Earliest Indicator of Bank Failure Is Deterioration in Earnings

Yadav K. Gopalan

The Great Recession (roughly the period from late-2007 to mid-2009) will go down as an extraordinary period for the U.S. banking sector.[1] In addition to the distress faced by the largest investment and commercial banks, 168 depository institutions failed from 2007 through 2009. Although this may seem like a relatively small number when compared with the 1,858 banks and thrifts that failed from 1987 to 1993 during the height of the savings and loan crisis, the dollar value of failed bank assets is unmatched. Thus far, the Great Recession has seen roughly $540 billion of failed bank assets, which is roughly 1.5 times the dollar value of assets that failed in 1987-1993.[2]

When investors, journalists and other interested parties look for signs of weakness in the banking sector, they tend to analyze data reported by banks in their quarterly Reports on Condition and Income (or call reports). Regulatory agencies, however, can identify signs of bank weakness through a unique prism—the CAMELS ratings that the agencies assign banks following examinations. Captured in these ratings is information gleaned from an examiner’s intimate knowledge of an institution that can be used to construct expectations for the future prospects of the banking organization.

Analysis of the S&L crisis suggests that the banks and thrifts that failed were particularly exposed to poor asset quality, poor risk management and passive bank management. In the contemporary episode of bank failures, asset quality issues in the commercial real estate sector are a particular problem, but in general, the reasons for failures in the past are the reasons for failure today.[3]

To better understand the financial and supervisory characteristics of failed banks, we at the St. Louis Fed examined data on commercial banks that failed from 1990 to 2009. We looked to see when each of the CAMELS scores—capital, asset quality, management, earnings, liquidity and sensitivity to risk—started to deteriorate for these banks as a group. The threshold for “started to deteriorate” was when each rating first hit 3 on the CAMELS’ 1 to 5 ranking system (with 1 being best and 5 being worst). Our review of each failed bank started 14 quarters before its failure.

Chart 1

Supervisory Ratings of Failed Banks

A Look at Failed Banks from 1990 - 2009

Chart 1

This chart takes all of the failed banks from 1990 to 2009 and looks at their CAMELS ratings 14 quarters before failure. The ratings go from 1 to 5, with 1 and 2 considered healthy, 3 being the threshold for deterioration and 5 being the worst. The earnings component deteriorates first because asset quality problems in banks lead to greater provisioning for loan losses – which have a direct impact on a bank’s earnings.

The results of our analysis were not surprising. Banks that fail experience deterioration in asset quality. The deterioration first shows in a bank’s earnings level (the “E” component of CAMELS) as banks begin to provision for potential loan losses. This occurs well in advance of other financial health indicators.

The next CAMELS components to show deterioration are “asset quality” and “management,” both hitting the 3 mark nine quarters before failure. Not surprisingly, the management component rating starts to deteriorate soon after the earnings component does, reflecting ongoing asset quality issues and regulatory initiatives by bank supervisors to clearly communicate with management, as well as hold management accountable for the bank’s conditions.[4]

Next to deteriorate is the “capital” component of the CAMELS rating, hitting the first warning level seven quarters before failure. Our experience suggests that capital ratios often do not fall as quickly as asset quality deterioration because of the ability of banks, in some cases, to raise new capital. Other institutions attempt to increase capital ratios by reducing the size of the balance sheet, shedding assets through reduced lending or asset sales. Note, however, that capital ratios do drop off rapidly one year from failure, as bank investors may realize that the institution has reached a point of no return and do not see viability in the bank’s operations.

The final two CAMELS ratings to fall are “liquidity” (six quarters out) and “sensitivity to risk” (two quarters out).

In addition to the six CAMELS ratings, we looked at the trend in core earnings of the failed banks. Bank supervisors call this the “earnings run rate,” defined as the sum of net interest income and net noninterest income by average assets. The run rate measures how much money is being made (or lost) as institutions open their doors for business every day. As shown in Chart 2, failed banks between 1990 and 2009 on average experienced a negative earnings run rate a full four quarters before failure.

Chart 2

Earnings Run Rate

A Look at Failed Banks from 1990 - 2009

Chart 2

In conclusion, while weakened or deteriorating asset quality is the primary driver of bank stress, the recognition of this stress has historically first shown up in earnings performance. This stress is next reflected in a bank’s management rating as, in the case of an institution that ultimately fails, bank management is unable to reverse the negative trends in earnings and asset quality. Capital ratios, while important, tend to deteriorate well after the bank’s condition has weakened.

Endnotes

  1. The end of the current recession has not officially been called yet; however, estimates are that we emerged from recession in mid-2009. Refer to the St. Louis Fed-maintained FRED database at http://research.stlouisfed.org/fred2/ [back to text]
  2. The failure of Washington Mutual and IndyMac in 2008 constitutes roughly 62 percent of the $540 billion of failed assets. [back to text]
  3. See “Why Are Banks Failing?” at www.stlouisfed.org/publications/central-banker/fall-2009/why-are-banks-failing [back to text]
  4. See “Supervision Spotlight on Root Cause of Bank Failures” at www.philadelphiafed.org/bank-resources/publications/src-insights/2009/fourth-quarter/q4si2_09.cfm [back to text]

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