	Background

Ten states concentrated in the western, midwestern, and southeastern  United States—all areas where the housing market had experienced  strong growth in the prior decade—experienced 10 or more bank failures  between 2008 and 2011 (see fig.1). Within these 10 states, 86 percent (257) of the failed banks were small  institutions with assets of less than $1 billion at the time of failure, and 52  percent (155) had assets of less than $250 million. Bank Failures Were Largely Related to Nonperforming Real Estate Loans, but Also Highlighted the Impact of Impairment Accounting and Loan Loss Provisioning

In the 10 states with 10 or more failures between 2008 and 2011, failures  of small and medium-size banks were largely associated with high  concentrations of commercial real estate (CRE) loans, in particular the  subset of acquisition, development, and construction (ADC) loans, and  with inadequate management of the risks associated with these high  concentrations. Our analysis showed that small failed banks in  the 10 states had often pursued aggressive growth strategies using  nontraditional and riskier funding sources such as brokered deposits. Among other things, the IG  found that these banks exhibited strong management, sound credit  administration and underwriting practices, and adequate capital. But in general fair value-related losses contributed little to the  decline in net interest income and regulatory capital that failed banks  experienced overall once the financial crisis began. Current Accounting Practices for Loss Provisioning May Have Delayed Reporting of Credit Losses during the Recent Crisis

A loan loss provision is the money a bank sets aside to cover potential  credit losses on loans. The Department of the Treasury (Treasury) and  the Financial Stability Forum’s Working Group on Loss Provisioning  (Working Group) have observed that the current accounting model for  estimating credit losses is based on historical loss rates, which were low  in the years before the financial crisis. Treasury and the Working Group noted that earlier recognition of loan  losses could have reduced the need for banks to recognize increases in  their incurred credit losses through a sudden series of loan loss  provisions that reduced earnings and regulatory capital. To address this issue, the Financial Accounting Standards Board has  issued a proposal for public comment for a loan loss provisioning model  that is more forward-looking and focuses on expected losses. This  proposal would allow banks to establish a means of recognizing potential  losses earlier on the loans they underwrite and could incentivize prudent  risk management practices. Moreover, the proposal is designed to help  address the cycle of losses and failures that emerged in the recent crisis  as banks were forced to increase loan loss allowances and raise capital  when they were least able to do so (procyclicality). FDIC Used Shared Loss Agreements to Attract Bidders at Least Cost to the Deposit Insurance Fund

FDIC is required to resolve a bank failure in a manner that results in the  least cost to the Deposit Insurance Fund (DIF). During the most recent financial crisis, FDIC facilitated these sales by  including a loss share agreement, under which FDIC absorbed a portion  of the loss on specified assets purchased by the acquiring bank. From  January 2008 through December 31, 2011, FDIC was appointed as  receiver for the 414 failed banks, with $662 billion in book value of failed  bank assets. 2). By comparing the estimated cost of the shared loss agreements with the  estimated cost of directly liquidating the failed banks’ assets, FDIC has  estimated that using shared loss agreements has saved the DIF over $40  billion. FDIC officials stated that the acquiring banks were  being monitored for compliance with the terms and conditions of the  shared loss agreements. The Impact of Bank Failures on Local Communities Was Mixed

The acquisitions of failed banks by healthy banks appear to have  mitigated the potentially negative effects of bank failures on communities,  although the focus of local lending and philanthropy may have shifted. However, the effects could be potentially significant for those limited  areas that had been serviced by one bank or where only a few banks  remain. For example, several  bank officials noted that in the wake of the bank failures, underwriting  standards had tightened, making it harder for some borrowers who might  have been able to obtain loans prior to the bank failures to obtain them  afterward.
Why GAO Did This Study

Between January 2008 and December 2011--a period of economic downturn in the United States--414 insured U.S. banks failed. Of these, 85 percent (353) were small institutions with less than $1 billion in assets. Small banks often specialize in small business lending and are associated with local community development and philanthropy. The failures of these banks have raised questions about contributing factors. Further, the failures have raised concerns about the accounting and regulatory requirements needed to maintain reserves large enough to absorb expected loan losses (loan loss allowances)--for example, when borrowers are unable to repay a loan (credit losses).
This statement is based on findings from GAO's 2013 report on recent bank failures ( GAO-13-71 ) required by Pub. L. No 112-88. This testimony discusses (1) the factors that contributed to the bank failures in states with the most failed institutions between 2008 and 2011; (2) the use of shared loss agreements in resolving troubled banks; and (3) the effect of recent bank failures on local communities. To do this work, GAO relied on issued report GAO-13-71 and updated data as appropriate.

What GAO Found

Ten states concentrated in the western, midwestern, and southeastern United States--areas where the housing market had experienced strong growth in the prior decade--each experienced 10 or more commercial bank or thrift (bank) failures between 2008 and 2011. The failures of small banks (those with less than $1 billion in assets) in these states were largely driven by credit losses on commercial real estate (CRE) loans, particularly loans secured by real estate to finance land development and construction. Many of the failed banks had often pursued aggressive growth strategies using nontraditional, riskier funding sources and exhibited weak underwriting and credit administration practices. The Department of the Treasury and the Financial Stability Forum's Working Group on Loss Provisioning observed that earlier recognition of credit losses could have potentially lessened the impact of the crisis. The accounting model used for estimating credit losses is based on historical loss rates, which were low in the prefinancial crisis years. In part due to these accounting rules, loan loss allowances were not adequate to absorb the wave of credit losses that occurred once the financial crisis began. Banks had to recognize these losses through a sudden series of increases (provisions) to the loan loss allowance that reduced earnings and regulatory capital. In December 2012, the Financial Accounting Standards Board issued a proposal for public comment for a loan loss provisioning model that is more forward looking and would incorporate a broader range of credit information. This would result in banks establishing earlier recognition of loan losses for the loans they underwrite and could incentivize prudent risk management practices. It should also help address the cycle of losses and failures that emerged in the recent crisis as banks were forced to increase loan loss allowances and raise capital when they were least able to do so.
The Federal Deposit Insurance Corporation (FDIC) used shared loss agreements to help resolve 281 of the 414 bank failures during the recent financial crisis to minimize the impact on the Deposit Insurance Fund (DIF). Under a shared loss agreement, FDIC absorbs a portion of the loss on specified assets of a failed bank that are purchased by an acquiring bank. FDIC officials, state bank regulators, community banking associations, and acquiring banks of failed institutions GAO interviewed said that shared loss agreements helped to attract potential bidders for failed banks during the financial crisis. FDIC compared the estimated cost of the shared loss agreements to the estimated cost of directly liquidating the failed banks' assets and estimated that the use of shared loss agreements saved the DIF over $40 billion.
GAO analysis of metropolitan and rural areas where bank failures occurred and econometric analysis of bank income and condition data suggested that the acquisitions of failed banks by healthy banks mitigated the potentially negative effects of failures on communities. However, the focus of local lending and philanthropy may have shifted. Also, bank officials whom GAO interviewed noted that in the wake of the bank failures, underwriting standards had tightened. As a result, credit was generally most available for small business owners with good credit histories and strong financials. Further, the effects of bank failures could potentially be significant for communities that had been serviced by only one bank or where only a few banks remain.