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PERSPECTIVES ON OPEN BANK ASSISTANCE An Address By L. William Seidman Chairman Federal Deposit Insurance Corporation Before The Government Relations Committee of the Association of Bank Holding Companies September 17, 1986 Washington, D.C. I'm pleased to have the opportunity to join you today and share a few thoughts about FDIC assistance to troubled banks. However, before I begin I must warn you — we're taking the names of those w h o show mor e than idle curiosity a b o u t thi s topic. W h a t I'd like to do is briefly g o over F D I C assistance (Section 13(c)), talk about some of the problems w e face a n d finally p r o v i d e an indication of what to expect from the F D I C in the future. I'll b e h a p p y to e n t e rtain q u e s t i o n s at t h e end. As background, let m e e m p h a s i z e a f e w p r i n c i p a l points. First, things hav e changed since the F D I C formulated its current written policy on open b a n k assistance. T h e n u m b e r of c o m m e r c i a l b a n k failures is up sharply and growing. Unlike past experience, m a n y of today's failures largely result from severe economic conditions— -not incompetent or dishonest management. Second, the vast majority of failures are small commercial banks, a fact which focuses attention on the need for equitable treatment. This goal w a s s o m e t i m e s o v e r l o o k e d in t h e past. Third, a n u m b e r of t r o u b l e d institutions a re subs i d i a r i e s of multibank holding companies. Assistance to such b a n k s presents a series of questions which frankly were not contemplated w h e n our existing policy was written. Among the more significant of these is the treatment and status of h o l d i n g c o m p a n y creditors. Fourth, free enterprise and the desire for market discipline mandate shareholders a n d m a n a g e m e n t a re h e l d r e s p o n s i b l e for t h e i r actions. A s s i s t a n c e policies s h o u l d n o t d i s r u p t this relationship. With these thoughts in mind, let m e provide some history of FDIC a s s i s t a n c e a n d an indication of w h e r e w e a re heading. The FDIC first received authority to assist b a n k s to prevent them from failing in 1950. S uch assistance could b e given only if c o n t i n u e d operation was considered essential to provide adequate banking service in the community. With the number of banks and branches in most areas, essentiality was a p retty tough test. A s y ou might expect, there w as not a significant number of assistance transactions. Of course, there weren't m a n y failures, either. U p until 1982, only five b a n k s o b t a i n e d assistance. Normally, we either arranged a purchase and assumption transaction (P & A) or simply liquidated the b a n k and p a i d off i n s u r e d depositors. Philosophically, the FDIC was opposed to giving assistance— w e thought then (and still do) that it is best if unprofitable institutions are allowed to exit the marketplace. So we provided assistance only in those cases w h e r e the bank was just too big to handle with a P & A transaction (back then the FDIC could not go out-of-state to find a merger partner) and w e were convinced a 1 payoff would have major adverse consequences for the community. Small banks simply weren't eligible for assistance unless there was s o m e o v e r r i d i n g consideration. In fact, the only small b a n k w e assisted w a s Unity Bank, a special case b e c a u s e it w a s a m i n o r i t y - o w n e d b a n k in M a s s a c h u s e t t s . In October 1982, Congress passed the G a m - S t Germain Act. This Act had some pretty important provisions for dealing with troubled institutions. It authorized the n e t w o r t h certificate p r o g r a m , w h i c h w e h a v e u s e d successfully to assist mutual savings banks. It also gave the FDIC authority to look nationwide for bidders for large failed banks. Both tools proved to b e useful, a n d as y o u k n o w t h e y e x p i r e d M o n d a y . More relevant to our current topic, Garn-St Germain considerably expanded our authority for providing direct financial assistance to banks. Assistance could be provided in any case where the cost would b e less than t h a t of closing a n d l iquidating t h e bank. Although this law dearly expanded our powers, the philosophical view was open bank assistance should be avoided except perhaps to facilitate the acquisition of a failing bank. T h e dominant concern w as assistance would r e p r e s e n t a n u n d u e b e n e f i t f or an institution's shareholders. This philosophy was reflected in the Board's 1983 policy statement which established the basic criteria for an assistance transaction. The y are: (1) Executive management, directors, shareholders and subordinated creditors should not receive financial benefit greater than they would have if t h e b a n k h a d closed; (2) Any funds obtained from nonbook sources such as recoveries on charged off assets, b o n d claims, and claims against officers and directors w o u l d flow t o t h e F D I C until a s s i s t a n c e w a s repaid; operate; (3) The bank must obtain new sources of capital sufficient for it to and (4) Assistance must represent the least costly alternative for the FDIC. W e also described a variety of criteria which elaborated u p o n these policies. T h ese policies wer e intended to s u p p o r t o u r b a s i c belief tha t institutions m ust b e allowed to fail; and that shareholders, creditors and u n i n s u r e d d e p o s i t o r s m u s t n o t b e p r o t e c t e d f r o m financial loss. It also made d e a r that active mana g e m e n t and directors should not escape the normal legal and financial liability associated with the inadequate performance of their duties. In other words w e did not, and still do not, w a n t t o bail o u t t h e losers. 2 Under these policies, the F D I C has agreed to provide assistance to only t h r e e b a n k s so t h e y c o uld r e m a i n o p e r a t i n g entities. One was Continental. The other two were approved within the past six months. T hey are The Talmage State Bank— a $10 million institution— and B a n k of Oklahoma. T h e other assistance arrangements were designed to facilitate open b a n k mergers. In r e c e n t months, r e q u e s t s fo r a s s i s t a n c e h a v e i n c r e a s e d significantly. Currently, w e h ave around half a dozen applications f r o m commercial banks under consideration in Washington, plus others in th e field. In addition to these applications we have been approached b y n u m e r o u s other institutions. The most common problems with unsuccessful requests were they were not cost effective or management responsible for the banks' problems would have benefited. Other problems included requests designed primarily to bail out the bank stock lender or shareholders and/or the bank w as not considered in d a n g e r of failing. Today, w e find t h a t w e m u s t m e e t n e w situations a n d d e v e l o p innovative packages to meet the increasing supply of failed and failing banks (150 or more expected this year). W e must deal with failures of units in multibank holding companies and one bank holding companies, large and small. Constructing a lower cost alternative for the insurance fund is an increasing challenge. Given this environment it makes sense for the F D I C to review its policy toward open bank assistance. W e do adhere to the general philosophy bdiind our current policy; but, at the same time, w e want to increase our options for providing open b a n k assistance w h ere it is cost effective and beneficial to t h e stability of t h e system. In this regard our present written policy presents some difficulty. One obstacle is the requirement that shareholders and subordinated creditors (and those standing behind them, holding company creditors) b e n o better off than if t h e b a n k h a d closed. T h i s p r e s e n t s t w o practical problems. One, any program which benefits the bank will eventually provide some benefit to shareholders and creditors. Second, without the opportunity for some marginal benefit, shareholders and creditors will h a v e n o incentive to consummate an assistance transaction which could result in substantial savings for the FDIC. Thus, while w e consider a bailout clearly inappropriate, a total wipeout is not always in the insurance fund's best interest. N o r is it a l w a y s justified. Assistance transactions are particularly difficult in holding company situations. Our underlying philosophy is there is an obligation on the part of the whale organization to the health of each affiliate. T h e failure of one bank within a holding company could well lead to the failure of other banks in the organization. Problems should not b e viewed on a stand alone basis. 3 In that respect w e anticipate shareholders and creditors of t he holding company will share in some of the loss, not unlike w hat would have occurred if one of the b a n k s in the holding c o m p a n y failed. But again, a total wipeout is not required. This would not necessarily b e t he likely result if only one ailing subsidiary bank failed. Thus, the F D I C should seek a contribution from the holding company to reflect the equivalent of failure of a part of the holding company. And, that contribution m ust b e significant. Two recent examples demonstrate some of the problems and alternative approaches to dealing with failing b a n k s a n d t h e i r h o l d i n g companies. Recently, the First National B a n k of Oklahoma failed. In this case an open b a n k assistance transaction w as explored but the effort was n ot successful. Quite frankly, the institution ha d deteriorated significantly. The failed bank was the principal asset of the parent holding company. Thus, the interests of holding company shareholders and creditors in the b a n k were virtually eliminated. This demonstrates a key point. Creditors of a holding co m p a n y are not in t he same position as creditors of a bank. T h e y are in a position similar to b a n k shareholders. Let me compare this approach to the one used for t he Oklahoma City based Bank of Oklahoma. At Bank of Oklahoma, the holding company was highly leveraged and because of operating losses could not raise n e w funds in the marketplace. The subsidiary bank accounted for only 20 percent of the holding company's consolidated assets. It was about to fail. T h e recognized inability of the holding c o m p a n y to deal with the situation b e g a n to cause funding problems at the lead b a n k in Tulsa. If the Oklahoma City b a n k h a d failed, liquidity pressures could well h a v e lead to the failure of other affiliated banks. What w e agreed to do is assume $40 million of the bank's loans from the Federal Reserve and also purchase $90 million of cumulative convertible preferred stock. In return the FDIC will receive warrants at a nominal price r e p r e s e n t i n g 55 p e r c e n t of t h e b a n k h o l d i n g c o m p a n y ' s stock. Provided the FDIC's preferred stock is redeemed, the holding company may repurchase up to 80 percent of the FDIC's warrants at a price which repays most of our $40 million loan. The remaining 20 percent remain with the FDIC. In addition, dividends will not be paid on stock of the parent holding company for an extended period. The basic idea was to structure a transaction that provided temporary capital along with incentives for the holding company to repay the FDIC. Failing that, shareholders would suffer substantial dilution. Moreover, creditors of the holding co m p a n y agreed to convert $23 million, or just over 30 percent of their debt, to a capital instrument. They will earn no interest for three years and a below market rate thereafter. 4 Negotiations on this transaction resulted in severed n e w twists to o u r e x i sting policy statement. The FDIC did not take out assets as a part of the assistance plan nor did w e obtain first rights to recoveries from charged off assets. Incentives were provided to the b a n k to maximize revenues from edl sources, through penalties which increase with the amount of time that FDIC assistance remains outstanding. There was a small amount of widely o w ned subordinated debt in the bank. These creditors did not suffer the loss they probably would have experienced had the bank failed (because there was n o w a y to negotiate such c o n c e s s i o n s o n a t i m e l y basis). Assistance clearly appeared to b e least expensive route for t h e FDIC. It helped preserve the value of both the b a n k and t he entire holding company system. At the same time it was not a free ride. Shareholders and line b a n k c r e d i t o r s all g a v e material concessions. In conclusion, let m e s u m m a r i z e w h e r e w e are. Recent open bank assistance transactions have been considered for the following reasons: One, they provide the opportunity for substantial savings to the i n s u r a n c e fund. Two, they provide a mechanism for keeping loans and other assets within the banking system. Borrowers will b e deeding with bankers, not liquidators. Three, they can minimize the disruption to the local community which results f r o m b a n k failures. However, these advantages h a v e to weighed against the substantial disadvantages of the FDIC's short term (hopefully) involvement in the private sector t h r o u g h its o w n e r s h i p of warrants, p r e f e r r e d s t o c k or loans. Thus, Section 13 assistance to o p e n b a n k s i n v o l v e s a c o m p l e x situation in which advantages and disadvantages must b e weighed b y t h e Corporation. The Board of the FDIC will b e considering these factors as it deals with further policy statements in the area of open b a n k assistance. 5