Why Do Banks Fail? Arkansas Execs Offer Some Answers

(From left) Johnny Allison & Randy Dennis (Steve Lewis)

Johnny Allison and Randy Dennis could write a book about why banks fail.

But they boiled down their thoughts in interviews looking back at the biggest era of Federal Deposit Insurance Corp. bank takeovers in history. Hundreds of banks ultimately failed after the U.S. real estate bubble popped in 2007.

“What are the reasons banks fail?” Allison asked, rhetorically. “No. 1, poor management and bad decisions. No. 2, bad asset quality and bad loans.”

Allison, CEO of Centennial Bank of Conway, went on to list dangerous loan structures, a lack of capital and failure to keep adequate deposit reserves as big factors in bank defaults.

Allison refers to capital-poor banks as “zombie” banks. “They become very poor earners or are losing money,” burning through capital month after month with little income. “They try to raise new capital, but that is very hard to do when the bank is hemorrhaging losses.” In short, who wants to invest in a bank that’s losing money?

Dennis, who leads DD&F, the Little Rock bank consulting firm, said 2023’s six bank failures — after two consecutive years without an FDIC takeover — reflected an era far different from the Great Recession.

He said an understaffed FDIC was caught short “when Silicon Valley Bank failed, and then of course, Signature Bank immediately thereafter, and First Republic in the next month.” Silicon Valley Bank was based in Santa Clara, California, Signature Bank in New York and First Republic in San Francisco.

“A lot of laws were passed after the Great Recession, focused on bank holding companies,” Dennis continued. “These were really totally worthless for resolving these big failed banks. Banks generally fail because they run out of capital. Those three banks failed because of liquidity. They couldn’t withstand a run on the bank.”

Allison said he approached a speaker after a banking conference presentation last year in Scottsdale, Arizona, and asked how many banks the expert thought would have failed if the Federal Reserve had not provided unprecedented monetary aid during the great financial crisis, specifically loans to banks equaling the face value of all the bonds they held. “He said, ‘I’d say about a thousand.’ I told him, ‘I think your numbers are a little light.’”

The Fed was passing out loans to “broke banks” to the detriment of solid banks like Centennial, Allison said. “Was it the right thing to do? I think it probably was, in hindsight. The monster was so big, and the stupidity or inexperience of bankers, whatever you want to call it, had created something that could have been disastrous.”

SVB’s failure exemplified Allison’s first reason for bank failures: bad management and bad decisions. Investing heavily in bonds with ready money pumped into the financial system left banks vulnerable when interest rates rose, he said.

Silicon Valley Bank turned to Goldman Sachs to sell bonds in its liquidity crisis, but the deal netted the bank $21.4 billion on bonds with a book value of about $24 billion. When word got around on social media that SVB was in trouble and a $2.5 billion stock sale plan was foundering, investors started pulling out their money, and the bank run proved fatal.

“All banks buy some securities [U.S. and municipal bonds, etc.],” Allison said. “They are usually very safe investments and provide a source of liquidity if the bank needs cash to make loans or use for other purposes. But they have created additional danger in these high-inflation times.”

Allison thinks interest rates may still rise. “They have not killed the inflation snake yet,” he said.

The Great Recession era’s failures underlined Allison’s second trigger for trouble: bad asset quality and bad loans. Lenders in the early 2000s pushed adjustable-rate mortgages onto an army of borrowers who really couldn’t afford the properties they were buying. The loans were bundled into investment instruments, and when mortgage defaults began piling up, the house of cards folded.

Allison said bankers also err in making fixed-rate loans that are incompatible with the terms they’re offering to depositors, Allison said. “In a rising-rate environment it can be disastrous, as we’ve seen in this cycle, because the cost of funds has exceeded the rate charged on longer-term fixed-rate loans.”

Many banks get into “real trouble by lending more money than they have in customer deposits,” Allison added, citing a metric known as a loan-to-deposit ratio. “If Bank X has $100,000 in deposits and loans of $110,000, that equates to a loan-to-deposit ratio of 110%. They’ve loaned more money than they have in deposits, probably forcing the bank to purchase high-priced ‘brokered deposits,’ borrow high-priced money from the Fed or run [certificates of deposit] ads in the newspaper. It can become a vicious cycle that leaves no way out.”

Along with loan-to-deposit ratios, customers should consider banks’ capital ratios, Allison said. A tier 1 capital ratio measures a bank’s financial strength by comparing its core equity capital to its total risk-weighted assets. Financial regulators generally consider any capital ratio under 6% as a sign of real trouble. The higher the capital ratio, the better chance the bank has to survive hard times.

“If a bank is over 110% loan-to-deposit and 8% or less in capital, a depositor would want to certainly only put the amount of insured deposits into that bank,” Allison said. “If the big, bad wolf shows up at the door and starts huffing and puffing, that bank could be closed before the sun sets.”

This month, Centennial reported a common equity tier 1 capital ratio of 14.3%. Bank OZK of Little Rock reported its ratio of total common stockholders’ equity to total assets at 13.68%. OZK also reported a record quarterly profit, while Centennial’s earnings beat Wall Street expectations and its stock rallied.

Nevertheless, SVB’s rapid failure shocked Allison. “I had never been asked if Centennial Bank could pay out all uninsured depositors,” he said. “I instructed my finance department to give me a report as quickly as possible. The news at our company was very good: We can pay out all uninsured depositors without selling securities with our cash and lines of credit and still make a 1% return on assets.”

Not to brag, Allison said, but as the largest individual shareholder in Home BancShares, Centennial’s holding company, he sleeps very well. “All of our depositors and customers should too.”