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More Bank Failures

Mises Daily: Monday, August 25, 2008 by

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"There will be more bank failures, but nothing compared with previous cycles, such as the savings-and-loans days," Sheila Bair, chairwoman of the Federal Deposit Insurance Corp. (FDIC), said in an interview recently after $32 billion IndyMac was seized by Bair's organization.

The IndyMac failure is the second largest in history behind the failure of the $41 billion Continental Illinois National Bank back in 1984. What took Continental down and led to the biggest bank bailout in US history is the primary focus of Irvine H. Sprague's Bailout: An Insider's Account of Bank Failures and Rescues. The author spent over eleven years at the FDIC as Chairman and Director and oversaw 374 bank failures during his tenure.

He retired in 1986 and penned Bailout the same year. And although the book isn't new, the FDIC insider chronicled the events of four bank bailouts while his memory was fresh. Unfortunately, he left the bank regulator just midway through the crisis. From 1982 to 1992, over 2,000 financial institutions failed. Maybe his point of view might have changed had he been around for all the failures.

Sprague clearly outlines the FDIC routine when a bank is about to fold. The practice evolved in the 1980's when the deposit insurer was facing "an avalanche of failures." First there was a secret, kept under lock and key, "probable fail" list that was updated weekly. These were banks that were thought to have a high probably of collapsing in the coming 90 days (reportedly, IndyMac was not on this list). Once a bank makes the list, a determination is made if the bank can be sold, which is the preferred solution according to Sprague.

Next, bid packages are prepared. "What is offered for sale is all deposit liabilities, insured and uninsured, together with the good assets of the bank, usually including the bank building itself and certain performing loans in the bank," describes Sprague. Other healthy banks make bids for the failing institution, sans the problem assets. Preferably, the acquiring bank is twice the size of the failed institution and is well capitalized. The agency determines a minimum premium it will accept, and if the highest bid exceeds that number, that bidder will be opening the doors of their newly acquired branches on Monday after news of the failed bank is announced on Friday. For instance, The Topeka Kansas-based Columbian Bank and Trust was closed by regulators last Friday, becoming the ninth failure this year, but its nine branches opened on Monday as Citizens Bank and Trust based in Chillicothe, Missouri.

As the author points out the sales (shotgun weddings) are the easy ones. Unfortunately, there are not always bidders, even with the FDIC stripping out the bad loans. And the bulk of the book is spent chronicling (often tediously) the bailouts of Unity Bank, Bank of Commonwealth, and First Pennsylvania Bank, leading up to Continental rescue. In all cases the "essentiality doctrine" was invoked, although for different reasons. The regulator was worried about race riots in 1971 if the tiny $11.4 million minority-owned Unity Bank was allowed to fail, while Continental was judged simply as "too big to fail."

But Continental didn't hit the skids without help. Sprague spends a chapter on a little Oklahoma City bank called Penn Square that started the dominos tumbling. Penn Square grew from $62 million to over half a billion in assets in five years aggressively lending to the oil and gas industry. At the same time the bank sold over two billion in loan participations to Seafirst in Seattle and Continental, along with other banks. When oil prices tanked, so went the loans, and in turn the banks.

Of course not all banks are regulated by the FDIC. The Office of the Comptroller of the Currency (OCC) supervises national banks. The Office of Thrift Supervision (OTS) regulates thrifts. The Federal Reserve oversees bank holding companies and some banks, while the FDIC regulates most community banks. Plus, state government regulators are involved. So, as one would guess, there are turf battles aplenty according to Sprague. With all of this regulating going on, one wonders how anything could ever go wrong.

But ultimately, the FDIC is the entity that provides the deposit insurance, so it does the liquidating, even if the failing bank has another primary regulator.

Writing back in 1986, Sprague claimed at the end of Bailout that the deposit system was "still strong," and that the FDIC sticker means; "insured depositors can still sleep easily and because of that a lot of bankers can sleep easily, too." But remember, savings and loans used to proudly display the FSLIC (Federal Savings and Loan Insurance Corporation) sticker representing the entity that supposedly stood behind those deposits. But the FSLIC went bust despite repeated taxpayer capital infusions, including $15 billion in 1986 and nearly $11 billion in 1987. Before the end of the decade the deposit insurer was finally judged hopeless and abolished, with the responsibility of savings and loan deposit insurance transferred to the FDIC.

Now, the "IndyMac failure is expected to reduce the FDIC's designated reserve ratio for its deposit insurance fund to less than 1.15%," according to a report by A.M. Best Research. So, the FDIC must scramble and quickly develop a plan to increase its reserves to a whopping 1.25% of insured deposits that the law requires.

As Murray Rothbard explained in The Case Against the Fed, business firms cannot be insured, and especially not fractional-reserve banks. "If no business firm can be insured," Rothbard wrote, "then an industry consisting of hundreds of insolvent firms is surely the last institution about which anyone can mention 'insurance' with a straight face."

One wonders if chairwoman Bair held a straight face when she penned the conclusion to the FDIC's Depositor Bill of Rights: "The banking system in this country remains on a solid footing through the guarantees provided by FDIC insurance. The overwhelming majority of banks in this country are safe and sound and the chances that your own bank could fail are remote. However, if that does happen, the FDIC will be there — as always — to protect your insured deposits."