Q: What separates a bank that fails from one that makes it through this economic crisis?
Leggett: “A combination of factors. First of all, the level of success deals with management skill. It also deals with your area of specialization—what kind of lending are you engaged in. That influences how you will do. Additionally, the more diversified you are both with regard to geography and services that you offer, the safer you will be. The probability of failure declines as diversification goes up. What we tend to find is that those institutions that have gotten into trouble have been institutions that specialized in riskier forms of lending or had been involved in lending outside of their market and have rapidly grown through out-of-market financing. Another issue that has contributed with some recent failures is the heavy reliance on broker deposits. It’s a combination of broker deposits combined with risky lending. And when the institutions got in trouble, the ability to fund themselves with broker deposits failed. So you had a liquidity failure.”
Q: So does failure comes down to mistakes institutions have made in the past?
Leggett: “If you look at it, a lot of the decisions the institutions made in 2006 and 2007 are what are influencing performance right now.”
Q: What can a bank do right now to try to shore up their stability?
Leggett: “One of the key things is always to raise capital to strengthen the institution. You do have this Treasury Department program in place to purchase problem assets: you may find that’s a vehicle to improve your balance sheet. But clearly the other thing you have to do is to make sure management is working to ensure the survival of the firm. You have to have strong management and a board that agrees to the policies you’re going to follow. You need to take proactive steps to address the problem rather than merely react. You might allocate more resources for collections and be more engaged in early intervention with regard to problem assets.”
Q: What happens if the FDIC does have to step in?
Leggett: “Generally speaking, before the FDIC has to close an institution they will issue some sort of collective action involving improving underwriting practices or raising capital. If those don’t work, the FDIC will close the institution. They will have another institution assume the deposits of the bank. The FDIC will be left with the bad assets. In some cases it could be months between when the FDIC steps in and when they would actually close the institution, but in others it can happen very quickly. But 90 percent of banks on the FDIC problem list come off the problem list and are safe.”
Q: Talk a little about the role of construction loans.
Leggett: “What you’ll find is the deterioration in the housing market has been a major contributor to bank failures this year. The housing market declined and with banks that had specialized in funding builders, the builders got to the point where they could not repay their loans because they could not sell their houses. In many cases they hadn’t even finished construction of the homes. This had a detrimental impact with regard to the balance sheet. If you look at some of the banks that have filed this year, construction lending and especially excessive lending in construction was a major contributor.”
Q: What about the credit cycle?
Leggett: “We are probably in a recession, and we probably will see some banks have difficulty because of the simple fact that as the economy deteriorates, the ability of businesses and consumers to repay their loans becomes more difficult. But the banking industry is very well capitalized. So we’re looking at an industry that was fairly strong going into this. The areas where we’ve seen the highest decline in housing values, those would be the areas where we see the most stress on banks.”
Q: What financial institutions are the strongest right now?
Leggett: “You just have to look at what sectors of the economy are doing well. Agricultural lending is doing very well in part because commodity prices are higher. It’s important to realize that 98 percent of banks are well capitalized. They are very safe and sound. Once again, you’re looking at banks that are very well diversified.
Q: So what’s the overall outlook for banks in general in the coming months … or years?
Leggett: “There are going to be bank failures, but the industry is in a strong position. What will determine how many banks fail is how severe this recession is going to be. If we get proactive policy steps taken that will get the economy growing again fairly quickly, we should see a limited impact on financial institutions.”
