Banks failures continue in 2010, pose risk for economic recovery

The financial crisis had severe repercussion on the banking systems in America. The number of banks that have failed in the country in the last two years (2009 and 2010) is much higher than the number of bank failure in the rest of the 2000-2010 decade.

Overall about 270 banks have failed since October 2000 out of which 173 have failed in the last one year (July 2009 to May 2010). The number is 238 for the last two year period (July 2008 to May 2010). To give a perspective of how big the scale is the total number of FDIC (Federal Deposit Insurance Corporation) insured institution as on May 2010 were 7895. So the number of banks that have failed in the last two years is about 3% of the total number.

What is a bank failure?

Bank failure is basically closure of a bank’s operations mainly by the regulators because the bank is likely to face insolvency and the risk of the bank being unable to meet its financial obligation towards depositors and creditors are high. This arises due to erosion in the market value of the assets owned by the bank leading to lower capital (net worth) of the bank. If the market value of assets of a bank becomes lower than the market value of liabilities, the net worth becomes negative and the bank even if it liquidates all its assets will not be able to pay the depositors and creditors. The regulators generally look at the capital ratio as a sign for a probable bank failure. If there is a high probability of negative net worth of a bank, it is better to declare the bank failure because if the bank keeps on operating those depositors who have the information about the bank’s weak position will withdraw their money leaving even lesser capital for the less informed depositors. The major loss will then have to be taken by the remaining depositors.

Contagion effects associated with a bank failure

Failure of a single bank can lead to a string of such failures and shake the entire financial system as the banks are closely intertwined with many cross exposures. Failure of one bank can result in capital erosion for other banks thereby triggering a chain reaction which could over a short time spill over to a large number of banks. The impact of the current bank failures can be estimated by FDIC estimate that another 700 banks are at risk of failure.

Role of regulators to shield the financial system

Due to domino effect associated with a weak bank, the role of regulators becomes very important. In United States, FDIC takes over the weak bank to reduce its impact from the system. The bank's assets are seized and liquidated/sold to other banks and the depositors are paid the insurance up to deposit insurance limit which is currently $250,000.

An example of a big bank failing

Washington Mutual Bank (WaMu) is the largest bank failure so far. Founded in 1889, the American bank had annual revenues of about $16 billion before its failure in 2008. WaMu faced bank run after news of its weak capital position spread. In 10 day time about $16 billion dollars of deposits were withdrawn. The regulators took over the bank to prevent systemic risk to the whole system. Later, its assets were sold to JP Morgan Chase.

US' struggle to save financials continues with Citi

The US Treasury (UST) appears to have been haunted by Lehman Brothers woes. UST cannot see Citigroup falling down. It is such a big player in the financial system that its failure can jolt the already feeble banking system. According to an article on BBC news:

"If the bank were to collapse, it could have caused financial havoc around the globe, seizing up fragile lending markets and causing untold losses among institutions holding debt and financial products backed by the company. "

So here comes the biggy-big rescue package for the giant. Some crucial points in the package are:

• A pool of $306 billion assets identified and Citigroup will bear first $29 billion losses on it rest to be absorbed by UST , Federal Reserve (Fed) and Federal Deposit Insurance Corp. (FDIC).
• Treasury department will give $20 billion from the $700 billion package passed for rescuing the entire financial industry. This is under the Troubled Asset Relief Program (TARP).
  
• Govt will get $7 billion of preferred shares with 8% dividends.
  
• Dividends will be limited to $0.01 per share for next 3 years.
  
• 10 year warrants of $2.7 billion to FDIC and Treasury department at strike price of $10.61 per share.
• Citibank to help distressed homeowners.

The Citi's term sheet of agreement is available from Citigroup's website.

The impact of this package will be that Citigroup's capital adequacy will improve with additional $40 billion in capital benefits. This capital infusion will make the Citigroup's Tier-1 capital ratio at 14% well above the mandatory requirement. On the other hand this rescue has increased the burden on the US government and more than trillion dollars of tax-payers money is at stake. With more and more companies lined up for protection the $700 billion may fall well short. Automobile giants like GM and Ford are so close to bankcrupcy and they certainly require some capital infusion to keep them alive.

Despite the lucrative package, investors at Wall Street are still skeptical about the long term outcome of this. But one thing is sure that if this works out well in near future more of such packages will be seen making their way.