American Banker on why capital is a poor predictor of bank failure

The American Banker ran a column on why capital is a poor predictor of bank failure.  The author looks at the ability of management to manipulate bank capital, specifically by not reserving enough for loan losses, and concludes that capital is not a good early warning indicator of trouble.

The American Banker then asks

what do you think should be done to make the risks at banks more transparent?

Regular readers know that your humble blogger thinks the way to make the risks at banks more transparent is to require the banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

When the market is valuing the detailed exposures, it eliminates the ability of bank management to engage in accounting games.

The trigger for a Friday shutdown by the FDIC is undercapitalization. But while capital is "the last straw," it does not serve as a good long-term predictor of bank failures. 

Of the 322 banks that failed from 2008 to 2010, 293, or 91% were undercapitalized or worse the quarter before they were seized.  The majority of failed institutions held the worst capitalization designation, "critically undercapitalized."  

Yet the 322 banks remained well capitalized on average only 403 days and adequately capitalized only 298 days in advance of failure. 

In addition, failed banks most commonly took only nine months to move from the well capitalized category to failure, and six months from adequately capitalized to failure.  The minimum days from well capitalized to failure was only 100, or a little over three months. 

So why then is capital’s predictive power so poor? 

La Jolla Bank was well capitalized on Sept. 30, 2009. Just three months later, it was significantly undercapitalized, and only 50 days later, the bank was seized by regulators.  How did the bank’s equity evaporate so quickly?  The answer is simple; the bank’s allowance for loan and lease losses was flawed.... 

Capital’s poor predictive power is the result of a bank’s ability to decide how much to expense to their provision for loan losses, and when to provision.  Of course, regulators evaluate a bank’s ALLL methodology, but the fact of the matter is that banks can manipulate earnings, and consequently capital, through decisions about loss provisioning.