As the nation’s biggest financial institutions benefit from Uncle Sam’s financial stability programs, many of the smaller banks may have to shut their doors over the next few years.

To date, 37 banks have failed in 2009. Another 305 are on the Federal Deposit Insurance Corp.’s so-called problem list. Historically, approximately 13 percent of the institutions on that list fail. While the government doesn’t publicly predict how many banks might fail, one private company estimates that 500 to 1,000 additional banks may collapse if the economy further destabilizes.

The government’s much publicized stress tests tried to determine if the 19 largest financial institutions have adequate resources to withstand the next two years under a couple of different, worsening economic scenarios, one considerably more dire than the other.

Stress tests for small banks

The government didn’t apply the test to the more than 8,000 smaller banks, but Sandler O’Neill, an investment banking and financial advisory firm, did. It estimated that as many as 500 smaller banks might not be able to raise the capital needed to get through a prolonged, more strenuous downturn.

Robert Albertson, chief strategist at Sandler O’Neill, then ran additional loss ratio scenarios and came up with possibly 1,000 banks failing.

“It’s a theoretical machine exercise using numbers on a page with commonly accepted data,” says Albertson. “Is that a reasonable estimate of possible failures in the system? My answer is that it may be. It may also be on the high side because what we’re doing in this exercise is apply a Great Depression loss cycle on every bank in the country. But my personal thought is it’s certainly 500 and probably more.

“If you say between 500 and 1,000, I don’t think you’ll get a lot of argument from the industry that it’s an extreme number, nor would you get an argument in general that it shouldn’t happen. It certainly has the effect of removing weaker financial institutions or consolidating them with others to make for a more efficient banking system, but it’s a bad thing in that it disrupts communities and smaller banks, which are key to our communities; plus it costs money to close them.”

The FDIC’s Deposit Insurance Fund, or DIF, is the piggy bank the agency dips into if necessary to pay insured deposits and other expenses when an insured bank fails. So far this year, the cost to the DIF has been $10.5 billion. The latest balance given by the FDIC is that the fund had $13 billion as of March 31, 2009. The agency estimates that failures through 2013 will cost $70 billion; $28 billion has been set aside to cover potential failures over the next 12 months.

The fund is required to have a reserve ratio of $1.15. That means the fund should have $1.15 on hand for every $1 of insured deposits. The current reserve ratio is $0.27. The FDIC, as required, has formalized a plan to bring the reserve up to the required amount within seven years. Agency officials say costs to the DIF are expected to be front-loaded into this year and next and that the number of failures should start to diminish in 2011.

Some people have expressed concern that the FDIC will come up short in the future if bank failures continue at the current pace. The agency recently approved a one-time special assessment that will be paid by all insured banks in September and has said that another special assessment will be imposed if needed. Additionally, Congress raised the FDIC’s borrowing authority at the Treasury to $100 billion versus the previous limit of $30 billion.

“The FDIC brings in about $12 billion annually in regular assessment income that we charge the banks for deposit insurance, and then the one-time special assessment will bring in about $6 billion more, so that will be $18 billion coming in this year,” says FDIC spokesman David Barr.

“The other amount of money, or resource, that we have at our disposal is the $28 billion we’ve set aside for failures over the next 12 months — and we’ve used about $10.5 billion. So the FDIC has plenty of resources at its disposal without tapping the Treasury’s $100 billion. Even though Congress recently upped our borrowing authority, our chairman (Sheila Bair) would still prefer to have the banks support the DIF as opposed to going to the Treasury to tap the line of credit. But with all those resources at our disposal, we feel that we have sufficient resources to continue to protect depositors and make good on our obligation to protect customers.”

Solvency crisis?

Keith Hazelton, director of economic research at Oklahoma Bankers Association, says the number of banks that fail over the next few years will largely depend on how many of their customers remain solvent.

“The Fed and the Treasury have successfully concluded the liquidity crisis and the credit crisis, I believe. The one that remains now is the solvency crisis. Individuals, businesses and commercial real estate ventures — can they remain solvent? That’s just too much of a wild card to even guess at because it really depends on the shape of the recovery, and I think the jury is still out on that, especially on the consumer side.”

Interestingly, no Oklahoma-based banks have failed this year, and Hazelton says he thinks local banks learned some hard lessons during the energy bust in the 1980s.

“Credit decisions that were predicated on rising energy prices failed to materialize and the banks took a big hit. If you substitute housing for energy, you essentially have a mirror image in many parts of the country with what happened here in the midsection in the 1980s. You had a rapid run-up of an asset class in terms of valuation — far above what could be sustained.”

Let’s hope that lessons learned from the current crisis aren’t easily forgotten in the years ahead.

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