One of the reasons BankUnited failed in Florida last week was that it paid too much in interest. It’s a well-known pattern, going back at least to the 19th century, that banks that are financially weak may think to offer especially high interest rates to attract more depositors and build a stronger deposit base. Yet the high interest payments weaken the bank’s financial position further. This quickly becomes a downward spiral and in the worst case can become a Ponzi scheme, if the bank becomes so weak that it becomes impossible to pay back all the depositors. BankUnited in the end was uncomfortably close to this outcome, and that was one of the reasons it had to be closed down.
High interest rates on deposits are a red flag for banking regulators, and the FDIC specifically prohibits them for banks that are in a weak capital position. The FDIC tightened this rule today. Starting next year, banks that don’t have enough capital will essentially be prohibited from paying above-average interest rates. These rules affect only banks that are “less than well capitalized,” currently about 1 bank in 33.
The limitation on deposit interest rates reduces the competition between banks and should make banks generally more profitable, at least in theory. In specific communities, the rule could prevent a poorly capitalized bank from drawing deposits away from a healthy bank and perhaps causing both banks to fail. Instead, a struggling bank is forced to find ways to improve its operations and make a profit in order to improve its financial condition.
The Quarterly Banking Profile released this week by the FDIC did not seem to depict an industry in crisis when you look at the financial aggregates, but the loan portfolio is another matter. The percent of distressed loans is the highest it has ever been in the 25 years the FDIC has been keeping these statistics. Less than three years ago, the percent of distressed loans was at historic lows, but since then, the quality of bank loans has deteriorated at the fastest pace ever recorded.
This is one of the reasons the banks are shrinking. Banks are not making quite so many new loans, and the number of people working in banking is 4.4 percent less than a year ago.