Last week, California-based IndyMac became the largest bank to fail in two decades after a bank run depleted its deposits. Now, the Federal Deposit Insurance Corp.—which took over what’s left of IndyMac—says that 90 financial institutions are on its secret list of “problem” banks. How does a bank end up on this secret list?
By getting a bad rating, based on its financial situation and visits from inspectors. Every few months, federal regulators issue banks a “CAMELS rating” that goes from one (for the safest banks) to five (for the most suspect). If a bank scores either a four or a five, then it’s included on the list the FDIC compiles each quarter. (See Page 4 of this document [PDF] for the most recent disclosure of the size of the list and Page 20 for a brief discussion of the rating system.)
The exact data that go into a CAMELS rating are kept secret. (The acronym stands for capital, assets, management, earnings, liquidity, and sensitivity to market risk.) But the evaluation probably makes use of some information that’s available to the public, like the size of a bank’s “nonperforming assets“—loans and obligations that aren’t getting paid back—and whether it has enough capital to deal with unexpected losses.
The FDIC won’t release its problem list, and a bank isn’t allowed to disclose its CAMELS rating, either. One major reason is that if the public knew which banks were in trouble, the likelihood of a “bank run” might go up. A run occurs when a bank doesn’t have enough cash in its reserves to pay all those depositors who want their money back. To understand how this happens, start with a basic concept behind our banking system: A financial institution is required to keep only a small fraction of its deposits in reserve. This system allows banks to “multiply” the amount of money in circulation—increasing the amount available for investors to borrow, for example, and consequently stimulating economic activity. But it also means that if every depositor decided to liquidate his or her savings on the same day, the bank wouldn’t be able to make the payouts.
Under normal circumstances, this almost never happens. But if a bank’s customers believe that a bank is at risk of going under, they might rush to move their money elsewhere. This could happen because the bank is genuinely in trouble—say, it made a lot of bad mortgage loans. But even an entirely healthy bank can go under if enough depositors believe it to be unsafe. (For more on that case, read this classic paper [PDF] on the topic.) The FDIC was established during the Great Depression to limit the likelihood of a run: By offering insurance on deposits—up to $100,000 per depositor, in most cases—it makes people feel more secure in leaving their money in the bank. So, while bank failures still happen—at an average of just under five per year over the past decade—runs aren’t very common. In IndyMac’s case, the bank’s problems stemmed from bad mortgage loans, but some regulators also blame the run on a public letter from Sen. Charles Schumer expressing concerns about the bank.
Even though you can’t see the problem list, there are other ways to check on your bank’s health. In addition to the financial filings the banks make with the FDIC, private firms like Bankrate have their own models that rank financial institutions using similar methods. And the mere fact that a bank shows up on the FDIC’s trouble list doesn’t mean it’s likely to fail. According to research by FDIC economists (PDF), only a small percentage of the banks on the list actually go under. Changes in the banking industry may also make it more difficult for regulators to accurately model the risks of bank failure: After all, banks were once considered safer if they owned a lot of mortgages. That may explain why IndyMac wasn’t on the FDIC’s trouble list as recently as March 31.
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Explainer thanks Douglas Diamond of the University of Chicago, John McCune of SNL Financial, Timothy Yeager of the University of Arkansas, and Bruce Zanca of Bankrate.