3

It. Allan Gilbert

R. Alton Gilbert is an assistant vice president at the FederalReserve Bank of St. Louis. Christopher A. Williams providedresearch assistance.

~Federal Reserve Lending toBanks That Failed: Implications

for the Bank Insurance Fund1

EBATE THAT LED TO PASSAGE of theFederal Deposit Insurance Corporation Improve-ment Act (FDICIA) in 1991 focused on changesin public policy to reduce losses of the depositinsurance funds One aspect of public policysubject to such scrutiny was lending by the Fed-eral Reserve to troubled banks. A report pre-pared by congressional staff indicated that over300 of the banks that failed in 1985-91 wereborrowing from the Fed when they failed, andthat 90 percent of the banks that borrowed forextended periods of time eventually failed!Other evidence caused the authors of that con-gressional staff report to conclude that Fedcredit extended the life of borrowers that ulti-mately failed. Critics of Fed lending practicesconcluded on the basis of this evidence thatlending to troubled banks increased losses to

the Bank Insurance Fund (BIF).’ This concernled to constraints on Federal Reserve lending totroubled banks in FDICIA (see the shaded inserton page 4, ‘Restrictions on Federal ReserveLending Under FDICIA”).

Restrictions on Federal Reserve lending totroubled banks raise several issues, includingthe proper role of the discount window and thenecessary freedom of action for a central bankin limiting systemic impacts of problems in theoperation of a banking system. Failures of banksmay have systemic impacts if they cause otherbanks to fail or cause disruptions in the pay-ment system or financial markets. This articlefocuses on the more narrow issue of whetherFederal Reserve lending to troubled banks in re-cent years raised the losses of BIF. Critics of

1The author thanks Kenneth Spong and Walker Todd forhelpful information and insights. The views of the authordo not necessarily reflect the views of the Federal ReserveBank of St. Louis or the Federal Reserve System.

2See U.S. House of Representatives (1991c).3See Garsson (1991), Rehm (1991), Starobin (1991) and Todd(1991, 1992). The FDIC insures the deposits of banks andsavings and loan associations but maintains BIF as aseparate fund for commercial banks and mutual savingsbanks. Banks pay insurance premiums into BIF, which thencovers any losses when banks fail.

JANUARY/FEBRUARY 1994

4

Restrictions on Federal Reserve LendingUnder FDICIA

Il)l( I \ i-t’str-it-Ls ii’cleral l’ui’s,’rs C! Ilti(l~iiitLu 11)11 I.\ rc’~trir’tsFi’tl,-i-al Rt’sc’is t- ii—iidmg toliatiks that ciii not iin’et tlut iii tirittjrti eaprt.tI aru irndere,-i1itlaiii_i-tl bank Li; rio iiioti’ ban (illreqtnrt’nients I or pttrUOSt!5 of the alions thtt s in ant 120-din 1xriod. LInIC’ss 11w hi-adprot sinus restricting lending- II mink that ot liii’ ap~itci~iiiiti’lc’tlenii sLIfx’ItIslin ;i~i’iir\

tail—. to niei’I one ti’ mliii’ ol We niimmnni or tin- chairman ol I he ilnarti ol Cmeiiititsc—ai;itai Ie(jtliIeIi)etits b cI;tssilieti as iittdt’r— tettiti,’s liii’ hatiks inhibIt ..\ cot tilii’alion olt-apitalin-cl_ III addition, a bank is cIa~siliecl as ‘, iabiiiLt isacle termination thaI - in light oiunder c-aprtali-iu-d ii it h,5 a ton)positc’ Liii! i’ctiIltiiltiI- ((illtlitlt)Ii5 ~tntI (iIVSIiI1’taflti5 ill

raLing of S In iLs_.upirt isort agenet 11)1 Liii lit, local ntaiki’I the batik is trot ctiticalit tiii-O(Jllit Liletit rating uiitli’i a (0IIIFILIILtI)ie ILtliig ilc’ri-a1)it,IIi/_,’d_ is not e’LJn-ctccl Lii becutne t:rii—

s\sIc’Iml)_ It Oil ii it nieek tin! utlirinrurri CallitLil i(’~IltLIIid(’it~l})ittli/i’d ,iiti is not Ot1ie(tt’d Iiieqltiriini’Iits. \ (‘.\\til. I atm! ni 5 mcii(ates hi- placid iii t:oflM’rt atciislii1i in’ riciit (‘I shiftitiiiyuini’rit iiLliif_Zei 1)1 llJiltiIe_ _\ batik is ela~si _~ eertilicatioii of viability suspends the iiiiiiLlied as c-ritkualit unclenaprtalized 1 its langi— ()fl It-liclilig lot 111011’ I ban (~)dat s in antbIt c’qtritt is less than 2 perec’ill of its total 120—day period. A tieselte. Rank tint lend Inassets, a hank certiFied as 1111111! lot’ Gil class. bcgiti-

ruder- iettaii) tilCiIIiIstLllidi’5_ [lie I oderal flIng (Ifi the cia_s ol the c-in-Li it-alion_ ‘I his11,-sc-i-ye may be liable ti) the I I )I(: liii losse, Gil—day JmI—iIxi flint hi’ r’\littided or additionalresulting 110tH lo~iiisto uitderd.a1ntalt’~tI’dor G0—cl~t~peliciris (iii i(’i’t~jit cit acitlitiiiiial ttiit—

i-i-ito-ails nnderc~tpitalized banks. IF the 1’eder— td~neertilieatlons ol iahtlit_t If [lit’ 1-eclerall1e~,eI-\, bIrds to a bank Ito- rircile than ut e Ut-sc-I’ve istends credit Lo an LiIidlI’c’apitali/ed

cia~s after it becciti,,s ii’iLic-alit uticlircaruital- hank betoiiil hit’ limit ol GO days iniicd. and an l’DR deposil irisuhanti’ liluici in- 120—dat pi’rinti st ithoul a c-r-i-Lifit’al,’ uI iabili—ciii s a lns’~greater han st unit] lint e been tv in el let-I, the Roarci oF Cot er-ntws tnat beinc-ui-i i—cl in the absen,-e ol tiii’ loan, tb, liable to the fUI( for pail iii hi’ aclulitiorialBoai-d ot Cot ernor’ niat hi’ liable to the I flU. hiss incurred bt one of its cltptisil instir;tni’dfor- pat ol hit’ additional loss. Isirids as a i’esuhl_

li-il lending practices have emphasized anecdo- -

tal evidence from a few bank failure cases, - -

particularly the failures of the Bank of NewEngland and the Madison National Bank.~Thisarticle, in contrast, examines whether the record . -

Prior to passage of Fl)I( IA in 1991, the Feder-of Fed lending to many failed banks supports -

al Reserve had a long-standing policy of notthe arguments of the critics. - . - . -

lending to nonviable institutions, except whenThe evidence in this study indicates that loans such lending would facilitate an orderly resolu-

from the Fed to many of the failed banks in tion of institutions. Lending to facilitate orderlytheir last year were concentrated near the time resolutions had been undertaken in cooperationof failure and were allocated to the banks with with the institutions’ supervisors and with thethe greatest liquidity needs. The evidence does deposit insurance authorities. Under this policy,not support the argument that Federal Reserve the Federal Reserve loaned to some troubledlending to troubled banks increased the losses banks for extended periods of time. Two of theof the FDIC. large banks that received Fed credit for extended

4See Schwartz (1992), Todd (1992) and comments bypolicymakers in Rehm (1991). For hearings on the failuresof these banks, see U.S. House of Representatives (1991a,1991 b).

FEDERAL RESERVE BANK OF ST. LOUIS

periods of time were the Franklin National Bank,in 1974, and the Continental Illinois NationalBank, in 1984.~

In response to public criticism that the Feder-al Reserve had subsidized the Franklin NationalBank, the Fed amended its lending regulationsto establish a new, higher special discount ratefor protracted emergency assistance to particu-lar banks. Figure 1 indicates that such emergen-cy assistance—which has been called extendedcredit since 1980—at times has been thepredominant form of discount window lending.Prior to passage of FDICIA late in 1991, therewere no legal constraints on the size or dura-tion of Federal Reserve lending to troubledbanks.

THE DEBATE OVER LENDING TOTROUBLED BANKS

The Issues

Public discussion that led to passage of limitsin FDICIAon theauthority of the Federal Reserveto lend to troubled banks involved two issues.The first issue, philosophical in nature, involvedthe proper purpose for lending. Walker Todd(1988, 1991, 1992), a major contributor to thisdebate, has asserted that the proper role for thediscount window is to lend for short periods oftime to solvent banks that are temporarily illi-quid. Todd has described Federal Reserve lend-ing to troubled banks for extended periods oftime as the substitution of credit from the Fed-eral Reserve for capital of the banks, which heconsidered inappropriate use of the discountwindow.

The second issue involved the implications ofFederal Reserve lending practices for BIF losses.This second issue appears to have been moreimportant to Congress than the philosophical is-sues raised by Todd, because BIF losses may af-fect the budget of the federal government. Forthat reason, this article focuses on the secondissue in the debate, the implications of Fed lend-ing practices for BIF.

Critics of Fed lending practices cited two rea-sons why lending to troubled banks may have

5

increased BIF losses. First, credit from the Fed-eral Reserve may have given the borrowers ex-tra time to assume additional risk. Banks mayhave increased risk through rapid growth oftheir assets, in desperate gambles to regainfinancial strength, or through actions to benefitshareholders, such as paying dividends.

The second argument involved reductions inborrowers’ uninsured deposits. Deposits oftendecline when the public becomes aware of abank’s troubles, but deposits in denominationsabove the insurance limit of $100,000 per ac-count tend to fall more rapidly than fully in-sured deposits. Credit from the Fed may haveallowed the borrowers to remain in operationwhile funding relatively rapid declines in theiruninsured deposits. Without credit from theFed, these banks may have been unable to funddeposit withdrawals some time prior to theirfailure dates. Chartering agencies might haveclosed these banks earlier, when their unin-sured deposit liabilities were larger, if the Fedhad not made its credit available.

Implications of declines in uninsured depositsfor the losses to BIF in bank failure cases de-pend on the methods used by the FDIC toresolve these failures.°The simplest method isliquidation, in which the failed bank is closedand the FDIC pays insured depositors in full.The FDIC over time pays the uninsured deposi-tors a fraction of their deposits, which dependson the value of the failed bank’s assets. If thevalue of the assets is less than the value of theliabilities, the FDIC and the uninsured deposi-tors share as losses the gap between the valueof assets and liabilities. A decline in uninsureddeposits raises the cost to BIF if a case is resolvedthrough liquidation, since a decline in uninsureddeposits forces the FDIC to absorb more of theshortfall of the value of assets below liabilities.

In cases resolved through transfer of insureddeposits, banks bid for the deposit accounts of afailed bank in denominations below the insur-ance limit. The winning bidder assumes the in-sured deposit accounts of the failed bank, andthe FDIC makes a cash payment to the winningbidder equal to the deposits, minus the premi-

5For a view on the history of Federal Reserve discount win-dow lending, see Schwartz (1992). Thrift institutions havehad access to credit from the discount window since 1980,under provisions of the Monetary Control Act. This paperfocuses on lending to commercial banks. For conveniencealt depository institutions are called banks.

°Seethe appendix to Gilbert (1992) for an analysis of thedistribution of losses between the FOIC and uninsureddepositors under alternative methods of resolving bankfailure cases.

JANUARY/FEBRUARY 1994

6

um paid by the winning bidder.7 The cost of aresolution arranged as a transfer of insureddeposits tends to be lower than what the costwould have been under liquidation by theamount of the premium, net of administrativecosts of arranging the resolution. The FDICshares with the uninsured depositors any lossesfrom resolving the failed bank. Declines in unin-sured deposits have the same implications forBIF losses under liquidation and transfer of in-sured deposits.

During the years covered by this study,1983-90, the FDIC resolved most bank failurecases through a third method called purchaseand assumption (P&JA). In a case resolved throughP&A, the bank with the winning bid assumes allof the deposit liabilities of the failed bank andpurchases some of its assets. The cash paymentfrom the FDIC to the winning bidder equals alldeposit liabilities (insured and uninsured), minusthe value of assets purchased by the winningbidder, minus the premium. The FDIC does notshare any of the losses with uninsured deposi-tors in cases resolved through P&A, since thewinning bidder assumes all of the deposit liabili-ties. Even in cases resolved through P&A,however, declines in uninsured deposits mayincrease BIF losses. In some cases, resolutioncosts might have been lower if the failed bankshad been closed prior to the declines in unin-sured deposits and resolved through liquidationor transfer of insured deposits.

The Evidence

The staff of the House Banking Committee is-sued a report in 1991 that summarized patternsin Federal Reserve lending to insured depositoryinstitutions from January 1, 1985, through May10, 1991. The report concluded:

1. Ninety percent of all institutions that receivedextended credit during this period subse-quently failed.

2. The Federal Reserve routinely extended creditto institutions with CAMEL ratings of 5 by

their supervisory agencies (the rating thatindicates imminent danger of failure).~

3. Borrowers that failed remained open for10-12 months on average after being ratedCAMEL 5 by their supervisory agencies. Thereport implies that the banks would not havestayed open that long after being rated CAMELS without Federal Reserve credit.

4. Borrowings increased dramatically as the con-dition of institutions deteriorated.

5. The Federal Reserve took the highest qualityassets as collateral when banks borrowed, inamounts substantially in excess of the loanamounts.

6. of the 530 failed institutions that borrowedfrom the Federal Reserve in the three-yearperiod prior to their failure, 320 were bor-rowing at the time of their failure, with $8.3billion in discount window credit outstanding.

This paper investigates the implications of theseconclusions for BIF losses.

BORROWINGS BY A SAMPLE OFFAILED BANKS

This section presents information on FederalReserve lending to a sample of banks that failedfrom 1985-90. The number of bank failures peryear was relatively large during that period.Including these years yields a large sample offailed banks. The sample ends in 1990 to avoidfailures in periods in which Federal Reservelending to troubled banks was influenced by theprovisions in FDICIA. Since the content ofFDICIA was discussed and debated throughoutmost of 1991, the sample ends with the failuresin 1990. Note in Figure 1 that extended creditborrowings were relatively low throughout 1991and have been zero or relatively small since late1991, when FDICIA was enacted.

The sample is restricted Lo failed banks thatreported their deposits to the Federal Reserve

7Winning bidders in cases resolved through transfer of in-sured deposits often purchase some of the assets of thefailed banks.

°Whengovernment supervisors examine a bank, they give itratings from I (the best) to 5 (the worst) on five aspects ofits operations: Capital adequacy, Asset quality, Manage-ment, Earnings and Liquidity (CAMEL, for short). In addi-tion, supervisors assign a composite CAMEL rating from Ito 5, based on the ratings for these five components,Banks with composite ratings of 4 or 5 are classified as

problem banks and subjected to relatively close supervi-sion. Banks rated composite CAMEL 5 are in such poorcondition that their supervisors consider them to be inimminent danger of failing.

FEDERAL RESERVE BANK OF St LOUIS

7

Figure 1Total and Extended Credit Borrowings

each week in their last year, because the analy-sis involves deposit data in their last year. Thisrestriction affects the size distribution of thebanks in the sample. Relatively small banksreport their deposit liabilities and vault cashfor one week in a quarter, and their requiredreserves are set at the same level for a quarterbased on their reports. The maximum asset sizeof the quarterly reporters was changed over theyears 1985-90.

Restricting the sample to those that reporteddeposit data to the Fed in each of their last 52weeks reduces a potential sample of 870 failedbanks to 318. Figure 2 presents the size distri-bution of the banks in the sample, based ontheir total assets as of failure date. Restrictingthe sample to banks that reported their depositsweekly for their last 52 weeks eliminates thevery small banks. None of the banks in the sam-ple had total assets below $10 million, and only19 of the 318 banks had total assets below $20million as of their failure date.

Results derived from this sample of 318 banksmay not apply for smaller banks. In severalways, however, the observations on borrowings

in the report of the House Banking Committeeare similar to the patterns of borrowings bybanks in this study. Also) among the 870 banksin the broader sample, ratios of BIF loss to totalassets are not related systematically to assetsize, and the distributions of banks by resolu-tion methods are similar for the larger andsmaller samples of banks.

Table 1 presents the distribution of the 318banks in the sample by year of failure and bor-rowings in their last 52 weeks. Failures of thebanks occurred fairly uniformly over the 1985-90 period. About 58 percent of these banks bor-rowed in at least one of their last 52 weeks.Borrowings tended to be concentrated in theweeks just prior to failure. Of the 185 banksthat borrowed in their last 52 weeks, 154 (83.2percent) borrowed in at least one of their last13 weeks. For the 318 banks as a group, about54 percent of the total dollar amount of bor-rowings in their last 52 weeks occurred in theirlast 13 weeks. This observation confirms theconclusion in the report by the staff of theHouse Banking Committee that borrowings in-creased as the condition of the banks deteri-orated.

Billions of dollars9

80 81 82 83 84 85 86 87 88 89 90 91 92 93

JANUARY/FEBRUARY 1994

8

Figure 2Distribution of Banks in the Sample by Total Assets as of Failure Date

Total Assets as of Failure Date(in Millions of Dollars)

0-999 -

10-19.99 -

20-29S9 -

30-39S9 -

4049S9 -

50-5999 -

60-6999 -

70-79,99 -

80-89S9 -

90-99S9 -

100-1 49S9 -

150-199S9 -

200-299S9 -

300-399-99 -

400-49999500-599.99 -

600-699S9 -

700-79999800-89999

I I I

20 40 60 80

Conclusions of the staff report of the RouseBanking Committee leave the impression thatmany failed banks borrowed for long periodsprior to their failure. For instance, the observa-tion that borrowers remained in operation 10 to12 months on average as CAMEL-S rated banksleaves the impression that credit from the dis-count window was essential for keeping theborrowers in operation during their last 10 to12 months. This study indicates, in contrast,that only a small minority of the banks bor-rowed for at least half of their last year. Only28 of the 318 banks (8.8 percent) borrowed inat least 26 of their last 52 weeks.°The discountwindow may have become less accommodatingto troubled banks in 1989-90; only four of the94 banks that failed in those years borrowed inhalf or more of their last 52 weeks.

The sample of failed banks is distributed veryunevenly across Federal Reserve Districts, with

88 percent of the banks located in Districts 6,10, 11 and 12 (Table 2). These Districts also ac-count for most of the banks that borrowed intheir last 52 weeks. The banks that borrowed inhalf or more of their last 52 weeks were con-centrated in Districts 10 (Kansas City) and 11(Dallas), which may reflect differences in ReserveBank lending practices. While the 12 districtsfollow the same general policies on lending, thestaff of the district Reserve Banks have somefreedom to follow different lending practices.

Banks in the sample also differ substantiallyby the amount of their borrowings relative tothe size of their total deposits. For most of thebanks that borrowed from the Fed in their lastyear, average borrowings were small relative totheir average total deposits. Over their last 52weeks, for instance, 85 percent of the failedbanks either didn’t borrow from the Fed ortheir borrowings were less than 1 percent of

9The extreme cases in this sample involved two banks inthe Kansas City District that borrowed almost continuouslyfor about two years and then failed.

a

-a-a

Total Number of Banks

FEDERAL RESERVE BANK OF St LOUIS

Table 1Distribution of Sample Banks by Borrowings from the Federal Reserve in TheirLast Year

Borrowed in Borrowed in atNumber their last Borrowed in least 26 of

of 52 weeks their last their lastYear of failure banks (percent) 13 weeks 52 weeks

1985 50 26(520) 24 41986 60 36(600) 78 81987 60 43f717j 39 61988 54 30 f55.6) 26 61989 44 26 ~59 1) 18 21990 50 24 (480) 19 2

TOTAL 318 185(582) 154 28

Table 2Distribution of Sample Banks by Federal Reserve District

Borrowed in Borrowed in Borrowed in atNumber of their last their last least 26 of

Federal Reserve District banks 52 weeks 13 weeks their last 52 weeks

I 4 2 1 02 7 3 1 03 0 0 0 04 3 2 1 05 0 0 0 06 36 22 19 27 14 6 4 28 2 1 1 09 7 2 2 0

10 66 46 37 1011 148 85 75 1212 3,1 16 13 ,2

TOTAL 318 185 154 28

ti-i trig’ tot,tl dU1ttI,Its I l.iltli’ hI Itt (‘1111—

tI,I’,l l,c.tr iit’t iI1L,s \ttIt’ lii i~c’tI’l,tlI\t’ II) tIJt. I(l(’Ilt)’il’ .il .t I(’%\ cii tilt’ Il,IiiI~’, IO\\tliL,s olI11I’I-i’ hi,nii~-,i’\c-t’c’tl(’tl lii prrt’t’rrt cii tlic’tr Iit,iI

ile~iit~ils0\11 till-il l.i~l52 ni’PL - lhatin~ol 1101—I Ofl t0U~ Ii) It,t,il clt’pir~it’~ti’rnit’d tic hi’oti’c lu- la’,t I_i nc’t’l~’,titan ncr longer er

1)1 to I ithiri’ dale’, nit’ hoc i;~~iru,s ti-mit-ti \nalt-~i’,ol hi’ i’bhert oh I nh-cd i-Irsi’I ti

In i-Re arid deposiK dci 1101- a’. hank’, approached lending ho lrouhli’d hartk. on tin’ losse ccl liiiIht’ir hatiLir i- dali’ I or cn’.tanr’. hot Ioning—~oh hugtn’. nith i ompar NOIlS in I thu I ol RH lo, r-~1.5 hanL~vu t’i’dt’d 10 pt-runt oI heir tol,,l ,c-~sini,cled ttilh titi’ lailt’d hank, that hor ront’cidi’po~ct. titer heir list I. flI’i’k’. mm the I edecal lie cite and those that did rtot

10

Table 3Distribution of Sample Banks by the Size of Their Borrowings Relative to TheirAverage Total Deposits

Sum of borrowings divided by the sum of tohal deposits

over the following periods ending on failure dates:Last 13 weeks Last 26 weeks Last 52 weeks

Range of ratios of No. of Cumulative No. of Cumulative No, of Cumulativeborrowing to total deposits banks percent banks percent banks percent

Zero 164 51.57% 149 46.86% 133 41 82%0.000 < x 0 001 28 60 38 54 63.84 65 62.260.001 < x 0 005 29 69 50 29 72.96 52 78.620.005 < x 0.010 23 7673 23 80.19 21 85.220010 c x < 0.020 20 8302 22 8711 23 92450.020 c x < 0.050 25 90.88 24 94.65 15 97170.050-c x 0100 14 9528 10 97.80 6 99.060.100 C x 0200 11 9874 5 9937 2 99.690200 c x 4 10000 2 10000 1 100.00

borrow in their last year. The mean BIF loss ra-tios in Table 4 for banks that did and did notborrow from the Fed in their last year are notadjusted for differences among the banks, otherthan borrowings, that might explain differencesin BIF loss ratios, such as the condition of banksprior to borrowing or regional effects.

Mean BIF loss ratios are about 5 percentagepoints higher among the failed banks that bor-rowed from the Federal Reserve in their lastyear, and differences in the mean loss ratios arehighly significant. The high t-statistics for differ-ences in mean BIF loss ratios indicate that thereis only a very small chance that the BIF loss ra-tios of the borrowers and nonborrowers weredrawn from the same distribution.

The association between borrowings and BIFloss ratios in Table 4 does not necessarily indi-cate that Fed lending practices caused higherBIF losses. Perhaps the banks that borrowedfrom the Fed in their last year would have hadhigher BIF loss ratios than the other banks ifthe Fed had not loaned to them. Two observa-tions raise doubts about the argument thatloans by the Fed caused the higher BIF loss ra-tios among the borrowers. First, borrowings ofmost banks were concentrated near the time oftheir failure dates, long after they had assumedthe risk that led to their failure. Second, if Fed-eral Reserve lending caused the higher BIF loss

ratios among the borrowers, we would expectthe banks that borrowed the most relative totheir deposit size to have the highest BIF lossratios. This is not the case. Figures 3 and 4present information on the association betweenBIF loss ratios and ratios of borrowings todeposits among the banks that borrowed intheir last year. Measuring borrowings over thelast 13 weeks (Figure 3) and the last 52 weeks(Figure 4), there does not appear to be a posi-tive association between BIF loss ratios and bor-rowings ratios.

The remainder of this section attempts to de-termine whether Fed lending practices causedthe higher BIF loss ratios among the borrowersby investigating whether evidence supports theassumptions that underlie such a direction ofcausahty.

Did Federal Reserve Credit HelpKeep Problem Banks Open?

Credit from the Fed may have allowed theborrowers to remain open longer as troubledbanks than the nonborrowers. Supported byFed credit, the borrowers may have assumedadditional risk just prior to their failure, result-ing in larger losses to BIF when they failed. Thereport by the staff of the House Banking Com-

FEDERAL RESERVE BANK OF St LOUIS

11

Table 4

Association Between BIF Loss Ratio and Borrowings by Failed Banks in TheirLast Year

Mean BIF loss ratioGroup of banks based on borrow- (standard deviation in f-statistic forings from the Federal Reserve Number of banks parentheses under mean) difference in means

Borrowings in last 13 weeks’Yes 154 03067

0 1181)

No 164 0.2514 401(0 1253)

Borrowings n lash 26 weolcsYes 169 03079

(0l228~

No 149 0.2445 4.7310.11861

Borrowings in last 52 weeks.Yes 185 0.3007

(0.1253)

Na 133 0.2468 4.02(0.1175)

‘The BIE loss ratio is the ratio of the loss to BIF from a bank failure divided by total assets of the failed bank as of itsfailure date.

mittee emphasized such a link between borrow- failed banks is divided into two groups: thoseings and BIF losses. One of the key conclusions that borrowed from the Federal Reserve inwas that the failed banks which borrowed from their last 13 weeks and those that did not. Bor-the Federal Reserve in their last three years re- rowings are observed over the last 13 weeks be-mained open on average about 10 to 12 months cause any banks kept open only through accessafter supervisors rated them as CAMEL 5. The to Federal Reserve credit would be borrowingreport implies that these banks would have from the Fed near the time of their failure. Ta-been closed earlier if the Federal Reserve had ble 5 presents the distributions of these banksnot provided credit. by the length of time they were rated CAMEL 4

- or 5, and rated CAMEL 5, prior to their failure.There are two problems with such an infer-

- . Banks rated CAMEL 4 or 5 are classified asence. First, the report does not indicate when -

problem banks. It is relevant to know whetherin their last three years these banks borrowed -Federal Reserve credit helped banks ratedfrom the Federal Reserve. Suppose a bank bor- . . - -

- . CAMEL 4 or 5 remain in operation for relativelyrowed for one day three years prior to its failure - - . , . . -long periods prior to their failure, in addition toand was rated CAMEL 5 one year prior to -analysis that focuses exclusively on CAMELfailure. 1 his case would be included among the -

- a-rated banks.observations supporting the inference that Fed-eral Reserve credit helped some CAMEL 5 banks . -

- The distributions of banks by the number ofstay open for relatively long periods. -

months they were rated CAMEL 4 or S prior toA second problem is a lack of comparison to their failure are almost identical for the borrow-

the length of time that nonborrowers were rated ers and nonborrowers. The median number ofCAMEL 5 prior to their failure dates. Table 5 months between the time the banks were ratedprovides such a comparison. The sample of 318 problem banks and their failure was 20.5 months

JANUARY/FEBRUARY 1994

12

Figure 3Relationship Between Borrowings Ratios and BIF LossRatios Among Banks that Borrowed: Last 13 Weeks

Average Total Borrowings Divided by Average Total Deposits0.6 -

0.5- +

0,4- +

0.3-

0.2- + ++ ++

++ +0.1- ++ ++ + + ++

+ + + + +++ ++f + + + ~+ ~*++ ++ +

+ + ~ 4+~*-H- ++ +

—0.1- I I

0 0.2 0.3 0.4 0.5 0.6 0.7 0.8

Loss to BIF Divided by Total Assets as of Failure Date

Figure 4Relationship Between Borrowings Ratios and BIF LossRatios Among Banks that Borrowed: Last 52 Weeks

AverageTotal Borrowings Divided by Average Total Deposits0.6-

0.5-

0.4-

0.3-

0.2- + +

+0.1- + ++++ + +

0 ~+~~-++ ÷a4Jrt 14t4t4$f.itf+ + +

—0.1-0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8

Loss to BIF Divided by Total Assets as of Failure Date

Table 5Cumulative Distributions of Banks by the Length of Time They Were ProblemBanks Prior to Failure

Borrowed from the Federal ReserveIn their last 13 weeks.

No of months rated CAMEL 4or 5. less than Yes No

No of banks Percent No of banks Percent

1 5 3.2% 6 37%2 11 71 10 615 15 9.7 13 7.9

10 27 17.5 27 16.5

15 47 305 52 31.720 72 468 77 47025 96 62.3 105 64030 111 721 120 73.236 130 84.4 135 82.336 or more 154 1000 164 100.0

Median no of months rated CAMEL 4 or 5 20.5 20

No. of months rated CAMEL 5 tess than

1 15 9.7% 22 13.4%2 30 195 40 2445 46 289 63 384

10 77 500 102 62.215 111 72.1 130 79320 135 877 146 89025 148 961 153 93330 152 987 158 96336 153 994 162 96.836 or more 154 100.0 164 100.0

Median no, of months rated CAMEL 5 9 5 7

for the borrowers and 20 months for the non factor deteiinining how long the borrowers andborrowers.’° nonborrowei s rated CAMEL 5 remained in

operation. If access to Fed ci edit had been theI he banks that borrowed in their last 13 only factor, all of the borrowers would have

week tended to be rated CAMEL 5 somewhat been rated CAMEL 5 for relatively long periodslonger than the nonborrowers. The median prior to their failure, and all of the nonborrow-pei-iod the banks weie rated CAMEL 5 prior to ers rated CAMEL 5 for relatively short periods.failure was 9.5 months for borrowers, com This was not the case. Periods that both borpared to seven months for the nonborrowers rowers and nonborrowers were rated CAMEL 5

ranged from less than one month to three yearsAccess to credit from the discount window, or more. About 20 percent of the borrowers

howevei, doe not appear to have been the only were closed within two months of the time

10The median is used, instead of the mean, because the fewfailed banks that remained open for long periods asproblem banks could distort comparisons of means- Forinstance, among the 154 borrowers, three banks were ratedCAMEL 4 or 5 for over 60 months prior to failure’ amongthe 164 noriborrowers, four banks were rated CAMEL 4 or5 for over 60 months.

14

when their supervisors rated them CAMEL 5,whereas many of the nonborrowers remainedin operation rated CAMEL S for much longerperiods.

Suppose Table 5 is interpreted as indicatingthat access to credit from the Federal Reserveallowed borrowers to remain in operation slight-ly longer as CAMEL 5-rated banks. What wouldthis imply for losses to BIF? The idea that trou-bled banks should be closed promptly to keepthem from taking actions that expose BIF tolarger losses is based on the assumption thatsupervisors have been ineffective in preventingtroubled banks from taking such actions. Thisauthor, however, has found evidence that super-visors have been effective in constraining thebehavior of most of the troubled banks undertheir jurisdiction.

Some of the evidence reveals the behavior ofbanks while their capital ratios were below re-quired levels or while supervisors rated them asproblem banks. Supervisors attempt to limit as-set growth, dividends and loans to officers anddirectors of the banks (the insiders) of under-capitalized and problem banks. Gilbert (1991)reported that large majorities of the banks thatoperated in 1955-89 for four or more consecu-tive quarters with capital ratios below the mini-mum capital requirement in effect at the timereduced their assets, refrained from paying divi-dends and had lower insider loans while under-capitalized. Gilbert (1992) found that the banksundercapitalized the longest prior to failure hadthe fastest declines in their total assets in theirlast year, and the group of banks undercapital-ized the longest prior to their failure had thesmallest percentage paying dividends in theirlast year. Gilbert (1993) found that banks reducedthe growth rates of their assets and reducedtheir dividends when supervisors downgradedthem to problem status.

Another study tests directly the associationbetween the length of time prior to their failurethat banks operated with capital ratios belowthe minimum required level and the losses tothe deposit insurance fund resulting from theirfailures. Gilbert (1992) found no association be-tween losses to the deposit insurance fund andthe length of time banks were undercapitalizedprior to their failure. Thus, if Federal Reservelending practices allowed some CAMEL 5-ratedbanks to remain in operation slightly longerthan others, it is not clear that those lendingpractices had any effect on BIF losses.

Behavior of the Banks ThatBorrowed

Conclusions about the behavior of most trou-bled banks may not apply to those that bor-rowed from the Fed near the time of theirfailure. Since these banks were privileged tohave access to credit from the discount windownear the time of their failure, they may havehad other privileges not available to all troubledbanks.

The articles cited above indicate that troubledbanks subject to relatively close supervisiontended to reduce their assets and refrain frompaying dividends. Table 6 examines the depositgrowth and dividends of borrowers and nonbor-rowers that were rated CAMEL 4 or S one yearprior to their failure. Of these 238 banks, 96did not borrow from the Fed in their last year,and the remaining 142 banks borrowed at leastonce in their last year. The 142 borrowers aredivided into several groups, based on their aver-age borrowings over their last year as a percen-tage of average total deposits over their lastyear. For each of the groups in Table 6, basedon their borrowings ratios, the mean of the per-centage change in total deposits in their lastyear was negative. The borrowers tended tohave more rapid declines in total deposits intheir last year than the nonborrowers, andthose that borrowed more relative to the size oftheir total deposits tended to have faster ratesof decline in total deposits than the banks withlower borrowings ratios. These observations areconsistent with the view that the banks thatborrowed most relative to their deposits hadthe greatest liquidity needs.

About 15.5 percent of the banks rated CAMEL4 or 5 in their last year paid dividends in theirlast year, and this percentage was about thesame for the borrowers and nonborrowers.Dividends as a percentage of total assets, how-ever, were smaller among the borrowers thatpaid dividends in their last year (mean of 0.29percent) than among the nonborrowers thatpaid dividends in their last year (mean of 0.45percentL Based on deposit growth and divi-dends, supervision of the problem banks thatborrowed in their last year appears to havebeen at least as strict as the supervision ofproblem banks that did not borrow from theFed.

FEDERAL RESERVE BANK OF SI. LOWS

15

Table 6Deposit Growth and Dividends of Banks Rated CAMEL 4 or 5 Over TheirLast Year

Of banks that paiddividends, mean of

Mean of percentage dividends as percent-Range of ratios of borrowings change in total No. of banks that age of average totalto total deposits over the last No. of deposits over last paid dividends in assets over the52 weeks banks 52 weeks their last year last year

Zo’o 96 —121°/n IS 045%Ocx <0001 53 —131 5 0120001< x s0.005 35 —172 8 0410005 < x < 0010 16 —202 3 0220010< x c0020 17 -195 3 0270070 < x 0050 13 —27.3 0 N/A0050 C x 0.100 5 —299 3 0350100 < x < 0200 2 —19.2 0 N/A0.200 c x 1 58.3 0 N/A

TOTAL 238 37

Did Borrowers Rave LargerDeclines in Uninsured Deposits?

One of the arguments that Fed lending prac-tices raised BIF losses rests on the assumptionthat uninsured deposits declined more rapidlyat borrowing banks than at nonborrowingbanks, Table 7 indicates that for the banks thatborrowed in their last year, the mean of thepercentage change in large denomination timedeposits over their last 52 weeks (negative 34.3percent) was significantly different from themean percentage change in other deposits(negative 9.6 percent). Large denomination timedeposits of the banks that borrowed from theFed in their last 26 weeks also declined morerapidly on average than their other depositsover their last 26 weeks (negative 26.2 percentcompared to negative 8.6 percent).

This pattern of more rapid declines in largedenomination time deposits than in otherdeposits at boi-rowing banks, however, is almost

identical to the record fot- the banks that didnot borrow from the Federal Reserve in theirlast year.’2 Credit from the Federal Reservedoes not appear to have facilitated more rapiddeclines in large denomination time deposits atthe banks that borrowed from the Fed. Theseobservations fail to support one of the argu-ments linking access to credit from the discountwindow and BIF losses: that declines in unin-sured deposits near the time of failure weremore rapid for borrowers than nonborrowers.

.vederat .Beserve Lending toTroubled Banks .Mav .t.tnvc .LivnitedRIP .Losses bit Proinotuig OrderlyResoiu.tkns

Resolution of a failed bank through methodsother than liquidation takes some time for theFDJC to arrange. The FUIC has to prepare apackage of assets and liabilities for bidders to

‘1lnstructions for reporting deposits call for classifyingbrokered deposits in denominations of $100,000 or less assmall denomination time deposits.

12The t-statistics for differences between the mean growthrates of large denomination deposits at the borrowers and

nonborrowers, measured over their last 26 weeks and overtheir last 52 weeks, are less than 0.2.

.JANt IARY/FFRRIJARY -tQqd

Table 7Deposit Growth of Failed Banks in the Last Year: Borrowers and Non-borrowers

Banks that borrowed from the Banks that did not borrow from

Fed in their last 52 weeks the Fed in their East 52 weeks

Mean percentage change in total deposits intheir last

26 weeks(t-stat,stic for difference in growth rates forborrowers and nonborrowers) — 13.0 Va f —2.38) — 10.3 °,o

52 weeks(t-statist’c for difference in growth rates forborrowers and nonborrowersl — 17.3 1 —2.79) -- 11 7

Mean percentage change in large time depositsin the last 26 weeks —26.2 —256

Mean percentage change In deposits other thanlarge time deposits in the last 26 weeks — 8.6 — 70

l-slalistics for difference in means of growthrates of large lime deposits and other deposits - 901 — 5.63

Mean percentage change in large time depositsin the last 52 weeks - 34.3 —33.5

Mean percentage change in depositsother than large time depostis in the last52 weeks - 96 — 6.0

t-statistics for difference in means of growthrates of large time deposits and other deposits - 683 — 5.51

c’’arnint’. aIlt,~~llit’ru tinit- ti z’s~t’s~us ~ak’i’ nt’nr- the time uI thi’ii- fuilui-e. ‘I able S indicatesand ar-r-angc’ Icu- tran-~li’rut he a~,t’tsand liabil— that (In’ pc’rct’ntagi’s ut hatiLS i’t’~øl~ctl In eachlies lii tlit’ ~ iriimit~lnclcIc’i. I’ti’,tiliiti,iii.s aIiZIii,t4i’(l (II thu tliet’e IflttbIodS %~Pit’ ,ih@t.il thu s.tnie tin’

Zi,, tiLc..\ tenth to he less e~jieu~i~e to the I-I )R’ the liank¼hat hoi-ron’ed in theft hasl 13 n eeLstFi:ici othici t\ ~)t’~ ut I_t%~,OltItiOii~._i ‘ t.t’iithiiig Ii’,’ auth those thai diii not ‘ lhc’si ob’,t’i ‘~ations dolit’ I ccitt-al Reser~t’ nun have aIlo~~ed “-otiie cud ~UliliiirI liii’ argLlmt’nl I hat t-’c-tier’ah Resi’i-~e

hank’. to n’in.iiii opt’it n bile he II )R n ni-Led lii lu’iiditu~ teal’ lit timt’ nI adore laeihitaled -c-so—iuuiuniuiizc’ r-c’’,cjlctliuiiu t-c,’-,ts lcititiiis ltitiictglu utit’tluciuls t,thiii’ tI1~nihicittiti1ilittui.

Uuu’ mi-ru il t’~iclt’rit-c’thai I echetal Hi-sene l.iqntd.tlions cii taiheal banks rnichrt hia~t’menleuiditig lacilitated oi’tiei h~ rt’snitjtions fl notch bc mole c’orumtorr n itbout I t’der’al Re’,er\ p c-iedit toa luu~~ii- ~ut’nrrrligc’ uI lirILildallons among hut li’tutilihi’d Iwiuks. stole ht)ITO%~el’s tadh~iuik5that borioni’ti 10111 hi’ I i’dPiah Iie’.t’i-~i’ rapid tii’PIi it’.’, iii tltt’ii touth deposits in thuc’h’ ha’.l

“See Gibert (1992)

‘‘Results are similar to ihuse ir rable S it the div’sinn between tne two g’oups of banks is based on bo’~ow’ngsinthe 2b weeks ending ‘n to lure

17

Table 8Distribution of Banks by Borrowings Near the Time of Their Failure and byResolution Method

Borrowed from the Federal Reservein their last 13 weeks:

Yes NoResolution method Number Percent Number Percent

Purchase and assumption 122 79.2% 129 78.7%rransfer of insured deposits 23 149 24 146Liquidation 9 58 11 _6 7

TOTAL 154 100.0 164 100.0

year than nonborrowers (Table 7). Withoutcredit from the Federal Reserve, rapid depositdeclines might have forced the FDIC to liquidatemore banks. This argument, however, does notprovide a strong defense for Federal Reservelending to troubled banks, since the FDIC hasauthority to use its resources to keep troubledbanks open until it can determine the least cost-ly method of resolution. Options available to theFDIC include lending to troubled banks, inject-ing capital through open bank assistance, andoperating failed banks as bridge banks whilethey search for buyers, as in the case of theBank of New England.

CONCLUSIONS

About 60 percent of the sample of banks thatfailed in 1985-90 borrowed from the FederalReserve in their last 5Z weeks. In addition, loss-es of the Bank Insurance Fund were largeramong the banks that borrowed from the Fed-eral Reserve in their last year. The combinationof these observations could be interpreted asevidence that the Federal Reserve engaged in amajor operation of sustaining the life of trou-bled bamjks that eventually failed, and that theFederal Reserve increased BIF losses substantial-ly by lending to many banks near the time oftheir failure.

This evidence, however, does not necessarilyprove that Fed lending practices caused thehigher BIF loss ratios of the borrowers. Perhapsthe Fed made loans to banks which would havehad relatively high BIF loss ratios with or without

Fed loans. This article investigates whether evi-dence supports the arguments that Fed lendingcaused larger BIF losses.

One argument is that Fed credit extended thelife of the borrowers, giving troubled bankswith little to lose additional time to assume risk.Borrowers were rated CAMEL S by governmentsupervisors (in imminent danger of failing)slightly longer prior to their failure than thenonborrowers. Additional evidence, however,indicates that the borrowers tended to havefaster declines in total deposits and tended topay smaller dividends than the nonborrowers intheir last year. These observations on depositgrowth and dividends are consistent with theview that the banks which borrowed from theFed in their last year were under strict supervi-sion appropriate for troubled banks.

The evidence does not support the argumentthat borrowers had relatively rapid declines intheir uninsured deposits near the time of theirfailure, which would have raised the cost ofresolution through methods other than pur-chase and assumption. Large denomination timedeposits declined at about the same rates onaverage for borrowers and nonborrowers overtheir last 26-to-52 weeks.

It is possible to make an argument that, inmany cases, Federal Reserve lending to failedbanks helped limit BIF losses. Jn most cases,borrowings were concentrated in a few weeksjust prior to failure. These loans may have al-lowed the banks to remain in operation, fund-ing deposit withdrawals, while the FDIC workedto arrange resolutions less costly to BIF than

JANUARY/FEBRUARY 1994

is

liquidations. Evidence on resolution methods inthe bank failure cases, however, does not sup-port this interpretation. Percentages of failedbank cases resolved through purchase and as-sumption, transfer of insured deposits to otherbanks and liquidation were about the same forborrowers and other failed banks.

Overall, the evidence does not support the ar-gument that Federal Reserve lending to failedbanks affected the costs of bank failures to BIF.

REFERE.NCES

Garsson, Robert M. Gonzalez Says Fed Actions Fueled theBank Fund’s Losses,” American Banker (June 12, 1991).

Gilbert, R. Atton. “Implications of Annual Examinations forthe Bank Insurance Fund,” this Review (January/February1993), pp. 35—52.

_______- ‘The Effects of Legislating Prompt CorrectiveAction on the Bank Insurance Fund:’ this Review(July/August 1992), pp. 3—22.

“Supervision of Undercapitalized Banks: Is Therea Case for Change?” this Review (May/June 1991),pp. 16—30.

Rehm, Barbara A. “Lawmakers Attack Fed Lending: DiscountWindow Called Costly Prop for Shaky Banks,” AmericanBanker (May 13, 1991).

Schwartz, Anna J. “The Misuse of the Fed’s Discount Win-dow:’ this Review (September/October 1992), pp. 58—69.

Starobin, Paul. “Out the Window:’ Nationa/ Journal (June 22,1991), pp. 1557—62.

Todd, Walker F “FDICIA’s Discount Window Provisions:’ Fed-eral Reserve Bank of Cleveland Economic Commentary(December IS, 1992),

_______- ‘Banks are Not Special: the Federal Safety Netand Banking Powers:’ in Catherine England, ed-, Govern-ing Banking’s Future: Markets vs. Regulation. Kluwer Aca-demic Publishers, 1991, pp. 79—lOS.

_______ - “Lessons of the Past and Prospects for the Futurein Lender of Last Resort Theory:’ Proceedings of a Confer-ence on Bank Structure and Competition (Federal ReserveBank of Chicago, May 11-13, 1988), pp. 533—fl.

U.S. House of Representatives, Committee on Banking,Finance and Urban Affairs. The Failure of the Bank of NewEngland Corporation and Its Affil/ate Banks. Hearing, 102Cong. 1 Sess. (Government Printing Office, 1991a).

_______- Failure of Madison National Bank. Hearing, 102Cong. 1 Sess. (Government Printing Office, 1991b).

______- “An Analysis of Federal Reserve Discount WindowLoans to Failed Institutions” (June 11, 1991c).

FEDERAL RESERVE BANK OF ST. LOUtS