37,000 banks, 5,000 bank failures, 158 years. That’s the stuff of dreams, if you are a researcher at the New York Federal Reserve.
Liberty Street, the NY Fed blog, has just published a series of excellent posts about what this treasure trove of data can tell us about bank failures, and that is a lot.
First, bank failures have some things in common:
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As early as four years before their failure, the failing banks showed increasing losses and deteriorating solvency
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They increasingly relied on expensive (noncore) funding
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They followed a boom-bust growth pattern
Second, the opposite seems true as well. If a bank is on a downward trend for solvency, is relying more on noncore funding, and has had rapid growth that is now reversed, there is a higher chance that it will fail within the next three years.
In other words, there is not only correlation, but also causality at play.
Third, most often the bank has only itself to blame. Runs get a lot of press and we-would-have-survived-if-only-the-depositors-hadn’t-fled.
That’s not what the data shows.
Even in the pre-FDIC days, when bank runs were more common, more than 80% of the bank failures cannot be ascribed to jittery customers pulling their savings.
However, it is true, both then and now, that depositors are sticky until it becomes apparent (through rising insolvency) that the bank is heading for Fail Town and then it all happens at once.
Alas, liquidity means little without solvency, or might even be contrary because short-term liquidity can be very expensive and only seem to temporarily duct-tape foundational cracks in the balance sheet.
As much as this data is beautiful in itself, it would, of course, be next level if we could turn it proactive. The authors of the posts and the underlying paper have some ideas such as using the bank failure commonalities as early detection metrics, and if the flags go up, tell banks to take corrective measures such as strengthening solvency and reducing funding costs. And how can banks do that? Surprise, surprise, they can hold more capital relative to their risk-weighted assets.
Just as we shouldn’t equate correlation with causality, we shouldn’t equate how banks fail—they become insolvent—with why they fail, which can be due to many reasons and some of them only apparent in view of the past 158 years.
One is reminded (because one’s mind makes leaps and bounds) of the quote by Søren Kierkegaard:
Life can only be understood backwards; but it must be lived forwards. (1843)
Source: Correia, Sergio, Stephan Luck, and Emil Verner. September 2024. “Failing Banks.” Federal Reserve Bank of New York Staff Reports, no. 1117, https://doi.org/10.59576/sr.1117
Regitze Ladekarl, FRM, is FRG’s Director of Company Intelligence. She has 25-plus years of experience where finance meets technology.
This article is part of the FRG Risk Report, published weekly on the FRG blog. To read other entries of the Risk Report, visit frgrisk.com/category/risk-report/.