A Parsimonious and Predictive Model of the Recent Bank Failures

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INTRODUCTION

The collapse of the housing and equity markets and the ensuing recession has led to the largest number of bank failures since the Savings and Loan crisis of the late 1980s and early 1990s. Since the start of the financial crisis in 2008 through 2009, there have been 167 bank failures in the United States (FDIC Bank Failures, 2010). The purpose of this analysis is to examine the financial condition of banks during this recent financial crisis and determine whether there are key financial indicators that could signal potential failure. The seriousness of the financial crisis is described by the Federal Deposit Insurance Corporation (FDIC) in the 2008 Quarterly Report.

FDIC-insured institutions reported a net loss of $32.1 billion in the fourth quarter of 2008, a decline of $32.7 billion from the $575 million that the industry earned in the fourth quarter of 2007 and the first quarterly loss since 1990. Rising loan-loss provisions, large write-downs of goodwill and other assets, and sizable losses in trading accounts all contributed to the industry's net loss. More than two-thirds of all insured institutions were profitable in the fourth quarter, but their earnings were outweighed by large losses at a number of big banks (p. 1).

The increase in bank failures that began in 2008 was largely precipitated by the collapse of the U.S. housing market. Falling home prices led to declines in securities tied to home loans forcing banks to take write-downs on their balance sheets. Falling home prices combined with losses in the stock and bond markets resulted in historic declines in household wealth. The U.S. officially entered into recession in December 2007.

The financial crisis that began in early 2008 worsened the recession, making this not only one of the longest but also one of the most severe U.S. recessions since World War II. Real gross domestic product (GDP) declined at an annualized rate of 5.4% in the fourth quarter of 2008, 6.4% in the first quarter of 2009, and 0.7% quarter of 2009. Real GNP returned to positive growth of 2.2% on an annualized basis for the third quarter of 2009 and 5.7% in the fourth quarter of 2009. (Bureau of Economic Analysis, 2010). Because of the recession, bank failures continued with 130 failed banks in 2009 (FDIC Bank Failures, 2010).

The current banking crisis is broad based and linked closely to defaults on residential real estate and small business loans. Smaller banks that were linked to construction, real estate development, and small businesses loans were most at risk. This current bank crisis is different from the bank crisis of the late 1980s and 1990s, which was largely linked to defaults in the commercial real estate, agricultural, and petroleum industries, and particularly in oil and agricultural producing regions.

This paper investigates the financial indicators associated with recent bank failures. The number of predictor variables is limited to six for reasons of parsimony. Previous literature has addressed the topic of predicting bank failure; however, our model differs from previous studies in four important ways. First, our model is parsimonious, using only six financial indicators to predict bank failure. Second, our model uses logistic regression to weight the six financial indicators into a composite measure of failure. Third, we use data from the recent bank failures to develop our model. Fourth, we incorporate various costs of misclassifying banks as failed or not failed. The regression model results in a prediction of the likelihood of failure, which correctly classifies up to 98% of the sample as failed or not.

The remainder of the paper is organized as follows: Section 1 describes the extant literature on failure in banks. Section 2 discusses the indicators associated with failure and the related hypotheses testing. The results of testing the failure model are analyzed in Section 3, and the Section 4 concludes the paper. …