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Reckless Lending by Small Banks Worsened Financial Crisis

As more banks go under, it's useful to have a gander at the FDIC Inspector General's post-mortems of recently failed institutions. These "material loss reviews" underscore how poor management, rather than unstoppable macroeconomic forces, is to blame for most bank failures. The reports also drive home that smaller banks, along with the too big to fail crowd, played a part in the financial crisis.

Here's a sample of recently closed banks, all of which had less than $1 billion in assets, along with the FDIC's verdict about why they folded:

1st Centennnial Bank (Redlands, Calif.) 1st Centennial failed primarily due to bank management's pursuit of asset growth concentrated in high-risk [commercial real estate/acquisition, development and construction] loans without adequate loan underwriting and credit administration practices.
Freedom Bank (Bradenton, Fla.) FB failed primarily due to bank management's aggressive pursuit of asset growth concentrated in high-risk CRE loans with inadequate loan underwriting and a lack of other loan portfolio and risk management controls.
Havens Trust Bank (Duluth, Ga.) Haven failed due to bank management's lack of oversight and failure to control risk in its loan portfolio. The key events leading to the failure of the institution included rapid loan growth concentrated in high-risk CRE construction and development loans.
Main Street Bank (Northville, Mich.) MSB's rapid deterioration and ultimate failure can be attributed to bank management's aggressive pursuit of loan growth just nine months after opening, fueled by a significant increase in brokered deposit funding, and resulting in concentration of higher-risk loan types, including (1) construction and development, (2) home equity, and (3) non-owner occupied residential improvement loans (rehab loans).
Security Pacific Bank (Los Angeles, Calif.) SPB failed primarily due to bank management's pursuit of a high-risk business strategy focused on rapid asset growth concentrated in CRE/ADC loans, which were financed primarily with wholesale funding sources, including volatile non-core deposits and borrowings.
Notice the recurring themes? High-risk lending, aggressive growth goals, loan concentration. All signs of pilot error. Haven Trust, for example, launched in 2000 with $29 million in assets and grew to roughly $575 million by 2008. But apart from assigning blame (always a useful exercise), these backward-glancing reports provide us with forward-looking criteria for figuring out which banks, especially smaller players, are in trouble.

Almost without fail, these are institutions that heavily funded housing and condo construction, along with land purchases and development. Much of their loans, often upwards of 40%, were for construction projects. Underwriting standards were lax, internal controls weak. Capital reserves were inadequate. Risk management was virtually non-existent. Managers emphasized fast, rather than steady, growth.

Historically, small banks have been known for their prudent lending and generally conservative approach to doing business. A common refrain among community bankers these days is that they didn't cause the financial crisis. True enough. But they did profit from it, at least for a time.

Graph courtesy of Federal Reserve Bank of St. Louis.

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