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Small Bank Failures Driven by 1 Loan Type

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A government report identified less than a dozen states with an elevated number of bank failures and found that one category of loans was frequently at the heart of their problems. The report also found that credit losses should have been recognized earlier.

Between 2008 and 2011, there were 414 bank failures, including commercial banks and thrifts. Ten states had at least 10 bank failures.

The 10 states were concentrated in the West, Midwest and Southeast and had seen strong housing market growth during the prior decade.

The findings were discussed in the report, FINANCIAL INSTITUTIONS Causes and Consequences of Recent Community Bank Failures, released Thursday by the Government Accountability Office.

The 20-page report was prepared because of concerns about the accounting and regulatory requirements needed to maintain reserves large enough to absorb expected loan losses.

The report indicated that the failure of banks in the 10 states with less than $1 billion in assets was largely driven by losses on commercial real estate loans — especially construction-and-development loans. Small financial institutions accounted for 85 percent of all bank failures during the studied period.

In addition, many of the failed banks often pursued aggressive growth strategies using nontraditional, riskier funding sources. They also had weak underwriting and credit administration practices.

The report also highlighted how the impact of the financial crisis could have been lowered with earlier recognition of credit losses.

“The accounting model used for estimating credit losses is based on historical loss rates, which were low in the pre-financial crisis years,” the report said. “In part due to these accounting rules, loan loss allowances were not adequate to absorb the wave of credit losses that occurred once the financial crisis began.

“Banks had to recognize these losses through a sudden series of increases (provisions) to the loan loss allowance that reduced earnings and regulatory capital.”

A proposal was issued in December 2012 by the Financial Accounting Standards Board for a loan loss provisioning model that is more forward looking and incorporates a broader range of credit information.

“This would result in banks establishing earlier recognition of loan losses for the loans they underwrite and could incentivize prudent risk management practices,” the GAO said. “It should also help address the cycle of losses and failures that emerged in the recent crisis as banks were forced to increase loan loss allowances and raise capital when they were least able to do so.”

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