How to tell if a bank will fail?
Hey monekeys!
In 2008, we saw several major banks, including Lehman Bros., collapse. Over the last decade, it seems like Deutsche bank has also been on a steady decline.
Perhaps someone who worked in either of these, or some other collapsed/collapsing bank could comment on this: Do you think there are some common traits or other signs characteristic of banks that meet this fate? In a recession, what differentiates a bank that fails from a bank that survives—or is it just up to fate at that point?
House Lannister will probably fail within the next two months
When you figure out the formula for predicting bank failures, the regulators would like to have a word with you.
The difficulty in doing downside analysis for financial institutions is the extreme sensitivity of earnings to small changes in asset quality. Banks are generally levered at 10x (i.e. 10% capital ratio) which magnifies these changes.
My first gig out of school was working in safety and soundness examination. A hot topic is always the adequacy of the provision for loan and lease losses. It works in the same way AR loss allowance and associated bad debt expense works for receivables.
So, in answer to your question, a bank (more specifically, a deposit holding financial institution), will start to have losses driven by higher and higher provisions for loan and lease loss expense which deteriorates the banks capital, which in turn, increases leverage beyond the regulatory thresholds. This happens relatively fast and is very hard to predict.
The more vulnerable (and more profitable in good times) banks will have lower T1 capital ratios and higher L/D ratios which magnifies the effect of losses on bank capital.
There are generally two things to watch out for with a bank: solvency (regulatory capital) and liquidity (which for most banks is a combination of deposits and capital markets funding). As stated above, banks are highly geared with asset-to-equity ratios in the 20x range. Small changes in the value of assets like loans or securities held for trading can wipe out a bank's equity. For a commercial bank with no IB, loans to customers will likely be the main asset on the balance sheet. A downturn in the economy and an uptick in defaults coupled with worse than expected asset recoveries can lead to a big hit to equity. For IB's with large market making books, a market correction of those assets can also wipe out equity (see UBS and the 20 bn hit they took on sub-prime mortgages which required a state bail-out).
With regards to liquidity, if a bank looks like it's going to collapse you will likely see depositors rush to withdraw their money which causes a run on the bank. A great example of this in Europe was the Spanish bank Popular last year. Overnight the bank had to be rescued by Santander. Eqquity holders and tier 1 and 2 bond holders were wiped out in that transaction. Another example is in Ireland where the banks became too reliant on bond financing over deposit taking. When the credit markets dried up the banks couldn't roll over their debt and were forced to go cap in hand to the central bank for a bailout.
Used to dabble in this area, so I'll offer a few thoughts:
As others mentioned, it's almost always driven by asset quality and credit losses. This can happen abruptly and is usually not a slow bleed of sub-par performance like DB
Bad assets usually show up in NPAs (non-performing assets, which includes NPLs and foreclosed real estate) and NPLs (generally loans 90+ days past due)
Once a charge-off is actually taken, it is labeled a NCO (net charge-off) and flows through the income statement
Banks set aside a loan-loss reserve on the balance sheet for eventual credit losses
Banks usually fail when the realized losses (NCOs) outstrip the reserve and cause earnings to go sharply negative
Since banks are usually levered 10:1 assets to equity, losses quickly eat away at the equity capital stack
The four best ways I've seen to monitor failure risk are: (1) closely watching the pipeline of bad loans - they usually track different categories like sub-standard assets->doubtful assets-> loss assets; if a high percentage of bad loans are making it all the way through to loss assets and you have a lot of new problem assets still showing up in substandard, there is likely a major credit problem; (2) look for banks that are trading well below tangible book value; during good times banks trade mostly on P/E basis, but during bad times investors look at liquidation/tangible book value; a very low P/TB means investors are expecting meaningful write-offs; (3) look at the Texas Ratio - this was first created during the savings & loan crisis that took place in the 80/90s mostly in Texas. The ratio takes the value of the bank's non-performing assets divided by the sum of the tangible equity and loan loss reserves. A ratio of more than 100% means that if the bank had to write off it's bad assets, it would eat entirely through the equity funding and existing reserves and be insolvent. Banks can bounce back from being over 100%, but this is a very useful ratio during downturns; lastly, (4) look for enforcement actions from regulators like the OCC. Bad banks will get slapped with cease & desist orders and other enforcement actions by their regulators. Usually these are for poor controls that are often a precursor to bad underwriting and potential credit losses.
Hope this helps.