the American taxpayer, raced to save the “Too Big To Fail” (TBTF) institutions who are now so arrogant as to pay themselves unconscionable bonuses.  At the same time, nary a finger has been lifted to help community institutions which did not take unsuitable risks and did not over lever their balance sheets.  Given that the community institutions are the major lenders to America’s small businesses, where most jobs are created, the following is an outline of a plan to save these institutions without the use of taxpayer dollars.

Today, any of the more than 500 institutions on the FDIC’s troubled bank list find it impossible to raise capital (unlike the behemoths whose future existence is guaranteed because they are TBTF).  Any institution or private sector entity with capital looking to deploy it in the community banking sector simply wait for the FDIC to act first, as the FDIC’s bank closure model discourages capital investment prior to such closure.  When the FDIC closes a bank, it invites private sector entities to “bid”.  It then sells the closed institution’s deposits and some select assets to the bid winner, usually at bargain prices and often with “loss sharing” agreements (for any future loan losses on the assets purchased).  So, why would a rational private sector entity put capital into a watch list institution before the FDIC closes it, as the deal is so much sweeter after closure?

So, here is the plan.  What if a community bank could “recapture” its loan losses from ’08, ’09 and possibly even through ’10 into a special category which will count as regulatory (not GAAP) capital.  This would basically restore small bank capital to 12/31/07 levels.  At the end of 2010, the banks would have to begin to amortize this special regulatory pot over a fairly long period, say 7 to 10 years.  This will allow banks that were healthy at the end of ’07 to survive and earn their way back to health.

There are many benefits to this solution:

• No taxpayer dollars – the FDIC, which collects premiums for its fund directly from the insured institutions, will have time to rebuild its fund rather than borrowing from American taxpayers as they will have to do in 2010;
• While their GAAP capital will still show undercapitalization, once survival is assured, the capital markets will open up, and many of these institutions will have the capability of raising private capital themselves.  After all, even Citigroup was able to raise capital the week of December 13^th because their future existence is assured (TBTF); 
• While a few of the small institutions on the FDIC’s watch list may deserve to fail, the vast majority do not.  These institutions are vital to many local economies.  We saved the TBTF institutions who were deserving of failure (their large risky bets); maybe we should help the more deserving by simply altering a regulatory capital regulation;
• It is widely acknowledged that one of the failures in Japan’s 20 year fight with deflation is their refusal to recognize the bad loans on the books of their financial institutions.  Because they won’t lose their regulatory capital under this plan, banks will more rapidly recognize their bad loans and purge them from their books.  They will have an incentive to do so before the “recapture” period ends on 12/31/10.  This will accelerate the healing process in their local economies and put them (both the bank and the local economy) back on the road to health.

Robert Barone, Ph.D.

December 20, 2010