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Undercapitalized Banks Fall To Lowest Level In 3.5 Years

By Robert Clark and Nathan Stovall, SNL Financial

The overall pace of resolutions has slowed dramatically in the last two years. Ninety-two banks failed in 2011 after 157 saw their doors closed in 2010. The pace of failures has slowed even more considerably in 2012, with 50 banks failing this year.

Failures accounted for the bulk of the decline in undercapitalized institutions in the third quarter. Eight banks previously deemed undercapitalized have failed since SNL last published the list of undercapitalized banks in the industry. However, the number of undercapitalized banks fell by 12 from the linked quarter, even though five institutions previously not deemed undercapitalized joined those ranks as of Sept. 30 data.

Indeed, Georgia and Florida, home to 85 and 68 bank failures this cycle, respectively, tied for the most operating, undercapitalized institutions, with five banks falling below the 4% Tier 1 risk-based capital threshold at Sept. 30. Tennessee has the third-most operating undercapitalized institutions as of Sept. 30, with three banks falling below the threshold. Tennessee has not seen nearly as many bank failures as Florida or Georgia, with just three banks failing in Tennessee this credit cycle.

The FDIC defines undercapitalized banks as those with a total risk-based capital ratio below 8.0%, a Tier 1 risk-based capital ratio below 4.0% or a Tier 1 leverage capital ratio below 4.0%, unless the bank is a CAMELS one-rated institution. In that case, a bank would be undercapitalized if its leverage ratio is less than 3.0%.

Forty-two banks and thrifts were undercapitalized, based on the criteria of having Tier 1 ratios below 4%, at Sept. 30, compared to 54 institutions at the end of the second quarter and 72 institutions a year ago, according to SNL data, representing linked-quarter and year-over-year decreases of 22.2% and 41.7%, respectively. With the decline in the third quarter, the number of undercapitalized institutions has fallen to the lowest level since the first quarter of 2009.

The number of undercapitalized banks in the industry has steadily declined for the last eight quarters, but failures have been largely responsible for the declines rather than banks finding their way out of trouble through other means. The story changed in the first quarter, when seven banks built their capital levels either through recapitalizations, mergers or balance sheet shrinkage and de-risking, coupled with modest earnings in some cases.

The trend did not really continue in the second quarter, though, when just three banks found their ways out of trouble through de-levering while 15 banks that escaped undercapitalized territory in the period failed. The story was the same in the third quarter, when 12 banks failed and just three banks found their way out of trouble through recapitalizations.

In part aided by failures, the decline in undercapitalized institutions far outpaced the decline in the number of banks on the FDIC's "problem list." The number of institutions on that list has fallen but remained elevated in the third quarter at 694 institutions, compared to 732 in the second quarter and 844 a year ago, a 5.2% drop from the linked quarter and 17.8% down from a year ago.

The relatively low level of undercapitalized institutions is noteworthy, though, since the overall level remains somewhat skewed to the high end by Capitol Bancorp Ltd., which has had eight of its banking subsidiaries among the list of undercapitalized banks for quite some time. Excluding those banks, the number of operating undercapitalized institutions stood at 27 at Sept. 30.

Capitol Bancorp's banking subsidiaries are hoping to escape undercapitalized territory through a prepackaged bankruptcy plan. A private equity firm has announced plans to invest inject $50 million into Capitol Bancorp, and that could help attract other investors to achieve the minimum it needs to complete the plan, but many observers believed the plan could be daunting since it is contingent on raising additional capital. The company just announced that its reorganization plan faces an eight-week delay

Like most of the Capitol Bancorp subsidiaries, the majority of undercapitalized banks in the industry remain in areas of heavy distress that have produced a substantial portion of the nation's bank failures.

When excluding the banks that have failed or sold since the end of the third quarter, SNL data shows that 35 banks were undercapitalized based on Sept. 30 data, compared to 42 banks at the last publication of the list of undercapitalized banks.

The few banks that escaped undercapitalized territory did not find their way out of trouble through traditional raises in the capital markets and primarily managed to boost their capital ratios by capital raises from a few investors.

There were some signs early in the year that capital-raising activity might be picking up, but much of the transaction activity has supported offensive growth rather than full-scale defensive recapitalizations. Some banks, particularly larger institutions, have issued preferred equity to support growth, and fewer institutions are tapping the capital markets through

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.