George and Mary Bailey had just been married and were heading off on their honeymoon when a commotion caught their eyes. The citizens of Bedford Falls had descended on the bank where George worked, all seeking to withdraw their deposits, leaving the bank on the brink of collapse.
This fictional scene, played out by Jimmy Stewart and Donna Reed in the 1946 film “It”™s a Wonderful Life,” created the perception of what a bank failure looks like. But when a bank fails, it”™s often far less dramatic.
Since the Federal Deposit Insurance Corp., or FDIC, was created in 1933, 11 banks in Westchester County and 15 banks in Fairfield County have failed. There has only been one bank failure in Westchester and one in Fairfield in the past decade.
Anatomy of a failure
The story of Port Chester”™s USA Bank, the one Westchester County bank to fail recently, is one largely of mismanagement and the failure of its board to properly oversee the business, according to reports obtained from the FDIC inspector general”™s office.
Founded in 2005 and insured by the FDIC, USA Bank”™s business plan was to focus on residential lending for single-family and multifamily homes. These loans were projected to form about 44 percent of the bank”™s portfolio. But by the end of 2006, the bank had ventured deeply into lending for commercial real estate and construction projects, especially speculative lending in the Greenwich real estate market ”” a sector that took big hits during the financial crisis.
Meanwhile, a large portion of USA Bank”™s deposits came from a volatile source ”” brokered deposits, where a third-party broker brings a large deposit to the bank upon which the bank often has to pay a higher-than-usual interest rate. Brokered deposits weren”™t part of the bank”™s original business plan, but according to the FDIC report, they nonetheless totaled $43 million, or 56 percent of the bank”™s total deposits, at the end of 2006.
“It”™s a riskier source of funding,” said Robert Chersi, executive director of the Center for Global Governance, Reporting and Regulation at Pace University”™s Lubin School of Business. “Usually, you have local depositors putting money in a local bank. With a brokered deposit, it”™s about a depositor searching for the highest interest rate. When they are no longer getting that high rate, they pull the deposit out and take it somewhere else.”
Slowly, the gulf grew between USA Bank”™s loan repayment income and outgoing interest payments and withdrawals upon its deposits. The FDIC report said the bank lost $13,368,000 between December 2008 and December 2009. Losses of more than $2 million followed from December 2009 through March 2010.
When USA Bank was finally shuttered by the New York State Banking Department (now the Department of Financial Services) on July 9, 2010, state regulators had determined the bank had inadequate capital to continue operating.
The aftermath of a failure
The FDIC was immediately appointed as the bank”™s receiver. A receiver has to dispose of a failed bank”™s assets ”” specifically, its loan portfolio ”” with an eye toward maximizing their value, as well as settling the bank”™s debts and paying out claims to insured depositors.
As anyone who has read the plaque at the teller window at a local bank knows, deposits at an FDIC-insured institution up to $250,000 are protected by insurance. But what about those who have taken out loans from the failed bank?
“Borrowers do not have the same protection that depositors do,” Chersi said. A small business with a loan from a failed bank “might not be that bad off if a bank steps in with the same terms and customer service ”” but that”™s not always the case.”
When the FDIC sells off the failed bank”™s loan portfolio, the holder of the loans will change, and the new holder could use the terms of the loan to its advantage.
“The biggest risk is an acceleration or a change in the interest rate by whoever takes over the loan,” Chersi said. An acceleration requires the borrower to immediately pay off the loan”™s principal and any accrued interest. Often, small businesses take out loans to fund operations or to reinvest in expanding the business. They can be particularly vulnerable, as “all of a sudden, they”™ll be faced with an acceleration and only have hard assets, not cash.”
Generally, banks are risk-averse, and borrow in the short term and lend for the long term, Chersi told the Business Journal. While bank failures such as that of USA Bank don”™t happen often, they do happen.
In the case of USA Bank, the FDIC sold $151.9 million of the failed bank”™s assets to New Century Bank of Phoenixville, Penn. It was estimated that the failure would cost FDIC”™s Deposit Insurance Fund approximately $61.7 million, according to the press release announcing FDIC”™s sale of the assets on the day the Port Chester bank was shut down.
Chersi”™s advice for bank customers is simple.
“Borrowers are generally in the better position in case of a failure, because they have the money, whereas the depositors are trying to get their money out,” he said. But both depositors and borrowers “should know your account. Know your bank ”” are they solvent?”
Actually, brokered deposits are normally cheaper than local alternatives. The current low interest environment has probably reduced that down to virtually no difference but in my 30 + years as a bank funding manager, brokered deposits were always one of the cheapest sources of deposit money and, because they are regularly available to fill in maturity gaps at longer maturities than local depositors are willing to accept, they are very helpful in managing a bank’s interest rate risk. Used wisely and allowing for stop-gap fill in money from sources like the FHLB they presented no greater risk than any other deposit source.The concept of brokered deposit risk is a conjured piece of regulatory over-reaction. It is really nothing more than a regulator’s way of limiting growth to a level that reflects real growth in the local economy rather than funding the temptation of overly speculative real estate development. In a way it is more a way of keeping bankers in line on the loan side than representing a real risk on the funding side.