Banks: Forget Too Big to Fail, How About Too Small to Succeed?

Banks: Forget Too Big to Fail, How About Too Small to Succeed?

 According to the FDIC’s latest Quarterly Banking Profile (here), as of September 30, 2013, there were 6,891 federally insured banking institutions, down from 6,940 at the end of the second quarter and down from 7,141 as of September 30, 2012. There were 8,680 banking institutions as recently as December 31, 2006, meaning that there are 1,789 (or about 20%) fewer banks in the U.S. than there were a little less than seven years ago.

The latest quarterly figures represents the lowest level for the number of banks since the Great Depression, according to a front page December 3, 2013 Wall Street Journal article (here). The Journal article details how the industry has shrunk to its current level from its high water mark of over 18,000 banking institutions as recently as 1984.

Two banking crises since 1984 account for a significant part of the decline. Between 1985 and 1995, as a result of the S&L crisis, 1,043 institutions failed (as discussed here).  More recently,  the global financial crisis has taken its toll on the U.S. banking industry – since January 1, 2007, 534 banking institutions have failed, or more than six percent of all of the banks in business at the beginning of the period.  But though there have been a huge number of bank failures in recent years, the closures alone do not account for the continuing decline in the number of U.S. banks.

According to the Journal article, the reasons for the continuing decline in the number of banks include “a sluggish economy, stubbornly low interest rates and heightened regulation.” These problems are particularly acute for smaller banks, which often depend on lower margin loans. Declining interest margins hurt smaller community banks more than larger banks, because the smaller banks’ business models – what the Journal describes as “traditional lending and deposit gathering”—rely on interest income. These pressures have caused a number of smaller institutions to merge or consolidate.

At the same time, no new banks are forming to replace the banks that are disappearing. According to the latest Quarterly Banking Profile, there was only one new banking institution formed in the first three quarters of 2013 (the first federally approved banking start up in nearly three years), while 159 institutions were merged out of existence and 22 institutions failed during that same period.

As one banking executive quoted in the Journal article asks with respect to the pressures facing smaller banks, “Can you be too small to succeed?” The problems smaller banks face was detailed in an interesting November 30, 2013 article in the Economist (here), about the travails of Marquette Savings Bank of Erie, Pa. The bank, which has weathered the financial crisis in relatively good shape is facing pressure from regulators to sell the mortgages it originates as well as to change its appraisal practices. Although the regulators pressures derive from justifiable concerns, they also threaten to undermine the keys of the bank’s success.

There is every reason to believe that consolidation in the banking industry will continue. Among other things, the FDIC and the banking industry are both still dealing with the fact that – even years out from the worst of the financial crisis – a large percentage of the remaining banks are “problem institutions.”  On the positive side, the number of banks on the FDIC's "Problem List" declined from 553 to 515 during the third quarter. (The agency calls those banks that it rates as a “4” or “5” on a 1-to-5 scale of risk and supervisory concern “problem institutions.”)On the other hand,problem institutions still represent about 7.47 percent of all reporting institutions, down from about 7.96 during the second quarter.

Even though the number and percentage of problem institutions is down from the low point during the worst of the financial crisis -- there were 888 problem institutions at the end of the first quarter of 2011 – the number of problem institutions remains stubbornly high. Many of the remaining problem institutions are unlikely to leave the list based on their own financial improvement. Many are likely to drop of the list either by merging or by failing.

Of course, the vast majority of banks are not problem institutions. But whether healthy or not, most remaining banks are small. Of the 6,891 banks at the end of the third quarter, 6,223 (or slightly more than 90 percent) have assets of under $1 billion. Many of these institutions are thriving and will continue to thrive. But others will face economic and regulatory pressures that may lead them to merge and combine.

It is hard to say where all of this will lead. It does seem likely that the number of bank failures will continue to slow, and it is always possible that an improving economy will enable more banks to remain strong and independent. However, at least right now, the likeliest outcome would seem to be that the number of banks will continue to shrink.

There are a number of practical consequences from the shrinking number of banks. Among other things, the Journal article raises the question whether as smaller community banks go out of existence, will it become harder from smaller businesses outside urban areas to obtain the credit they need.

All of these developments have consequences for the D&O insurance industry as well, or at least the portion of the industry focused on providing insurance for banking institutions. The carriers in this sector are already reeling from losses arising from the wave of bank failures and related litigation. These losses are continuing to accumulate at the same time that the overall universe of potential buyers continues to shrink. The carriers are struggling to spread an adverse loss experience across a shrinking portfolio. The accumulating losses from prior underwriting years and the shrinking customer pool means that it is harder for these carriers to show an underwriting profit on a current calendar year basis. The heightened loss experience and shrinking customer base suggests that these carriers will be facing pressure on their premium levels for some time to come.

At the same time that the carriers are dealing with these forces, they are also dealing with another dynamic that will even further complicate things for them. A shrinking customer base means less business for everyone. Carriers worried about maintaining their portfolios will have to figure out how to respond as competitors go after their business. As much pressure as there may be to maintain premium levels, competition may force carriers to adjust their premiums to avoid losing business.  

It is still a tough time for banks. It is also a tough time for their D&O Insurers as well.

The Desolation of Smog: Sixty years ago, London was more polluted than Beijing is today. (Here).

 Read other items of interest from the world of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.

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