An examination of the 'Texas ratio' as a bank failure model.

Author:Jesswein, Kurt R.
Position::United States. Federal Deposit Insurance Corp
 
FREE EXCERPT

INTRODUCTION AND BACKGROUND

So long as there have been banking institutions, there have been banking failures. Whether by fraud and deceit or more commonly by poor decision-making and risk management strategies, the banking industry has periodically experienced severe downturns and suffered through the failure and/or suspension of multiple institutions within very short periods of time.

Although numerous at times, bank suspensions and failures prior to 1920 tended to be small in comparison to the ever-increasing number of banks (Board of Governors, 1943). However, this all changed with the coming of the roaring 20s and subsequent Great Depression years which saw the number of banks across the country cut in half from over 30,000 in 1921 to around 15,000 at the time of the creation of the Federal Deposit Insurance Corporation (FDIC) in 1934; over 9,000 banks suspended operations from 1930 to 1933 alone (Board of Governors, 1943).

The introduction of the FDIC saw a marked change in this pattern as the U.S. Department of the Treasury now had a mechanism in place to assist banks that were experiencing difficulties. Although bank suspensions continued at a pace of some fifty per year from 1934 to 1940, the FDIC was also assisting twenty-five to thirty banks per year with the acquisition of failing institutions. This lead to a long period of stabilization which saw double-digit bank failures only three times in the ensuing four decades with most of the failures resulting in purchase-and-assumption (P&A) transactions in which the FDIC helped healthier institutions acquire most if not all of the failing bank's assets and liabilities.

This all changed in the 1980s as deregulation of the banking markets and increased volatility in the financial markets combined to cause a significant increase in the number of troubled financial institutions. As seen in Table 1, of the approximately 3,600 bank failures that have been overseen by the FDIC since its creation, more than 2,900 occurred between 1980 and 1993. Most of these transactions involved purchase-and-acquisition transactions but the FDIC also became involved with assisted acquisitions (AA), transactions in which it provided direct financial assistance to institutions agreeing to acquire failing institutions. There were over 500 of such AA transactions in this time period with almost half of them occurring in 1988 during the height (or perhaps better depth) of the fury of bank failures.

Passage of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 and subsequent Federal Deposit Insurance Corporate Improvement Act of 1991 marked the next changes in the handling of bank failures by the FDIC. There was a noted shift away from assisted acquisitions to various purchase-and-acquisition transactions as well as to direct payouts (PO), in which the FDIC simply paid off the insured deposits and allowed to institution to fail.

As the 1990s progressed and the new millennium dawned, the banking markets stabilized with relatively few financial institutions failing--in fact there were NO failures in either 2005 or 2006--but this would change. Significant upheavals in the financial markets towards the end of 2007 and into 2008 and beyond have once again introduced an increases amount of bank failures. This has created a situation in which many bank customers and other interested parties are becoming increasingly concerned about the health of their own financial institutions. Sixty-two institutions have failed from the beginning of 2008 into early 2009. With such failures appearing to come with increasing frequency, it is not unusual to find regular headlines such as "If it's Friday, there must be a bank failing somewhere across the country" (Ellis, 2009). Thus, there has been a renewed interest in looking for ways to discover which financial institutions were on the verge of financial failure.

REVIEW OF BANK FAILURE MODELS

Given the importance placed on banking institutions in the operations of smoothly running economies, there have been varied attempts to develop models to assist in finding those financial institutions more likely to suffer financing hardships or worse. As early as the 1930s we find examinations of the causes of bank failures given the chaotic situation and widespread failures among financial institutions during the late 1920s and early 1930s (Spahr, 1932).

Such studies all but disappeared until new groundbreaking work focusing on the financial difficulties of industrial firms began to appear in the late 1960s (Beaver, 1966; Altman, 1968). These studies began to look to financial and accounting ratios as indicators of financial distress through either univariate (Beaver) or multivariate (Altman) models. Meyer and Pifer (1970) and Sinkey (1975) subsequently developed models that examined financial difficulties of banks using accounting and financial ratios more commonly associated with banking institutions. For example, Sinkey incorporated such ratios as cash plus U.S. Treasury securities to total assets, total loans to total assets, provision for loan losses to total operating expenses, total loans to sum of total capital and reserves, total operating expenses to operating income, loan revenue to total revenue, U.S. government securities' revenue to total revenue, municipal securities revenue to total revenue, interest paid on deposits to total revenue, and other expenses to total revenue in his study.

Subsequent studies tended to focus on the development and testing of computer-based early warning systems (EWS) that might be used to prevent bank failure or reduce the costs of failure. Such studies tended to expand the quantitative analysis of the models (Kolari, Glennon, Shin & Caputo, 2002; Wheelock & Wilson, 2000) or...

To continue reading

FREE SIGN UP