BankNotes ...

Sheila Bair argued to Congress last week that the government should "impose greater market discipline on systemically important institutions." Her rationale for the argument was that those large firms have been funded by the market as if they were too big to fail, while their management teams depended on faulty risk management practices; these circumstances, combined with ineffective regulation, created a the bulk of our current economic problems. Bair's commentary indicates that we will ultimately have much more regulation throughout the financial industry, simply because what happens to large institutions will trickle down to impact the smaller community banks.

Bair went on to say:

It is true that we need to create an effective, bailout-free system to unwind large failing institutions - and to do so without creating a financial tsunami that wipes out the rest of the economy. But the reality is that everyone will feel the impact of a large institution's failure. It is impossible that a CitiBank, Wells Fargo, Bank of America or Chase failure could result in only a slight ripple through the economy. Those closest to the institution will feel the pain the most and people on the far fringe, the least -- but it will be felt by all nonetheless. The government needs to stop trying to make our lives pain-free in all aspects of life. We simply cannot be shielded from ALL risks.

In the current meltdown, for example, shareholders felt the brunt of the financial crisis pain. Investing is an inherently risky enterprise, and to devise regulation that would soften the impacts of investment failure runs contrary to the tenants of our economic system. Because shareholders voluntarily took risks with the companies they invested in and supported, they should absorb the repercussions when those firms fail.

Bair agrees with this argument. She advises:

Under the new resolution regime, Congress should raise the bar higher than existing law and eliminate the possibility of open assistance for individual failing entities. The new resolution powers should result in the shareholders and unsecured creditors taking losses.

Bair also addresses the current priority given to secured creditors. Such creditors have, in the past, made credit decisions based on collateral value without thoughtfully considering creditworthiness as well. This puts the creditor at risk of default and forced liquidation, while encouraging lack of discipline in the market. Addressing this issue can help to minimize costs to receivership and spread out losses related to failures more broadly.

The full text of Sheila Bair's testimony can be found at: http://www.fdic.gov/news/news/speeches/chairman/spoct2909.html

In the beginning of 2009, the media was pushing the idea that this would be the year for the community bank. Many smaller banks had not weighted down their balance sheets with subprime loans, asset-backed securities and complex derivatives. In theory, they had the stability to pick up loan customers that had been turned away by larger institutions. Columbus Business First published an article entitled, "Larger competitors' retrenchment may give smaller banks opening." And Business Week said, "As big banks struggle, community banks are stepping in to offer loans and lines of credit to small business customers."

Getting in to the banking industry during a power shift from big banks to small ones would appear to be an attractive opportunity for bank executives and community leaders who wish to be bank investors. But the predictions of a few publications don't sufficiently address the risk involved in buying a bank. Bank investors need to have some framework for separating the good targets from the bad ones.

In a speech made last July, San Francisco Fed President Janet Yellen summarized the characteristics of at-risk community banks. She cited:

• High concentrations of construction loans for speculative housing projects
• Concentrations of land acquisition and development loans
• Poor appraisal systems
• Weak risk-monitoring systems

Looking ahead, Yellen also identified "income-producing office, warehouse, and retail commercial property" as an area of potential risk. She cited rising vacancies and poor rent dynamics, which are putting negative pressures on property values. These value declines can be particularly problematic for maturing loans that need to be refinanced. Community banks that maintain large portfolios of commercial property loans should be proactively managing these risks. Bank acquisition groups should verify that target banks are updating property appraisals, recognizing impairments early, and negotiating work-outs with borrowers when appropriate.

Tim Coffey, Research Analyst for FIG Partners, LLC, agrees that commercial real estate is the next area of risk for banks. In an interview, Coffey said,

Coffey's comment was included in a report by The Wall Street Transcript that also quoted commentary from other banking analysts. The consensus among them was that some community banks are still facing potentially disastrous problems ahead.

Separating the good acquisition targets from the bad ones, then, requires careful analysis of the balance sheet, loan portfolio and the bank's current risk management practices. If the bank isn't managing risk proactively, there could be unknown problems brewing within the loan portfolio. Buying a bank with known problem assets is a manageable challenge-but buying a bank with unknown problem assets is something else entirely.

A few weeks ago, a writer from The Atlanta-Journal Constitution interviewed me to obtain some background information on the current crisis in the banking industry. The article, entitled "Several Georgia banks in jeopardy" was published on October 19, 2008.

According to The Atlanta Journal-Constitution, twenty-five percent of Georgia's banks are facing dangerously high loan delinquency rates. Further, the statewide delinquency rate as of June, 2008 has increased six times over since June, 2006-amassing a total of $6.6 billion of past-due debt. The rise is primarily linked to the turn-down in housing, an industry that had formerly been a mainstay of the state's economy.

Even as default rates skyrocket, experts acknowledge that high delinquencies alone won't necessarily cause a bank to fail. Another determining factor is insufficient reserves. The FDIC and the Federal Reserve Bank have been actively consulting with several Georgia banks to address reserve levels, lending practices and the management of non-performing loans.