According to FDIC data, 140 domestic financial institutions failed in 2009 at a cost of over $1 billion to the FDIC’s insurance fund. The United States experienced more failures in 2009 than it did during the rest of the decade combined (55 failures occurred between 1999 and 2008.)
While the 140 failures represented a mere 1.7% of the total financial institutions in the United States, many may wonder why the industry has experienced a sharp increase in failures. Listed below are 5 non-exhaustive signs of a troubled financial institution to educate the public.
High level of non performing assets (asset quality) – Arguably, the primary contributor to any financial institutions failure has been poor asset quality. In simplistic terms, the function of a financial institution is to invest the funds it raises in assets that earn a higher rate of return. Assets will usually take the form of loans and securities, and the viability of the financial institution is dependent on the performance of these earning assets.
When an asset is impaired, the interest a financial institution earns is at risk as is the original principal of the asset. Since the principal represents the financial institution’s own capital, any losses need to be absorbed via the loan loss reserve (see sign #3 below) or equity. Consequently, you will hear bankers often state that “ten or more good loans are needed to compensate for one bad loan.”
What to look for: Most analyses pertaining to asset quality will evaluate the level of non-performing assets (mostly loans) to the financial institution’s assets and equity levels. The three ratios below present several common asset quality performance metrics.
Non-Performing Loans (“NPLs”)/Loans – For purposes of this article, NPLs are defined as those loans 90 days or more past due or on non-accrual status. This ratio represents the percentage of the loan portfolio that is non-performing.
Non-Performing Assets (“NPAs”)/Assets
– NPAs are NPLs plus a financial institution’s Other Real Estate Owned (OTCPK:OREO
). OREO is real estate property that the bank has repossessed and taken title to after failure to dispose of it during foreclosure proceedings. This ratio represents the percentage of a financial institution’s assets that are non-performing.
NPA/[Tangible Equity+Loan Loss Reserves (“LLR”)] – This ratio measures the level of non-performing assets to the financial institution’s tangible equity base and LLR. Commonly referred to as the “Texas Ratio” in the industry, this ratio is very important to analyze and reflects the institution’s ability to absorb losses. For instance, a ratio of 20% would indicate the possibility that the institution’s tangible capital could decrease by approximately 19%-20% if all NPAs resulted in a charge-off (this also assumes the loan loss reserve is the standard ≤ 1.00%). Given the highly leveraged nature of financial institutions, a modest decrease in capital can lead to material adverse effects.
The aforementioned ratios should not be viewed in isolation. View them in conjunction with the firm’s other ratios and strategy. For instance, a financial institution may post apparently poor asset quality ratios, but embarks on a riskier strategy that yields a higher risk-reward benefit to afford higher levels of non-performing assets. However, in general terms, asset quality issues may prove to be the bane of a financial institution.
Asset quality issues also exacerbates loss of liquidity. First, a financial institution will experience decreased liquidity due to higher borrowing costs. Then, if borrowing costs increase too much due to a higher probability of default, the financial institution may lose its sources of funding (i.e. borrowers will withdraw in mass – referred to as a “run on the bank”, and the institutional markets will not provide funding).
Lack of asset diversification – Loans will comprise the majority of a financial institution’s balance sheet. These loans can vary greatly in type from residential loans to commercial/industrial loans and governmental loans. Each loan type requires a different set of expertise and underwriting criteria and provides a different risk-reward tradeoff.
While most financial institutions will specialize in extending a certain type of loan, all should have exposure to a variety of loan types to provide for diversification and an optimal risk-reward tradeoff. One caveat pertains to thrifts and savings and loans, which are required to invest primarily in residential loans.
Recently, many financial institutions experienced losses in their securities portfolio as a result of Fannie and Freddie securities. For some institutions, significant ownership of Fannie and Freddie securities facilitated failure. Similar to the benefits of loan portfolio diversification, diversification of the securities portfolio reduces the probability that no one security type may materially impact performance.
What to look for: For loans, examine the composition of the loan portfolio and determine whether it is diversified given the financial institution’s strategy and competitive advantage. Moreover, analyze macro economic data and determine whether the financial institution may experience financial difficulty. Ultimately, the performance of the financial institution’s loan portfolio will be manifested in the asset quality ratios mentioned above.
Financial institutions are limited to the type of securities that may be purchased. A financial institution that possesses a sound and well balanced securities portfolio will own a large percentage of non-exotic instruments (i.e. U.S. Treasuries, rated bonds, and municipal securities) that are liquid and marketable.
When analyzing a financial institution, review the composition of the securities portfolio to determine if the portfolio is diversified. If not, determine whether the composition of the securities portfolio fits into the intended strategy and whether the composition deviates greatly from that of the peer group.
Finally, to determine the value and performance of the securities portfolio, review the ratio of the fair value of the securities to the amortized cost of the securities (i.e. what was paid to purchase the securities).
Inadequate loan loss reserves – When a financial institution extends a loan, it theoretically sets aside a certain amount of that loan as a loan loss reserve to provide cushion against future losses (i.e. charge-offs). Although the financial institution does not know the certainty of that particular loan defaulting, it utilizes historical and analytical data to estimate the potential for loss across different loan types.
The financial institution will establish a loan loss reserve on its balance sheet by funding a loan loss provision on its income statement. Think of a loan loss reserve as a bucket of inflows comprised of loan loss provisions and outflows comprised of charge-offs. What remains in the bucket is what is available for future charge-offs. The intent is to ensure that the bucket does not overflow (at the expense of depressed net income) and that the bucket is not empty (at the expense of safety and soundness).
What to look for: The adequacy of loan loss reserves is measured by several ratios, but the two prominent ratios are (i) the loan loss reserve as a percentage of the loan portfolio, and (ii) loan loss reserves as a percentage of non performing assets.
Historically, industry experts expected financial institutions to post a loan loss reserve that represented at least 1.00% of the loan portfolio. However, this ratio may mask the financial institution’s loan loss reserve adequacy since it does not account for the riskiness of the loan portfolio. For instance, is a 1.00% loan loss reserve sufficient for a financial institution that caters to borrowers with low credit scores and high levels of recidivism?
Henceforth, a more representative ratio of the quality of an institution’s loan loss reserve is to calculate the loan loss reserve to non performing assets. This ratio would provide insight into whether the institution possesses sufficient loan loss reserves to cover current non-performing assets in the event those assets resulted in a charge-off. At a minimum, financial institutions today should possess 100% coverage and ideally, the financial institutions should possess coverage higher than 100% to minimize material adverse conditions/reactions to earnings or capital.
Sustained losses – The objective of any business is to make a profit and financial institutions are no exception. For many financial institutions, bad loans and other factors have led to net losses rather than net profits. Net profits allow financial institutions to pay dividends and increase capital levels. The absence of profits depletes capital and increases the riskiness of a firm.
While every firm can experience a loss, be wary of the “ordinary extraordinary charges”. From time to time, a financial institution will announce that it experienced a loss due to an irregular event such as a loss on the sale of a business line, severance costs, or other losses not expected under the due course of business. However, certain financial institutions post these ordinary charges on a regular basis. The recurrence of extraordinary charges is not healthy for a firm since they tend to be large expenses. Moreover, frequent recurrences of extraordinary charges signal that the institution’s business model may not be sound.
What to look for: Two other factors to review in addition to “ordinary extraordinary charges” are listed below.
First, review the financial institution’s net interest margin, which is the difference between what the financial institution earns on loans and what it has to pay to fund those loans relative to its assets. For example, if a financial institution with an average loan portfolio of $1,000 earned $100 in interest income and paid $60 to fund those loans, its net interest margin would be 4.00% ($100-$60)/$1,000. Generally, a higher ratio is desired, but too high of a ratio may indicate that a financial institution possesses a high risk-reward tradeoff.
Second, review the percentage of income derived from non-interest income as this income is not subject to credit risk and does not require a capital investment. In the most recent economic downturn, those institutions that derive a large percentage of income from non-interest income have fared better than those that have relied on interest income.
Management – This factor is more difficult to quantify, but no less important than the others. As a matter of fact, it may arguably be one of the most important as all of the other factors listed are heavily influenced by management decisions. While federal regulations prevent felons and/or those who have been at the helm during a failure from operating a financial institution, there are warning signs to look for.
What to look for:
Changing strategy – Despite the thousands of financial institutions in the United States, most do possess a niche to sustain future profits. Some are focused on meeting the needs of the local community while others are concerned about meeting the needs of the global business community. Whatever the strategy, most develop a unique expertise that is not readily possessed by other financial institutions.
While diversification definitely possesses benefits, changing a strategy too quickly can lead to material adverse effects. Each strategy change should be well contemplated and approved by the board of directors. The financial institution must ensure that it possesses the intellectual capital to execute such a strategy and, most importantly, it must ensure that the timing is appropriate. No institution wants to be the one that enters a bubble right before it bursts.
Poor compensation policies – Most financial institutions employ fair compensation practices that reflect a pay-for-performance philosophy. However, recent news has revealed that certain institutions have employed poor compensation policies that present severe principal-agent conflicts.
Be wary of institutions that institute any of the following measures: (i) pay excessive bonuses while the financial institution posts large losses (ii) recalibrate performance objectives to meet bonus requirements (iii) pay retention bonuses when there is no clear need to do so, and (iv) post much higher efficiency ratios than the peer group
Dishonesty – This trait speaks for itself. Pay attention to what management states its intention is and what it actually executes upon. Moreover, when a financial institution hires a new executive, perform research on the individual and continue to pay close attention to the executive’s previous employer(s). In some cases, decisions made by departing executives have had detrimental effects on a financial institution after the executive resigned.
Poor corporate governance – If possible, complete research and reach a conclusion on the composition of the board of directors. Does the financial institution hire a large percentage of board members that presents a conflict of interest? (i.e. familial or business relationships)? Do the board members attend the meetings or is there a high level of absenteeism? Are the board members comprised of relevant individuals who possess appropriate credentials and experience to lead the institution to a profitable future?
Answers to questions of this nature will help determine whether management’s objectives are aligned with those of its investors and its customers.
In closing, the aforementioned five signs are but a select number of factors used to uncover troubling trends in financial institutions. Many other factors, such as off-balance sheet arrangements and stock issuances, not mentioned in this article should also be considered in making an evaluation. However, one must comprehend the fundamental signals before proceeding to other factors – especially considering that the five factors listed in this article are interdependent. Obtaining data for financial institutions is not difficult given the intensive regulatory environment, but interpreting the data can be. This will prove accurate as the regulatory authorities expect another busy year for failures.
 An efficiency ratio measures the percentage of each dollar earned that needs to be paid to non-interest expenses (mainly salaries and benefits). As an example, an efficiency ratio of 60% implies that you pay out $0.60 of every $1.00 earned in non-interest expense. Generally, a lower ratio is desired, but too low of a ratio is cause for alarm.
Author Owns Shares of BAC