Wednesday, September 2, 2009

The Bank Failure Rumor

Yesterday’s U.S. stock market decline has been blamed on a rumor that a major bank was insolvent and might close or might need an emergency bailout. People have been asking me what the story is.

I first have to say that there are plenty of reasons why the stock market might decline: the decline in the economy, for instance. So it is entirely possible that the bank failure rumor was planted as an excuse for a stock market that was going to decline anyway.

The stock market aside, though, the suggestion that a large bank is in financial distress is entirely correct. You do not have to speculate to say that. Three of the six largest bank failures in U.S. history have occurred since last year, and this wave of bank failures is just getting started. Most of the 50 or 100 largest banks in the United States and maybe a third of the smaller ones are in some degree of trouble right now, and the economy will get worse before it gets better.

The only thing that can save a large bank in a state of financial collapse is large sums of money. That money can come from the bank’s own operating profit, from private investors, or from the U.S. Treasury. Unfortunately, there is little hope for an operating profit for the banking system as a whole over the next three years, as the credit contraction continues and loan losses work their way through the system. There is some private investment money out there still, but not much; that financial reservoir is pretty well tapped out at this point. Congress, for its part, is hardly eager to make the Wall Street bailout an annual occurrence. And so, it is hard to imagine that all of the remaining large banks in the country will squeak by somehow for the next three years.

And the prospect of additional bank failures is not anything to be overly concerned about. If yesterday’s 2 percent stock market move was based on the thought of a single bank failure, regardless of how large that bank might be, it was an overreaction. The dim profit prospects that many banks face in the coming years are already largely reflected in their stock prices. If a series of large bank failures were to occur, it could slow down some important businesses, but it will not kill off many businesses or strike any kind of major blow to the economy. It could even be beneficial, at least for the banking sector. Zombie banks, the hapless banks that just keep bleeding money, are eating up most of the deposit base that could otherwise be available to relatively healthy banks. If deposits end up moving from zombie banks to other banks that have a fighting chance of survival, it makes it much easier for those banks to keep going.

The bottom line: More bank failures are on the way. Observe the deposit insurance limits. Reduce your cash levels if necessary by making payments before the due date. Beyond that, don’t worry about it. Banks may fail, Wall Street may never be what it was before, but the banking system will be fine.