Bad Parenting: How Bank Regulators Foster Problem Banks Like BAC

By Jeff Bailey

Like the U.S. health care system, banking regulators spend tons of money and effort on patients after they�ve become seriously ill, but do far too little in the way of preventive medicine. The result is a regulatory scheme that magnifies ugly cycles in banking, rather than smoothing them out.

One could argue the U.S. also suffers bigger banking problems than it otherwise would because its regulators are ass kickers during a downturn, when banks really don�t need to be told to hunker down. But the same regulators are pushovers during good times when the seeds of trouble are being planted.

Note Bank of America (BAC), a current basket case, during the good years of the early-to-mid 2000s, letting its tangible common equity (a more conservative measure of capital) as a percentage of total assets drop steeply, the result of growth via acquisition and too little raising of capital.

 Bank of America Corporation Tangible Common Equity Ratio Chart by YCharts

 

Those, of course, were the years when capital raising would have been easier, given BofA�s lofty stock price, but regulators went along with the bank�s risky expansion, including the disastrous acquisition of Countrywide Financial and its mortgage mess.

Bank of America Corporation Stock Chart by YCharts

Bank of America, of course, was hardly alone, as we see its three big-bank brethren for the most part following the same pattern, and then after the financial collapse lifting their tangible equity ratio through  stock sales and asset shrinkage.

Bank of America Corporation Tangible Common Equity Ratio Chart by YCharts

It isn�t just growth that strains capital. Banks get giddy during good times and start mailing out fatter dividend checks, too. Some banks in recent cycles have also become big purchasers of their own stock, an odd habit in an industry where capital seems always in short supply.

Bank of America Corporation Dividend Chart by YCharts

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Compounding this behavior by the banks, the Federal Deposit Insurance Corp.�s fund, designed to backstop the U.S. banking system, is perpetually under-sized for the job. And the FDIC (at the urging of its overseers in Congress and the executive branch, who all suffer from short memories and are far too fond of Wall Street campaign contributions) tends to reduce deposit insurance premiums during the boom times, and then jack them up during a crisis. Thus, the FDIC fund never gets big enough to handle giant bank liquidations, and its premiums are a tax on banks when they can least afford it. Unable to liquidate the biggest banks, the FDIC arranges their sale, and thus the too-big-to-fail banks become even bigger.

Bank of America Corporation Total Assets Chart by YCharts

Funding these beasts, as Bloomberg Markets Magazine revealed late last month, becomes an international nightmare in a panic.

The FDIC handled 157 bank failures last year, with combined assets of $93 billion, and losses to the deposit insurance fund of about $24 billion. That�s about a 26% haircut on those assets. If a $1 trillion-plus bank failed and sustained losses at that rate, of course, the cost would be more than $250 billion.

The FDIC fund can borrow $100 billion or more from the U.S. Treasury and another arm of the government. But relying on that ability essentially offers a taxpayer guarantee of the banks, rather than a bank-funded insurance plan as intended.