One of the recurring questions this year has been whether it is realistic to count on regulatory supervisors and auditing firms to catch risky financial practices in banks. In general, the answer seems to be no: bank personnel can too easily conceal the extent of risks they are taking, not just from outside observers, but from bank executives and internal auditors. That view was reinforced in the Fed’s handling of JPMorgan’s high-risk derivatives trading which nearly brought down that bank in 2012. Bank examiners knew in 2008 of the trading risks JPMorgan was taking, but never followed up nor shared their concerns with others at the Fed and the O.C.C. By 2011 regulators had forgotten about JPMorgan’s high-risk trading, and in the meantime, the bank’s traders in London kept raising the stakes on their bets.
A Fed Office of Inspector General report laments the lack of coordination and continuity, but even assuming those problems had been overcome, it is no sure thing that a follow-up examination would have discovered the scale of the risks the bank was taking. And even if they had known everything, it is hard to imagine that regulators would have intervened to prevent the bank’s near-death experience. Wall Street banks in general were taking enormous trading risks between 2009 and 2011 in the hope of earning enough to cover their respective financial shortfalls. For a time this worked, as the markets moved generally in only one direction. The Fed must have known in a general sense of the extent of risks banks were taking, but opted to cross its fingers and look the other way — a policy approach confirmed in leaked New York Fed tapes last month that showed examiners unwilling to confront equally serious shortcomings at Goldman Sachs. The Fed must have worried, along with the rest of us, that careful, prudent bank management would not be enough in a financial sense to keep Wall Street going.
Of course, hoping for the best is hardly a strategy for avoiding a global financial calamity in the future. The need for reform is obvious, but even the Fed Office of Inspector General has little to suggest. Its ten recommendations are well taken but offer nothing to ward off the next giant bank trading debacle, whether at JPMorgan or elsewhere. As long as banks are governed by the too big to fail policy, in which a giant bank is all but guaranteed to be kept together even in bankruptcy, it is hard to see what anyone can do to get banks to take their financial risks literally.
Too big to fail may have been written into formal policy, but that does not mean that policy cannot change. On Monday New York Fed president William Dudley suggested that regulators and legislators may be forced to break up the giant banks if Wall Street’s casino culture cannot be reformed.
There was a billion-dollar bank failure tonight, the largest in a year, though perhaps not really as large as its financial size would suggest. The O.C.C. closed National Republic Bank of Chicago. State Bank of Texas has assumed the deposits and is purchasing two thirds of the assets. The remaining assets are not available for purchase because they are tied up in bankruptcy litigation, as I will explain in a moment.
The failed bank specialized in loans to hotel operators, most in New York and Illinois, and this approach became a problem by 2011 as the hospitality business was slow to recover from the recession. By 2013 the bank had completely stopped making new loans as regulators pressed it to improve its capital position. After years of impressive profits, the bank posted losses of more than $100 million between 2012 and the first half of 2014. The bankruptcy of the bank’s largest customer, the owner of 34 hotels who owes on a staggering 21 percent of the bank’s portfolio, left it with few options. The O.C.C. issued a series of orders for the bank to improve its operations, which led eventually to the removal of the bank’s president in July. That order gives little insight into the unfolding drama inside the bank at that time, but there must have been some inkling of danger to the bank, as the order gave the president only 24 hours to clear out his desk and turn in his badge.
Now that the bank has failed, the FDIC will likely seek to seize the hotel properties of bankrupt borrowers, putting their respective bankruptcy reorganization plans in doubt.
Illinois has seen more than its share of bank failures this year, with five of the national total of 16.