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Why So Many Small Banks Failed

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Commercial mortgages played a big role in the failure of small banks during the credit crisis and the years that followed, according to a new government report. But other factors were also at play.

In 10 states that experienced strong housing market growth during the prior decade, there were 10 or more commercial bank failures between 2008 and 2011. In all, 414 banks that were insured by the Federal Deposit Insurance Corp. failed during the four-year period — with the bulk of those failures occurring in 2009 and 2010.

Among financial institutions with less than $1 billion in assets, bank failures in the 10 states were mostly driven by credit losses on commercial real estate loans.

The findings were discussed in Causes and Consequences of Recent Failures of Community Banks released Wednesday by the Government Accountability Office.

GAO conducted the study because the small bank failures raised questions about contributing factors, including the possible role of local market conditions and the application of fair value accounting under U.S. accounting standards.

The failed banks also often pursued aggressive growth strategies using nontraditional, riskier funding sources. In addition, they exhibited weak underwriting and credit administration practices.

“Fair value accounting also has been cited as a potential contributor to bank failures, but between 2007 and 2011 fair value accounting losses in general did not appear to be a major contributor, as over two-thirds of small failed banks’ assets were not subject to fair value accounting,” the report stated.

Some state banking associations told the GAO that the degree of credit losses were exacerbated by federal bank examiners’ classification of collateral-dependent loans and evaluation of appraisals used by banks to support impairment analysis of the loans.

But federal banking regulators noted that regulatory guidance on CRE workouts issued in October 2009 directed examiners not to require banks to write down loans to an amount less than the loan balance solely because the value of the underlying collateral had declined.

Federal regulators additionally noted that examiners were not generally expected to challenge bank appraisals unless underlying facts or assumptions about the appraisals were inappropriate or could support alternative assumptions.

Failed, small banks extended progressively less net credit as they approached failure, a GAO analysis of data from 2006 to 2011 found. But after being acquired through receivership, the acquiring banks generally increased net credit.

“However, acquiring bank and existing peer bank officials GAO interviewed noted that in the wake of the bank failures, underwriting standards had tightened and thus credit was generally more available for small business owners who had good credit histories and strong financials than those that did not,” the report said. “Moreover, the effects of bank failures could be significant for those limited areas that were serviced by one bank or where few banks remain.”

The GAO said FDIC loss-sharing agreements enabled the resolution of 281 banks in the period studied. During the duration of the loss-sharing agreements, Deposit Insurance Fund receiverships are expected to pay out $42.8 billion.

“The acquisitions of failed banks by healthy banks appear to have mitigated the potentially negative effects of bank failures on communities, although the focus of local lending and philanthropy may have shifted,” the government report said. “For example, GAO’s analysis found limited rural and metropolitan areas where failures resulted in significant increases in market concentration.”

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