Magazine article Business Credit

Are Safe Banks Hazardous to Your Wealth?

Magazine article Business Credit

Are Safe Banks Hazardous to Your Wealth?

Article excerpt

"May you live in interesting times" is the Chinese curse that most of us live by today, and the changing times in banking have influenced much more than just interest rates, It is time for some kind of change; the FDIC reports that in the past five years, more federally insured banks have failed than in the entire preceding 51 years since the establishment of deposit insurance in 1934. The FDIC has recorded 897 bank failures between 1986 and 1990, and the banking system is still singing the blues. Deep down South, no one is whistling "Dixie" anymore, and the change in tune is definitely downbeat. What is going on, where is it going to, and when is it going away?

Way Down South

The Sunbelt states have prospered since the end of World War II. Florida still gains 1,000 people every day and many of its cities are cited among the more desirable places to live. The Southeast has earned its place in the sun as a decent area to live and work, to get rich, and retire. Meanwhile, bankers still aim for better than 15 percent return on equity and one percent return on assets, and we kept on target during the 1980s by increasing fee income, lopping off head count, playing the sale/leaseback game, leveraging even more on minuscule capital bases, and churning our securities portfolios. Bankers are not so starved for profits that we're ready to stew our wingtips or chew on our attache cases, but we still hunger for some self-respecting capital. As the banks beef up their equity, watch them trim more fat by cutting out non-essential services and slashing backroom employees.

Capital Idea

Here's some more food for thought; banks must meet stiffer capital requirements, 7.25 percent of total assets for 1991, and a hefty 8 percent for 1992. Capital means risk-based capital, and that means certain kinds of loans will require more capital than others.

The new bank regulations dictate a complex "risk weight" formula, but a sampling of the process will illustrate the point. Cash has a zero percent risk weight, home mortgage loans have a 50 percent risk weight, and all other loans 100 percent. In other words, commercial loans, secured or unsecured, are judged twice as risky as home mortgage loans. Of course, cash is riskless, and so it has a zero weight. On top of the higher capital requirements for commercial loans are capital requirements for so-called "unfunded commitments" and other off-balance sheet items, such as unused portions of lines of credit or revolving loans with maturities longer than one year. You can figure that you will have to pay, sooner or later, for the extra costs associated with the risk of being a commercial borrower.

Another way of expressing this is that we must have at least eight cents of capital for every 92 cents of debt. Now more equity would seem like a good thing, and it is, but it is costly. So why should you care?

There are lots of reasons. More equity means more dividends to cover with more after-tax earnings, and more earnings can only come from higher revenues and/or lower expenses. Higher revenues are most likely to come from a combination of higher interest rates and more fees. Besides, recession is a risky time to lend, so rates should be raised to offset the greater credit risk.

In addition, the costs of administering fewer loans with the fixed operating overhead of a bank must be passed on to borrowers. Expect to see commitment fees charged on line of credit accommodations, administrative fees levied to pay for overhead costs, and user fees tagged on to formerly free services such as credit investigations.

Then there are the fees charged by the bank regulators, which is akin to the IRS charging you a few bucks for processing your tax return. The FDIC has virtually doubled its fees over the last five years, fees which are paid by the healthy banks to cover the losses incurred in burying the dead banks. You will also ultimately pay directly or indirectly for these charges. …

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