Making Banks Safer and Banks to Avoid

by , Morss Global Finance

Bank lobbyists are working overtime to remove whatever teeth existed in Dodd Frank to keep banks safe. In the meantime, banks are getting back into creating new sorts of financial paper like what led to the 2008 bank collapse and global recession. If we want banks to be safe, we should start with the question “what makes them unsafe?” And for this, the late-2008 collapse gives us plenty to data to work with. Accordingly, I offer my hypothesis on why banks became unsafe and test it using Federal Deposit Insurance Corporation (FDIC) data.

Risk Taking Is Needed

Risk-taking is essential for progress. And I fully support the risk-reducing Federally-funded research provided over the years by the Defense Advanced Research Projects Agency (DARPA), the Office of Naval Research, the National Institutes of Health (NIH), and the Energy Department. However, I do question activities in the financial sector to change the risk profile of various financial investments. But if private sector players want to gamble with their money, let them. But I don’t want anyone gambling with my money, nor do I want to pay for their insurance to do so.

My View

The risk taking that led to the bank collapse should not take place in depository institutions: let the hedge funds, private equity companies, venture capital firms and investment banks make/lose money, come and go – that is normal – risk takers take risks, and some do not work out. But deposits should not be put at risk: bank runs are not good. The 2007 real estate risk bubble: why did it become so problematic? After all, the real estate cycle is well documented: the real estate market usually goes up for 8-10 years, the bubble bursts, the real estate market collapses, some real estate investors go bust, and it starts all over again. What was the problem in 2008 that caused all the panic? The exposure of depository institutions. Did anyone really care if Goldman Sachs or other gamblers went belly-up? Only insofar as it affected depository institutions. And the same was true in the European debacle. There also, the first thing done was to “bail out” the depository institutions.

My Solution

For the last few years, I have argued that banks should be required to manage their own loans to maturity and not engage in trading. In essence, we go back to Glass-Steagall and get the trading out of banks. A key point for me is how bank incentive structures change when they are allowed to trade: their primary focus goes from insuring that the loans they make will get paid back to making/packaging as many loans as they can to sell off for commissions. I believe that this change in incentive structures fundamentally changes the way bankers view loans: instead of viewing loans they make as their life blood, they focus on making as many loans as they can to maximize commission payments.

And let’s face it, much of the near-worthless financial paper generated by the financial industry in recent years stems from a desire to find new ways to make commissions:

  • create a new derivative/contract-on-contract;
  • make packages of them, and
  • create a market for them that will generate commission when they are bought and sold.

My solution is hardly novel: Senator Glass and Congressman Steagall felt the same way when they sponsored their bill in 1933; former Treasury Secretary Paul Volcker has supported this; and Ellen Brown argues “public banks are key to capitalism.”


If I am right that being able to sell off loans will reduce their quality and increase bank risks, this should be reflected in bank performance. More specifically, if I am right, banks that sell off loans should be riskier than banks that hold their loans to maturity.

Data to Test Hypothesis

I cannot find data that distinguishes between banks that hold loans to maturity and those that sell them off. The closest data comes from the FDIC. It has data on banks that distinguishes between banks that securitize and sell off loans and those that do not. Of course, many banks sell off loans without securitizing (insuring) them. And of course, those that sell off their loans and at least partially insure them will get in more trouble when things go bad than those that just sell them off. However, I believe it is worthwhile to examine the FDIC data, so I will see how and if the percent banks’ assets securitized and sold off affect its financial condition.

In what follows, I look at two dates: December 31, 2007 and March 31, 2009. The former was the height of the real estate boom; the latter was at the depth of the downturn. The collapse took its toll: according to FDIC data, 27 banks failed between October 2000 and December 2007. Since then, 487 have failed.

Table 1 provides a breakdown between banks that sold securitized assets and banks that did not for the two dates. The numbers were quite stable: the percent of banks selling securitized loans fell only slightly.

Table 1. – Banks Selling and Not Selling Securitized Assets, 2007, 2009

Source: FDIC

Table 2 summarizes the 4 categories the FDIC uses to assess a bank’s financial condition. And I use these in what follows.

Table 2. – FDIC Capitalization Categories

Source: FDIC

In Table 3, the average FDIC capitalization scores for banks that sell and don’t sell securitized loans are presented. All capitalization measures for the non-trading banks are better than those of banks selling securitized loans. And they are significantly better: statistically there is less than a 1% chance that they are not.

Table 3. – Capitalization Scores for Banks Selling and Not Selling Loans

Source: FDIC

Banks to Avoid

The FDIC provides detailed data on the capitalization condition of banks. According to its latest report (June 2013), the banks in Table 4 are “significantly undercapitalized. At least for now, I do not plan to open an account at any of them.

Table 4. – Significantly Undercapitalized US Banks

Source: FDIC


The data presented in this paper do not definitively prove that banks that sell off their loans are riskier than those that do not. Regrettably, I do not have that breakdown. But the data presented do contribute some evidence to the debate: banks that sell off securitized loans are riskier than banks not selling off their loans.

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