Iowa State finance professors study bank failures and the FDIC's role in their restart

AMES, Iowa -- Federal Deposit Insurance Corp. (FDIC) data shows that U.S. bank failures started to increase at the start of the economic crisis in 2008 (25) and exploded in 2009 (140) and 2010 (157). Through October, there have been 85 bank failures this year.

And a Sept. 26 TIME magazine story reported that with lower housing prices and rising numbers of delinquent mortgages, bank branch closings are on the rise again.

Iowa State University's Valentina Salotti says banks regulators have the situation under control. The assistant professor of finance has been studying recent bank failures and the role the FDIC has played in their resolution and says the rate of bank failures is slowing as the industry finds firmer financial ground.

"What the FDIC is saying as of very recently is that the pace of bank failure is actually decreasing," Salotti said. "The FDIC was really successful in finding good banks that were capable of taking over failed banks. And what they had to do at the beginning [of the economic crisis] was give them a lot of guarantees. What they were basically telling a potential acquiring bank was, 'We have this failed bank and we want you to take it over. If you take it over, we are going to guarantee a consistent amount of future losses on pools of single family, residential and commercial loans.'"

Salotti has been working with Arnold Cowan, an Iowa State professor of finance, on the research.

FDIC role in resolving bank failures

The researchers report that in the vast majority of failed bank cases, the FDIC uses purchase and assumption agreements to resolve failures. The FDIC also enters into a loss-sharing agreement on future losses of assets.

Through their analysis of FDIC data, Salotti and Cowan have found that acquiring institutions have experienced significant financial returns from acquiring failed banks, by comparison to acquisitions of non-failed banks during the same time.

"What we've been seeing is a buyer that's experiencing a really high positive abnormal return when they buy the failed bank," Salotti said. "The FDIC initially guaranteed a tremendous amount of financial losses from bad loans, etc., up front. And so the buyers' market for failed banks was initially very high."

Salotti reports that the FDIC is now making a lower guarantee on expected losses to buyers of failed banks. As a consequence, the estimated cost of failure has fallen by some eight points since the beginning of the financial crisis, and there's now also more competition to acquire failed banks.

"The FDIC keeps adjusting what they offer to those potential acquirers depending on the demand that they have for a failed bank," Salotti said. "So at the beginning, they were offering more guarantees because nobody was buying. Now they are slowly changing what they offer because there are many more banks potentially willing to acquire failed banks."

The trouble with the Troubled Asset Relief Program

The TIME story questions the impact that the $700 billion Troubled Asset Relief Program (TARP) had on providing financial stability to big banks during the economic crisis. It reports that while banks are holding more capital, they still aren't lending -- making them susceptible to future failure.

Salotti is also researching why certain banks received TARP funding and what they did with the money. She's found TARP-funded banks may have been a bit too ambitious in repaying their perceived "bailout money."

"TARP's capital purchase program was not designed as a bailout program, but as a program to help banks that were undercapitalized but had relatively sound loan portfolios. So it was meant as a capital injection to help them increase lending," she said. "The banks that typically got approved for TARP funding were banks that were a little short on capital, but had good loan prospects.

"The program was designed really well, but there was so much negative talk about it that some banks that were funded decided, 'We don't want to look like we received a bailout.' So they repaid too early," she continued. "If you look at who received funding and who has repaid it, almost everyone repaid. But they probably repaid too early while they may have needed the capital to further increase lending."

In spite of that, Salotti still sees banks to be in a much better financial place today than they were three short years ago and she expects the rate of bank failures to continue to fall.