Crisis Retrospective

The Cost of Selling a Failed Bank

During the crisis, the FDIC sold 500 banks… So, what did we learn?

 MIT Sloan researcher’s study of FDIC bank sales during the financial crisis finds auctioning banks can bring risk and expense

CAMBRIDGE, Mass., February 26, 2015—When a bank fails, the Federal Deposit Insurance Corp. takes the bank into receivership and auctions it to the highest qualified bidder. During the financial crisis and recession that followed, the agency sold nearly 500 banks, many of them important institutions in their communities and regions.

What happens when a bank is sold? Is the new owner likely to be in a position to resurrect it? How much money does the FDIC lose? And is selling a failed bank the best strategy when other options, such as injecting capital or liquidating assets, also are available?

MIT Sloan Assistant Professor Joao Granja, with Gregor Matvos, and Amit Seru of the University of Chicago explore these questions in a working paper, “Selling Failed Banks,” – the first major academic study on the bank sales that accompanied the recent financial crisis.

The researchers compiled data on all FDIC sales between 2007 and 2013 and analyzed the information using probability models and other techniques. They reached several important conclusions:

  • Buyers of failed banks tend to be local. Some 84 percent of banks that failed in the crisis were sold to buyers in the same state. A third of failed banks went to buyers in the same zip code.
  • Buyers tend to be in the same field as the bank they acquire. A bank that specializes in residential real estate is most likely to acquire a bank focused on residential real estate and is unlikely to buy a bank specializing in unrelated fields, such as construction loans.
  • Bank failures often are triggered by local economic conditions, which means that sometimes there are no sufficiently capitalized local buyers for a failed bank. In these circumstances, the FDIC sells the bank to a less qualified bidder, located far from the failed bank or in a different banking specialization.
  • When no well-capitalized local bidders are available, banks are sold to outsiders and that implies higher costs for the agency and less qualified new owners for banks.

“Bank sales have economic importance for the public at large,” Granja said. “When banks fail, there are implications for the communities in which the banks are located and the structure of the banking markets in these regions.”

Bank failures are a rare occurence… normally

Over 50 percent of the banks that failed were small community banks with significant relations and ties to their communities

Under normal economic conditions, bank failures and sales are rare. FDIC sales averaged about five annually for most of the 1990s and early 2000s. The financial crisis set off a wave of bank failures. Some that collapsed during this period were large institutions, such as Washington Mutual and IndyMac, while others were small and medium-sized.

“Over 50 percent of the banks that failed were small community banks with significant relations and ties to their communities. When these banks fail, these relations between borrowers and lenders are severed, which hurts the ability of firms and households in those communities to obtain financing.” Granja said. One of the most important conclusions of the paper is that banking remains very much a local business.

The researchers analyzed data on these sales and found that local banks that also have significant relations and local knowledge of the community are more likely to acquire the failed banks. The researchers concluded that “soft information” about local real estate markets, gleaned from being physically present in markets, is a key determinant in this process. “Even with new technologies, the banking business is still very much a people business,” Granja said. “The private information a banker gathers from clients from interacting with them daily is very important.”

Economic shocks ripple through…

Problems arise, though, when no local bank or bank in the same line of business is qualified to buy a failed bank, the researchers found. Economic shocks that cause a bank to fail affect nearby banks too, which means that local banks don’t have the capital to acquire a failed bank.

“If the best suitors are not available, someone further away has to come and take over the failed bank and that bank is not going to be willing to pay as much to the FDIC,” Granja said. The bank sales triggered by the financial crisis put a significant burden on the FDIC, which guarantees deposits. The agency’s deposit insurance fund lost $90 billion in the crisis. The cost to the FDIC in bank sales averaged 28 percent of the failed banks assets, according to the researchers. Granja said the study should be useful to policymakers devising strategy for the next time there is a surge in bank failures.

Options include bailing out banks through capital infusions and selling their assets piecemeal. “Selling banks may not always be the best approach,” Granja said. “We think it is important to understand the costs and benefits of each strategy.” Joao Granja is Assistant Prof. of Accounting at the MIT Sloan School of Management